By Fernando Berrocal
So, you've decided to incorporate your startup, which implies you want to recruit engineers, start selling your products, and eventually raise funds. How many shares should a business have to begin with? There should be enough shares to satisfy the founders, a pool for employee stock options, and future workers and investors. Some investors will eventually want preferred shares with special privileges, but that will come later and will involve more difficult decision making.
Isn’t my “Ownership Breakdown” more important? You may consider that the percentage split of ownership interests is more essential than the precise number of authorized shares. While it’s critical, it is not that simple. When it comes to keeping founders happy, encouraging new staff, anticipating unanticipated future changes, and preparing to take on investors, the number of shares you approve at the beginning makes the difference.
Authorized, Allocated Shares, Issued Shares, and Authorized Unissued Shares:
It's crucial to understand the differences between “Authorized”, “Allocated”, “Issued” shares, and “Authorized Unissued Shares” before moving on. These are the fundamentals of a business. In most situations, these concepts are described assuming fully diluted ownership, which occurs when your business is publicly traded after all stock-convertible options have been executed.
- Authorized Shares: These are the entire number of shares that a business is permitted to issue under its articles of incorporation.
- Allocated Shares: These are the shares that have been targeted for certain shareholders but have not yet been issued.
- Issued Shares: These are shares that have already been handed to holders (for example founder shares, employee shares, and investor shares). These are crucial in terms of voting rights.
- Authorized Unissued Shares: These are the shares that have been authorized but not yet issued or allocated. These will be used for future expansion.
Two major categories of shares specify the sequence in which they are exercised, and these are:
- Preferred Shares have a higher "preferred" status and a higher class of rights than “Common Shares”. They are usually developed and sold in a priced round to investors.
- Common Shares (or “Common Stock”) are given to employees and the general public. They are subordinate to the “Preferred Shares” and have no particular privileges.
The total number of authorized shares will match the total number of issued, allocated, and approved but unissued shares. Some organizations’ foundation agreements allow them to approve an infinite number of shares, but this is not the case for early-stage startups, which must preserve stability and confidence by approving just a restricted number of shares from the outset. When the need arises, a majority of shareholders or the Board of Directors can vote in favor of allowing new shares.
How Many Shares Should We Authorize?
Regardless of your initial funding, a new startup's sweet spot is usually 10 million authorized shares. However, just because 10 million shares have been approved does not indicate that all or even the majority of them should be allocated or granted to founders or thrown into the employee stock option pool immediately. For growth, a business has to keep its dry powder. It should be noted that all of the shares issued are Common Shares. Preferred Shares owned by investors and others do not immediately translate to Common Shares; instead, they represent a part of the total number of common shares available in the investor pool. Restricted shares are another story altogether.
Fairly splitting equity among founders may be a difficult task. While you may be tempted to allocate or issue the majority of the share authorization in the founder's stock, you should hold off since senior workers may desire to take on a larger ownership position as the business grows. Early stock splits owing to rapid expansion can also be handled using a store of approved, unissued shares (in the best of cases). The employee option pool, which is frequently utilized to reward consultants, normally receives around 20% of the overall authorization. It's vital to remember that the authorized share number does not include the number of preferred shares (which are often distributed to investors).
Why ten million shares rather than 1 million (or 5)?
It doesn't matter as long as you have a large enough number of shares to split for your future requirements. However, there are certain practical considerations, such as making it simple to divide and visualize—which is why even the most eccentric entrepreneur will almost always operate with a base-10 number. Employees have a strong desire for "more." Employees' options are more likely to be for a big number of shares at a lower exercise price than for a smaller number of shares at a higher exercise price. When you're at the bar, "I own 100,000 shares" sounds a lot better than "I own 10,000 shares," regardless of what it implies.
Stock option grant prices (or “Buy Prices”) will be cheaper if the strike price is lower. Remember that all scenarios reflect the same ownership interest in the business and are predicated on the same enterprise value, no matter how you slice it.
The term "cheap" is frequently used by investors. In the realm of startup finance, investors like to get in early and feel like they're getting a good deal, which translates to selling them more shares at a lower price, making it look cheaper.
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