Company Setup and Initial Ownership

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Company Setup and Initial Ownership

In this section we will begin our example of a fictional company to explain some more key concepts, and illustrate how valuation and dilution effect ownership as represented in the cap table, starting with the initial company setup.

exampleJoe and Pete started a software company, Pext, Inc., which is developing an app to help pets send and receive texts. They retained a well-known startup lawyer who incorporated their company in Delaware and helped them assemble and execute all of the correct documents with respect to the formation and organization of the company. The corporation was initially authorized under its charter to issue a total of 30M shares, 25M shares of common stock and 5M shares of preferred stock. Thus, the company had a total of 30M authorized shares.

The Stock Option Pool

The stock option pool is a specified number of shares set aside and reserved for issuance on the exercise of stock options granted to employees under a stock option plan or an equity incentive plan. Equity incentive plans have more awards available under them to issue than stock options (they also have stock bonuses, restricted stock awards, and sometimes other types of awards as well). The shares reserved under an equity incentive plan should be reflected on the cap table. Options are granted out of the pool via grants that are approved by the board. Each grant reduces the remaining available pool, until it is topped up again by the board authorizing the reservation of additional shares under the plan from the authorized shares. The strike price is the exercise price of the stock option.

important Because stock options can be executed to purchase stock, they need to be accounted for in the cap table; and the stock option pool impacts both the percentage ownership calculation and potentially the price per share, as we will see below.

founder When a company is founded, the founders are wise to set aside 10-15% of the equity in an option pool for future new hires, contractors, and advisors. Over the first few years that equity gets allocated to the new hires, members of the board of directors, advisors, and independent contractors. When the company goes to raise money, savvy investors will want to see that option pool topped up to 10% or 15% again in anticipation of the company hiring many more employees.

Why does the stock option pool need to be so big? The earlier the stage of the company and the more senior the employee, the more equity that employee will demand. Bringing in a seasoned CEO to a very early-stage company (if one of the founders is no longer going to be the CEO) may require giving them 10% of the equity, likely vesting over four years. That is the high end, but even an experienced senior engineering lead or sales executive might command 2%-3% of the equity.* Steve Ballmer received 8% of Microsoft stock when he joined as the 30th employee, and now owns more of the company than Bill Gates. Smart CEOs track a budget of equity for employees, directors, and advisors. That stock gets allocated via stock option grants approved by the board of directors. As the company matures it needs to give out less stock to each employee, even senior ones, but the number of employees it is hiring is also increasing.

When investors are doing diligence on a company, one thing they check is how many shares (options) are left in the stock option pool. A case is often made that this pool needs to be topped up before the investment or as part of the investment. We will see the impact of this as we follow our example company.

exampleAfter agreeing on their relative proportionate stock ownership in the company (60% to Pete and 40% to Joe), Joe and Pete also set aside 15% in an equity incentive plan (commonly referred to as a stock option plan) for future advisors, contractors, and employees. Pete and Joe allocated a total of 10M shares to the cap table, including 1.5M for the stock option plan. They did not issue all of their authorized shares, because they needed to reserve out of the authorized but unissued shares at least enough shares to cover potential future co-founders, investment rounds, and a possible topping up of the stock option pool. Pete and Joe each bought their respective shares of stock from the company at a fraction of a penny per share. Immediately after these stock issuances, there were 8.5M issued and outstanding shares, and 10M shares on a fully diluted basis (counting the entire option pool share reserve).

Figure 1: The Initial Cap Table

Shares or OptionsIssued and OutstandingFully Diluted
Pete5,100,00060.00%51.00%
Joe3,400,00040.00%34.00%
Issued and Outstanding8,500,000100.00%
Option Pool1,500,00015.00%
Total Fully Diluted10,000,000100.00%

You can see in the table the difference in the ownership percentages based on the two different ways to calculate it (bold numbers represent the inputs driving the calculations). The first column represents calculating a founder’s ownership as a percentage of shares outstanding; the second column shows the calculation on a fully diluted basis taking into account the option pool. While this may seem like a mundane distinction, we make a point to call it out because it comes up in terms sheets for priced rounds. You do not measure someone’s percentage ownership by reference to the total number of shares the corporation is authorized to issue. The various different approaches to calculating ownership will come up when discussing how much of the company investors are going to own after they put their collective money in. Thus, the fact that the company is authorized to issue as many as 25M shares of common stock is irrelevant to determining a founder’s percentage ownership. The company could be authorized to issue 1B shares; it would not matter.

Dilution From Adding a Co-Founder

The simplest example of dilution comes from adding another co-founder. This is different from adding another employee, which we will explore below. It is similar to the impact of selling shares in a priced round, but we will save that discussion for further on in our example so that we don’t tackle too many variables at once!

exampleJoe and Pete decide to add a technical co-founder, Rachel. After negotiation, the parties agree that Rachel will receive 15% of the company. Rachel buys her shares directly from the company out of the corporation’s authorized but unissued shares.

Figure 2A: Co-Founder Gets 15% Ownership Calculated As a Percentage of Issued and Outstanding Shares

This is what the cap table looks like after Rachel purchases stock from the company such that she owns 15% of the issued and outstanding shares.

