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When incorporating a start-up company, founders are typically concerned with growing their company and bringing in capital to execute their vision. To properly set the company up for growth, the company needs to have a sound policy for allocating equity. There is not just one correct way for all start-ups to allocate their stock. Rather, there are many considerations that founders must address. The path to a sound corporate equity structure starts from the very beginning. Even before incorporation, meet with your co-founders and discuss these issues to ensure you start the right way.
After determining the amount of stock your company will authorize, which is the total amount of issuable stock, you will decide how much stock each founder will receive. The number of stock issued to each co-founder should be catered to each co-founders’ involvement and relationship with the company. If one of the co-founders has a passive role in the company’s business operations, it may not make sense to issue them the same amount as someone more involved. Although this may be a difficult discussion to have with your co-founders, it ensures that the ownership of the company rests with the members closest to it.
After determining the appropriate amount of stock each founder should receive, founders will need to execute some form of a stock purchase agreement. This agreement will dictate the terms of each founders’ ownership in the company. The value of each share at an early-stage company will likely be very low, so the purchase price will be small, but it is integral to enter into this agreement.
In these agreements, companies should consider whether they want to include provisions like right of first refusal, IP rights, limitations on transfer, vesting schedules, and other language that will solidify the boundaries of a given shareholders’ interest. A right of first refusal provision will give your company the initial right to buy stock from an existing stockholder that is planning to sell their interest before they can sell it to any other buyer. IP rights provisions will dictate what intellectual property will belong to the company after a stock purchase. Limitations on transfer can include many different provisions that essentially prevent the purchaser from selling their stock unless certain conditions are met. Vesting schedules are discussed below.
Founders should determine whether to implement a vesting schedule into their issued stock. A vesting schedule is a time-based restriction to issued stock, typically applied to founders’ and employees’ stock. It incentivizes critical members of the company to stay for the long-term by preventing the member access to all their issued stock until they have been at the company for a certain amount of time.
Founders may feel like a vesting schedule is an unnecessary restriction on their interest in the company but there are a few reasons that implementing a vesting schedule is a good idea. First, potential investors love, and often request vesting schedules. From the investor’s perspective, a vesting schedule provides some assurance that the company’s key members are in it for the long haul. Second, a vesting schedule also provides an assurance to co-founders. It may seem unlikely that any of your fellow founders would abandon the company, but it is helpful to provide an extra incentive to make sure.
It is also important to decide how many of the corporation’s authorized stock will be available to issue and how many will be saved for later issuance. As your company grows, you may want to offer employees some type of equity package as compensation. To do so, you would want to set up an option pool that you can eventually pull from. Typically, an option pool should make up about 10-20% of total authorized stock, with the remaining stock allocated among founders, advisors, and investors. It is crucial to decide on an option pool early on because it will dictate your corporation’s total available stock.
Start-up companies usually benefit from hiring advisors or consultants that are not typical employees but have some sort of expertise that brings value to the company. Allocating equity to advisors is a practical consideration because the start-up may not have enough money to pay a typical compensation and it can be attractive to investors. Since advisors will usually not be involved with the management of the company, they will not be issued a large portion of the company’s stock. When deciding to bring on advisors, consider the value that they are adding and how much time they will be dedicating towards the company, and allocate stock accordingly.
A capitalization table, or cap table, is a document (usually on a spreadsheet) that provides a layout of the company’s ownership distribution. After tackling the equity issues raised in this article, it is important to keep an updated cap table that documents how your company has allocated its stock and to whom they allocated it to. Therefore, the table will include all the stockholders, how much they own, what type of stock they own, how much stock the company has issued and how many are still available for issue.
There are several different software platforms that you can use to store your equity documents and produce a cap table for you. Carta and Pulley are two examples of commonly used platforms. The best way to make sure your cap table is properly constructed and regularly updated is to hire a law firm to manage this platform for you. Hiring a law firm administrator is especially helpful for start-ups engaging in multiple financing rounds because expressing the specific terms of each financing instrument can be difficult.
You should consider hiring Lloyd & Mousilli to successfully implement your company’s equity allocation plan. Our firm has helped form hundreds of startup companies, and we have the experience and expertise necessary to set your company up for past, present, and future equity allocation.