Dilution From the Departure of a Founder

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Dilution From the Departure of a Founder

After two years with the company, Joe, one of the founders, has become restless and decides to leave the company to become a crabapple farmer in New Zealand. Because the company was set up by competent attorneys, the founders were on four year vesting schedules. Joe is exactly halfway through his vesting schedule, so upon his departure, the company will buy back 50% of his shares, or 1,700,000 shares. These shares were purchased by Joe as part of the company setup for a fraction of a penny per share, let’s say $0.001 per share. Joe would have originally bought his shares two years ago for $3,400, and will sell half back for $1,700. But aren’t Joe’s 1,700,000 shares, which represent 9.37% of the company—which a year ago had a post-money valuation of $10,000,000—worth close to a million dollars? They might be, but the terms of stock purchase agreement and the vesting schedules therein would have stipulated that upon departure the company has the right to buy back any unvested shares at the issuing price, in this case $0.001 per share. This is a bummer for Joe, but he is, after all, walking away with the 50% of his stock ownership which he had vested. When the stock is repurchased by the company it is typically retired or returned to the treasury, so for all practical purposes, it is removed from the cap table.

The good news for the other stock owners is that by removing a large chunk of the issued and outstanding stock from the cap table, their ownership stakes go up.

Figure 7A: Change in Ownership Stake After a Founder Departure

Shares or OptionsIssued and OutstandingFully Diluted
Founders8,300,00060.49%50.48%
Employees345,0002.51%2.10%
Convertible Note Investors1,448,29910.55%8.81%
Preferred Stock Investors3,628,70826.44%22.07%
Issued and Outstanding13,722,007100.00%
Option Pool Available2,721,53116.55%
Total Fully Diluted16,443,538100.00%

Because the number of founders’ shares has gone down, all other stock or option holders’ ownership stakes have gone up. In fact, Pete and Rachel’s ownership stakes have also gone up, but the founders’ ownership as a group has gone down.

Figure 7B: Detail on Founder Ownership From Figure 8A

Shares or OptionsIssued and OutstandingFully Diluted
Pete5,100,0037.17%31.02%
Joe1,700,00012.39%10.34%
Rachel1,500,00010.93%10.34%
Employees345,0002.51%2.10%
Convertible Note Investors1,448,29910.55%8.81%
Preferred Stock Investors3,628,70826.44%22.07%
Issued and Outstanding13,722,007100.00%
Option Pool Available2,721,53116.55%
Total Fully Diluted16,443,538100.00%

If you refer back to Figure 1, you can see that Pete’s original ownership was 60% of issued and outstanding shares, or 51% on a fully diluted basis. After bringing on Rachel as an additional co-founder, selling convertible notes, and then topping up the option pool and selling preferred shares, Pete’s ownership share was down to 33.07% of issued and outstanding shares, and 28.11% on a fully diluted basis (not shown in table.) After Joe’s departure, Pete’s ownership stands at 37.17% of issued and outstanding shares, and 31.02% on a fully diluted basis.

Note, that we have not accounted for the likely hiring of additional employees throughout the course of the two years. If more employees had been hired, it would have used up some of the option pool, which would have reduced the ownership percentages on an issued and outstanding basis, but not on a fully diluted basis.

What Angels Need to Know About Business Entities and Taxes

In Part III: Financings and Term Sheets, we covered the most common investment scenarios. In this section, we will review the most common types of entities in which you might consider investing, as well as the relevant tax issues that arise.

Angel investing involves a number of different tax issues for investors. You might wonder, for example, when can you recover your investment in a company for tax purposes? Can you deduct your investment in the year you make the investment? Is there a tax credit for making the types of investments you are making?

The tax consequences of any particular investment will depend on the type of entity in which you invest—typically either a C corporation, S corporation, or LLC taxed as a partnership—and how you invested—stock purchase, convertible debt or convertible equity, interest in an LLC taxed as a partnership, and so on.

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