Shares or OptionsIssued and OutstandingFully Diluted
Pete5,100,00051.00%44.35%
Joe3,400,00034.00%29.57%
Rachel1,500,00015.00%13.04%
Issued and Outstanding10,000,000100.00%
Option Pool1,500,00013.04%
Total Fully Diluted11,500,000100.00%

Note that the number of shares Rachel is issued to reach 15% is calculated prior to taking into account the dilution of the option pool. If Rachel was super savvy on dilution, she might have tried to negotiate a 15% ownership after taking into account the option pool—that is, on a fully diluted basis. Or, in other words, she could have asked Pete and Joe to bear the dilution from the option pool—not her. Smart investors often ask for their ownership to be calculated on a fully diluted basis (meaning, for the pre-existing owners to take the dilution hit for the option plan shares set aside). You can see the impact of this change in the calculation below.

Figure 2B: Co-Founder Gets 15% Ownership on a Fully Diluted Basis

Shares or OptionsIssued and OutstandingFully Diluted
Pete5,100,00049.68%43.35%
Joe3,400,00033.12%28.90%
Rachel1,765,00017.19%15.00%
Issued and Outstanding10,265,000100.00%
Option Pool1,500,00012.75%
Total Fully Diluted11,765,000100.00%

Rachel ends up with an additional 265,000 shares by changing how she defines her 15% ownership. This is exactly how it works with investors as well. The advantage that Rachel gets in this latter calculation comes at the disadvantage of the other (prior) owners.

Since Pete and Joe are savvy negotiators too, they make the point that it makes sense that all founders should be subject to dilution from the option pool. So our example will continue on from Figure 2A.

As you can see from this simple example so far, when the company issues additional stock to founders or (later) investors out of its authorized stock, it dilutes the ownership of the existing stockholders. They own the same number of shares, but their percentage ownership of the company goes down.

Dilution occurs when a company issues new shares (other than in connection with a stock split or other adjustment affecting all shareholders in the same way). Shares may be issued for any of the following reasons:

  • An additional founder may join who will get a significant share of the company.
  • Shares may be purchased by investors.
  • The company may increase the number of shares reserved for issuance under its equity incentive plan, or adopt one or more new equity incentive plans.
  • The company may issue shares or other convertible securities to lenders, strategic partners, landlords, and similar persons.

Dilution From Adding an Employee

When a company hires an employee and gives them stock options as part of their compensation, they usually issue the options out of the shares reserved for issuance under the company’s stock option plan (not the company’s authorized but unissued shares).

Joe and Pete hire a very experienced head of marketing and give them a stock option to purchase 3% of the company.

To translate the 3% of the company into a number of shares, Pete and Joe multiply 3% by the company’s issued and outstanding shares plus its entire stock option pool reserve. They are calculating the ownership on a fully diluted basis. This way, if they issue 3% to another executive the next week, that executive would get the same number of shares. Effectively, you don’t want each employee to dilute the next employee, especially since the board of directors may be approving option grants to five employees at the same time. This is how most companies translate negotiated percentages into share numbers; it does not have to be done this way, but it is the most common way.

Figure 3: First Employee Stock Option

Picking up from Figure 2A, the first employee is granted an option to purchase 345,000 shares (3% multiplied by 11,500,000), which represents 3% of the sum of the issued and outstanding shares and the entire stock option pool reserve.

Shares or OptionsIssued and OutstandingFully Diluted
Pete5,100,00049.30%44.35%
Joe3,400,00032.87%29.57%
Rachel1,500,00014.50%13.04%
Employee 1345,0003.33%3.00%
Issued and Outstanding10,345,000100.00%
Option Pool Available1,155,00010.04%
Total Fully Diluted11,500,000100.00%

345K shares were issued out of the option pool for Employee 1, the marketing director, which had several impacts (compare to Figure 2A):

  • It decreased the remaining option pool, which now represents a smaller percentage of shares.

  • It increased the total number of issued and outstanding shares and securities convertible into shares, which diluted all existing shareholders when their ownership is measured as a percentage of issued and outstanding securities.

  • It did not change the fully diluted ownership (which includes the option plan in the denominator) of the existing shareholders, because those shares were already in the option pool.

Dilution From Selling Priced Shares to Investors

What follows is a simple example of how ownership gets diluted with the selling of shares. In the next section, we’ll bring it all together and talk about how those shares get priced.

In a priced round, the company issues shares out of its authorized stock, either common stock, or more typically preferred stock. A specific number of those shares are sold to investors at a specific price. This new stock gets added to the cap table, which increases the number of issued and outstanding shares. All the existing shareholders (founders, prior investors, employees with stock options, advisors) have the same number of shares or options they had before the transaction, so they are all diluted in their ownership by the increase in the denominator (total number of shares).

founder Every time founders raise more money or issue stock options for new employees, they dilute their ownership. Prior investors are also diluted by these activities. The degree of dilution is determined largely by the ratio between the amount of money being raised and the pre-money valuation. If the founders raise too much money before they can justify a high valuation, they give up too much of the company too early.

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