Authorizing, Issuing and Diluting Shares
This is a short post to help explain how many shares of stock your company needs to have available to issue, limitations and requirements related to issuance (I'm also using the word “issue” instead of “sell” – if we say “sell” we're talking more about securities law compliance). This post focuses on corporations, since most unincorporated associations (LLCs and LPs) are not limited in terms of units of ownership, other than whatever is in the operating or partnership agreement.
- Terminology: A couple of definitions are useful here:
- Authorized Shares: Every corporation has a certificate (or articles) of incorporation – a “charter” – filed with the state in which your company was formed. Your corporation's charter sets the maximum number of shares your company is authorized to issue, and if you have more than one class or series of stock authorized, the maximum amount of shares of each you can issue.
- Issued and outstanding – The number of shares that the corporation actually has (not surprisingly) issued to stockholders that are still out there (meaning, having not been repurchased by the company, which makes them no longer “outstanding”, which is largely irrelevant to this discussion). At a bare minimum, you need to have at least as many authorized shares in your charter as you have issued and outstanding shares.
- Fully Diluted – the number of shares you would get if you added all the issued and outstanding shares, all the shares in the equity incentive pool (even the unvested and unallocated shares), plus all of the other securities you have that are convertible into common (preferred stock, warrants) as-if converted to common according to their terms. Fully diluted is the divisor used with your pre-money valuation to come up with a per share price for an equity round.
- Validly Issuing Shares, Sufficient consideration: To validly issue shares under applicable corporate law, the board of directors must authorize the issuance in writing (either by unanimous written consent or resolution at a validly held meeting). Applicable corporation law also requires that the corporation receive legally sufficient consideration, which is usually laid out explicitly in the statute (for example, Section 152 the Delaware General Corporation Law), and includes obvious forms of consideration (cash or other property, the value of which the board must take a position on) as well as intangible benefits such as promises of future serves. Some states are more restrictive however (for instance, services that have already been performed are okay consideration for issuance by a California corporation but future services are not, so shares issued against a promise of future services are not validly issued until the services are performed).
- How many shares do I need to authorize:
- Founder issuances: These will be your first issued and outstanding shares. First, you need enough to cover your issuances to founders. You don't want to issue so many shares to your founders that your Series A ends up being priced in penny increments, nor do you want to issue so few shares that your seed round or friends and family equity round has a bizarrely large issue price (hundreds or thousands per share for instance). For instance, if you had 4 founders and only issue 1 share to each, if you go into your Series A with a $3 million pre-money valuation, your share price for the Series A would be $750,000 which is just plain odd.
- Equity Pool: Even before you adopt an equity plan, you should consider including enough shares to your authorized common stock to cover an equity incentive/option pool. The option pool is usually 10% to 20% of your total fully diluted shares, though opinions vary. There isn't a ton of upside in authorizing a very large pool that you are unlikely to use in the near term, since the pool amount increases your fully diluted shares and thus, dilutes the founders in any equity financing round.
- Reserve for conversion of other securities: If your charter is going to authorize a class of preferred stock for an early friends and family round (including “blank check” preferred stock), or if you have or plan to have warrants (say for a service provider) you need to include at least an equivalent amount of common stock in your total authorized common stock amount on the assumption that any preferred you issue will be convertible into common.
- Voting: The number of authorized shares doesn't affect voting rights; only the issued and outstanding shares count for voting purposes. For example, if you had four founders you could give them each 1 share (25% of the voting power, each, and whether you have 10 shares authorized, or 10,000 authorized or 10 million authorized, each founder still has 25% of the voting power.
- Excess authorized shares: Excess authorized shares don't really matter that much. For Delaware franchise tax, there's an alternative calculation method that largely ignores the authorized share amount. And if your investors think you have too many authorized shares, they'll just make you reduce it.
There are competing rules of thumb, but a lot of startups will authorize 5 to 10 million common shares and issue half of them to the founders, with corresponding allocations to the initial option pool.
If you issue so many or so few shares that your capitalization looks odd, you can do a stock split to increase your outstanding shares pro rata, or a reverse split to decrease pro rata. And if you have too few shares authorized, you can amend your charter to increase it. But those things take time (board and stockholder votes) and money (primarily filing fees and legal fees).
- How do I increase the Authorized Shares – by charter amendment filed with the state (and payment of a fee, usually a few hundred dollars), after approval by the board of directors and stockholders.
- Special note on stockholder voting to increase authorized common stock: This post focuses on formation stage issues rather than the dynamics post-equity financing (where you have one or more classes of preferred stock in place), but if you are a Delaware corporation, you should check that your charter has a provision in it that allows you to increase your common stock by overall majority approval without a separate class vote of the common (it should reference with Section 242(b)(2) of the Delaware General Corporation Law). You need this for preferred equity financing rounds because every time you add preferred stock to your charter, you need to bump up your common stock by an equivalent amount and you don't want the common stock to have a separate class vote (and potential veto) that could hold up the transaction.
- Blank check preferred is a somewhat rare provision of the charter that creates a bucket of shares whose rights and preferences are open to board of directors determination, without stockholder approval. It’s somewhat rare because (1) even if you put it in when you form your company, your preferred investors will insist on getting rid of it at the first financing round and (2) if your initial board largely consists of your initial stockholders blank check preferred just lets you skip the mechanical process of taking a stockholder vote.