1. Terms Related to Issuing Stocks
2. Things to Consider Before Issuing Equity

Start up company shares allow new companies to attract and retain employees and provide a way for investors to value a start-up that lacks assets. To value start-ups, investors will look at the future potential and assign a value on those assumptions.

There are terms related to issuing stocks that are needed to understand stocks and how they work. These terms include:

  • Cliff vesting is the specific date at which employees receive the full benefits from the company's retirement account.
  • Equity is the value of the shares issued by the company.
  • Restricted stocks are company shares that are not transferred to the employee until specific conditions have been met. This type of stock is seen as part of their pay.
  • Shares are a portion or part of a larger amount that is divided with a group of people or with a group that contributes.
  • Stock options allow employees to purchase company stocks at a discounted or fixed rate price.
  • Strike price (exercise price) is the fixed price the owner is allowed to use to buy or sell shares.
  • The vest is the time the employee must work at the company before the shares reach their full value. This time is called a vesting provision.
  • 409A is the report that provides the value of your company's common stock.

Things to Consider Before Issuing Equity

Start-up founders know that equity is a powerful bargaining tool, but there are three things to consider before issuing stocks to avoid unintended consequences.

1. Stockholder voting rights, when given to a large number of people, may negatively impact the company founders ability to run the company as they see fit. With many start-ups, each stock share sold is given one vote. Stockholders are required by law in some states to vote on certain corporate actions. As a start-up, the company founders should hold at least 51 percent of the shares.

If the number of stockholders is large, there is also the burden of collecting signatures for situations where signatures are required. Acquisitions may require up to 90 percent approval, and if hundreds of people own shares, this will become burdensome to get all of the signatures. Also, when large blocks of shares are being issued to people who don't have the same vision for the company as the founders, a holdout or stalling may end the ability for the deal to go through. To avoid these issues, founders should be conservative with how many shares are sold.

2. Liquidation preferences are the stipulations that investors (preferred stockholders) will be paid first in the case of company liquidation (such as sale or dissolution of the company). After preferred stockholders are paid, then common stockholders receive payment.

Founders should be wary of accepting too much money from investors due to the possibility of getting nothing if the company is sold. For example, if a company raises $10 million in funds, but sells for $5 million, the founders walk away with nothing after the company expenses and debts are handled. In this scenario, the employees who are common stockholders will also receive nothing. The less money received for stock, the greater the chance the founder will receive a larger payoff due to a smaller liquidation preference.

3. Dilution is the decrease in the percentage of stockholder ownership when companies issue additional stock shares. Founders who limit the number of additional shares sold can help limit dilution. However, dilution is expected with any growing company. Valuation caps set a maximum value to determine the price the investment will convert to stock. Setting a valuation cap protects the founder from giving away too much of the company's value.

Founders should be realistic and value the company's future potential when negotiating valuation caps. This will affect profits, the ability to hire additional employees and to bring more investors into the company.

An example of dilution is if an angel investor receives a convertible note with a $3 million valuation cap for $500,000. If the company has 10,000,000 shares that are fully diluted, the conversion share price is $0.30, or $3 million divided by 10 million, the $500,000 investment is now 1,666,666 shares. The investor now owns 14 percent of the company which greatly decreases the founder's ownership portion of the company.

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