Capitalization & Stock Allocation
Does an industry standard exist for dividing equity among founders?
First-time entrepreneurs typically struggle during the company formation stage with the concepts and process involved in initial capitalization and stock allocation to founders. Experienced attorneys can provide guidance; however, there is no industry standard for dividing equity among co-founders.
When stock is initially awarded to more than one founder of technology-based companies, the division of equity ownership should be based (ideally) on a mix of the individual’s relative past and expected future contributions in certain key areas.
Elements of consideration in dividing founder's stock:
- Capital invested in the company
- Scientific leadership in the company’s field of interest
- Inventions or copyright that are expected to result in intellectual property
- Respective “sweat equity” invested to date
- Strategic value and level of participation going forward
Since these measures are very difficult to quantify, it usually comes down to a number that, among the interested parties, “feels right.”
However, you may want to first attempt to quantify the relative contributions of the prospective founders before applying the sanity test above. An excellent tool, called The Founders’ Pie Calculator has been provided for this purpose by Frank Demmler, an Associate Teaching Professor of Entrepreneurship (Donald H. Jones Center for Entrepreneurship at the Tepper School of Business) at Carnegie Mellon University. Demmler’s method allocates a certain amount of credit to contributions that may have already been made, and another portion to the many more things that need to be accomplished going forward.
And, things don’t always go as planned. Demmler (also an experienced VC) believes founders should, at the outset, “…consider equity ‘fairness’ in a context broader than the here and now”, and should consider these recommendations for a Founder Share Buyback Agreement as a minimal element of founder “pre-nups”.
An attorney or tax accountant should be consulted regarding the total number of shares that should be issued in the initial capitalization of the company, the price per share that should be paid by each founder, as well as the determination of the “cost basis” for the initial stock awards. You would also be advised whether or not an “83(b) election” should be taken, which refers to a U.S. tax code option that allows payment of taxes on the value of the stock when awarded (which may be justified as being worth very little at the formation stage), versus paying taxes on the gains as the stock is earned, or “vested”, in increments over time.
Even though it doesn’t have to be structured this way...
Downstream investors in the company will prefer to see that founders stock is being earned over time, just like the stock awards that will be established for follow-on employees.
NOTE: Scheduled vesting of founders stock provides an incentive for all founders to remain with the company for a reasonable period of time, and protects the remaining founder(s) if one or more leave early during the development stage of the company.
Founders stock should typically vest over a two to four year period. Stock awards to subsequent employees typically vest over four years, sometimes with a one-year “cliff” (meaning 25% vesting at the one-year anniversary, followed by pro-rated monthly vesting thereafter).
What about employee stock options? Is it necessary to include them in the initial capitalization?
Your attorney will offer guidance regarding the total amount of stock that should be initially established as “authorized” shares. From this, you will allocate and issue the major portion as grants to the founders, but should reserve a “pool” of stock that will be used as incentives for future employees.
Employee Stock Options
These shares will be granted eventually to employees (as well as advisors, directors, etc.) as “options” to purchase stock over an extended period of time, but at a price (market value) that will be established at the point of such grant awards. The allocation of the stock option pool normally varies between 10% and 20% of the total authorized shares. Some founders elect not to establish an option pool at the point of company formation in order to delay the “dilution” of founder ownership that results from this reservation of stock.
NOTE: Careful thought should be given to this decision, because you may need the availability of stock options (prior to the commencement of hiring employees) as an alternative to cash in compensating advisors, consultants and other early service providers who may be willing to accept the options in lieu of cash.
If your intention is to seek angel or venture capital in the near term...
Such investors will insist that you create in advance an option pool of the size range noted earlier, so that they do not have to absorb such equity dilution following their investment.
And, you would also have to pay an attorney to re-capitalize the company, so it’s generally preferable to establish the option pool at the outset.
What is a Capitalization Table?
A record of stock ownership, referred to as a capitalization or “cap” table is maintained by the company’s Chief Financial Officer, Controller, corporate attorney, or hired accounting firm in a spreadsheet document that reflects the record of company stock ownership. The example below reflects a simplified allocation of stock that might occur at the company formation stage.
Three co-founders form a company called NEWCO. Each founder will be working full-time and has an equally-important role, so the founders stock is divided equally among all three. Additional management talent will be needed in the near future, therefore 20% of the authorized shares will be set aside in an option pool.
In this scenario, with an assumed authorization of 12,000,000 shares, the Cap Table is quite simple:
|NEWCO Capitalization Table|
|Shareholders||Issued Common Stock||Full-Dilution Ownership|
|Total # of Shares Authorized||12,000,000||100%|
This simple example assumes the founders are fully vested in the shares that have been granted to them, and that the option pool eventually will be fully distributed. Even though the founders are the only initial shareholders, and each owns 33% of the currently-issued shares, the option pool must be included in the calculation of the “fully diluted” ownership position of each shareholder.
The company’s Board of Directors can authorize additional shares to be made available for issuance to future investors.
Following each round of financing a re-calculation of ownership will be performed that will reflect the reduced percentage ownership of each pre-existing shareholder...
Assuming the company’s total value is continuing to increase, the reduced percentage of ownership usually still equates to an overall growth in the total value of the stock being held.
This is especially true if the investor takes advantage of the opportunity to continue purchasing stock in each new round of financing. The Cap Table becomes quite complex as progressive rounds of financing occur and the list of shareholders grows, so a professional accountant (employee or service provider) must be responsible for maintaining this important capitalization history.
For more information on this subject, go to Raising Capital.