Founders often wonder: how do we divide up the stock when we first form the company? There is no clear-cut answer to the question. But here are a few thoughts
Let’s say there are 3 founders, and you believe all three are making (and will continue to make) contributions of equivalent value to the company in terms of ideas they have or work they do or connections they have, etc. In that case, there is certainly an argument for splitting up the stock equally, with each founder receiving 1/3 of the shares.
On the other hand, there is often one founder who had the idea and who has contributed more than other founders who were brought in later. In that case, there’s certainly an argument for a more lop-sided distribution.
If you have an even number of founders and they all have the same amount of stock, that can cause some difficulty if there’s ever a situation that requires a voting of shares, and the result is a tie. So it’s not a bad idea to structure the stock in a way that ensures there will not be any ties.
The bottom line is that it’s a negotiation. The key consideration is that the way stock is split up needs to be seen as equitable, or you’ll have problems down the road.
How Many Shares for Each Founder?
So you’ve decided what percentage of stock goes to each founder? The best answer may be — it depends. If you have 3 founders, it isn’t necessarily an even 3-way split. Is one person really driving the business concept, and other were recruited? Maybe the driver should get a lot more stock. Are there absolutely critical, almost irreplaceable skills that one founder has? Well, that argues for more stock.
In general, it’s a question of what skills, abilities, connections, etc. does each founder bring to the business – and how much of a contribution are they likely to make in the future? (Note: if they don’t end up contributing in the future – that’s where a stock buyback agreement is critical.)
At the end of the day, it’s a negotiation. It is important that it’s an arrangement that all parties agree is fair. (If not – you’ll have issues eventually.)
How Many Shares should we Issue?
When you set up the corporation, how many shares of stock should you issue? On the one hand, it’s a bit arbitrary. If there are 3 founders and they do a 60/30/10 split, then issuing 100 shares, and splitting them 60/30/10 is the same ownership structure as issuing a million shares and splitting them 600,000/300,000/10,000. But when thinking about a future investment round, there are some reasons to target specific ranges of stock. Your accountant can help here. Let’s just say that issuing 1 million shares (or even a lot more) would be more typical than issuing 100. This is a great topic to discuss with you emerging-business attorney or accountant.
The Stock isn’t (Quite) Free
The stock that goes to founders is purchased by the founders. But there’s a reasonable argument that when the company is first created, it has very little value, so the founder’s shares of stock are worth very little. I’ve seen cases where there were 1 million shares issued and the founders purchased their stock for a tenth of a cent per share (which implies a valuation of 1 million shares times 1/10th cent, which equals $1,000 — a low valuation indeed!
Later, when you bring on employees, you’ll typically issue stock options, as opposed to having people purchase stock. So you’ll need to plan on allocating a portion of the company stock to a stock option plan (see the following example).
Capital Structure after an Investment
Let’s consider a simple example. For arguments sake, let’s assume you decide on the following stock distribution:
- Founder 1 (the CEO): 50% of the stock
- Founder 2: 30%
- Founder 3: 20%
And let’s assume that when you create the corporation, you specify that there are 1 million shares of stock. One approach is to say that initially, the founders own all of that stock. In other words, they own 500K, 300K and 200K shares respectively.
Now let’s look ahead to when you take in some investment. Again, for a simple example, let’s say that you get a pre-money valuation of $4 million, and you’re looking for a $3 million investment.
“Pre-money” valuation of $4 million simply means that an investor looks at your company and team and decides that given the headway you’ve made, your company is worth $4 million. If the investor then invests $3 million, the post-money valuation is $3 million plus $4 million or $7 million. So:
- Pre-money valuation is $4 million
- Investment is $3 millon
- Post-money value is $7 million
Your investors will likely insist that you allocate some significant amount of stock to a stock option pool, so you have the options you’ll need to attract employees in the future. We’ll assume you and your investors agree that 25% of the stock should be reserved for options. (That would not be an unusual number.) So here’s what happens:
- The corporation issues new shares so there are shares to sell the investors (i.e., you’ll modify your Articles of Incorporation)
- The post-money valuation is $3 million plus $4 million, or a total of $7 million
- The investors will own three sevenths (3/7) or roughly 43% of the stock (that’s their $3 million investment divided by the $7 million total corporate value).
- The option pool was agreed to amount to 25%. So the option pool is 25% and the investors own 43%. That leaves 32% for the founders.
- So the founders’ 1 million shares are worth 32% of the company, which is 32% of a $7 million dollar value or $2.25 million.
- That means that the stock is priced at $2.25 per share.
- Before the investment, the founders owned 100% of the company. After the investment, the founders own 32% of the company.
- The CEO, who started owning 50% of the company, now owns 50% of 32%, or 16%
So to summarize:
- Your post-money valuation equals the pre-money valuation plus the dollars invested
- The percent owned by the investors equals dollars invested divided by post-money valuation
- The percent allocated to the stock option pool is determined through negotiation
- The founders own the remaining percentage.
- The founders’ percentage multiplied by the post-money valuation gives you the value of the founders’ stock
- The value of the founders’ stock divided by the founders’ number of shares gives you the share price
- Every share of stock allocated to the option pool dilutes the founders, not the investors. So there are competing objectives. You want sufficient options in the pool to be able to attract employees. But you want fewer options in the pool because you’d rather limit the dilution. It’s a balancing act.
- The reality is that additional options can (and will be) allocated later (at the next investment round, if not before). But that dilutes the first-round investors, so they’d rather see you allocate a larger number of options up front (when it dilutes the founders, not the investors).
- It’s worth doing your homework to determine how many options you need in the pool to take care of the employees you expect to hire between the first financing round and the second financing round.