Equity Planning for Startup High Tech Companies
by Chuck Boggs |Â Paladin Venture Development
The Purpose of Equity Planning
Entrepreneurs and their teams usually start a project excited about the potential of creating and providing some new product or capability to the marketplace.Â Very little thought is typically given to the structure of the company, often entrepreneurs rely upon an attorney to provide guidance about corporate structure.
If that attorney does not specialize in the corporate formation of high technology companies they are likely to provide generic legal advice that is not helpful to the high technology entrepreneur, and in fact can be harmful.
Starting and building a company without a carefully thought out equity plan is like constructing a building without a set of architectural drawings. A well thought out equity plan enables the entrepreneur, his team, and investors to realize the best financial return for their effort and risk.Â Without a well thought out plan it is extremely likely than all the parties will be unhappy when a liquidity event occurs.
At the Beginning
The high technology company should be incorporated in either Delaware (preferred ) or California.Â The initial equity structure should set aside 10,000,000 shares of common stock and 20,000,000 shares of preferred stock.Â The intention is that common stock will be held by founders, employees, board members, consultants and others.Â Preferred stock is issued to investors.
There are several reasons for maintaining two classes of stock, the primary reasons are:
1)Â Â Fairly compensate founders and employees with common stock whileÂ limiting dilution and tax impact,
2)Â Â Fairly compensate investors by providing them with a set of preferences that to the greatest degree possible, protect their investment and acknowledges risk.
The Classes of Stock, Utilization and Value
Upon forming the company the initial founders, in adhering to the example given the above (authorizing 10,000,000 shares of common and 20,000,000 shares of preferred), should issue four million shares to the founding team and reserve one million shares of common for incentive acquisition or options.Â It is preferred for founders and early team members compensated with common stock to actually buy the stock at a low price ($.001 to $.01) per share.Â Outright acquisition is preferable to options because options carry considerable tax exposure.
Since preferred shareholders have the advantage of the preferences (some of which are, first return of capital, liquidation and non dilution) the stock they acquire is priced higher than the common stock, typically $.25 to $.75 per share.Â In addition to protecting the investor with preferred shares this limits dilution for the founding team.
To provide an example of a company raising one million dollars the distribution of common and capital stock would be as follows:
|Common StockÂ Â||Stock Amount||Cash Paid|
|Founders||4,000,000||$.001 or $4,000.|
|Reserved forÂ Â Â Â Â Â Â Â Board, Consultants and others.||1,000,000||$.01 or $10,000|
|Investors||2,000,000||$.50 per share or $1,000,000|
|Total||7,000,000||$3.5M post funding|
Investors in this example own approximately 30%, if investors had bought common stock at $.10 per share they would own 10,000,000 shares or 66% of the company.Â Â Clearly limiting dilution for founders and providing preferences for investors works for all parties.