Startup Equity – Easy As “Stock Ownership” Pie

What Does Startup Equity Mean?

• Authorized Shares?
• Fully-Diluted Shares?
• Issued and Outstanding Shares?
• Outstanding Shares on an As Converted to Common Stock Basis?
• What does all of this mean?
• How does stock ownership affect your company?
• How do they affect your own potential for a big payout?

Startup Equity – Easy As “Stock Ownership” Pie

I certainly understand if you would rather pull out a fork and focus on a real slice of pie (a la mode of course), but . . . as you launch your new company and start to raise capital, you will need to understand these four key stock concepts and how they relate to the stock ownership of your company.

For illustration purposes, below is a sample cap table with some typical equity components:

1.   Authorized Shares

Calculation: 10,000,000 shares (A) Authorized Shares

Explanation: The Authorized Shares represent the inventory of shares that are available for issuance by your company.  The number of Authorized Shares is set forth in your company’s Certificate of Incorporation.  The Authorized Shares do not represent the ownership of your company and you are not required to issue all of the Authorized Shares.  You also can change the number of Authorized Shares by amending the Certificate of Incorporation.

Key Concept: You need to make sure that your company has enough Authorized Shares to cover the shares that currently are issued and outstanding (B + C), as well as the shares that will be (or might be) issued in the future (E + F + G).  In the above example, the 10,000,000 Authorized Shares adequately cover the 4,850,000 Fully-Diluted Shares (B + C + E + F + G), and there still are 5,150,000 of the Authorized Shares available for issuance.

2.   Issued and Outstanding Shares

Calculation: 4,000,000 shares (B + C)

Explanation: The Issued and Outstanding Shares represent the actual ownership of your company at a given point in time.  In our example, the Issued and Outstanding Shares of Common Stock (B) are combined with the Issued and Outstanding Shares of Series A Preferred Stock (C).  In many cases, the Series A Preferred Stock votes together with the Common Stock on most matters.

Key Concept: Because the Issued and Outstanding Shares represent the current ownership of your company, the related stockholders will vote on all matters that require stockholder approval.  The holders of Preferred Stock may have special approval rights for important company matters (e.g., new financing transactions, sale of the company, etc.), as well as the ability to vote generally with the holders Common Stock.  You will need to analyze the holders of the Issued and Outstanding Shares in order to determine if a specific company matter will be approved because these holders are the current owners of your company.

3.   Outstanding Shares, on an As-Converted to Common Stock Basis

Calculation: 4,600,000 shares (B + C + E + G)

Explanation: This stock concept combines the Issued and Outstanding Shares (B + C) with the shares that could become issued and outstanding now.  In our example, there would be an additional 600,000 shares of Common Stock outstanding (E + G), if the holders were to exercise all of the Stock Options granted (E) and all of the Common Stock Purchase Warrants (and any other Warrants) (G) currently outstanding into shares of Common Stock.

Remember that sometimes the shares of Preferred Stock do not convert into shares of Common Stock on a one-to-one basis. You will need to check the Amended and Restated Certificate of Incorporation regarding the current Preferred Stock to Common Stock Conversion Ratio and if it has changed recently due to Anti-Dilution Adjustments, etc.  Also, just because a Stock Option or Warrant is outstanding, it may not be fully Vested and therefore all of the shares underlying each of the Stock Options granted or Common Stock Purchase Warrants issued may not be exercisable right now.

Key Concept: This stock concept becomes important when your company is about to be acquired because the holders of Convertible Securities (e.g., Stock Options, Common Stock Purchase Warrants, etc.) also will be able to participate in the sale of your company as Stockholders if they exercise their Convertible Securities before the acquisition.  You will need to analyze the eventual ownership structure of your company after taking into account the exercise of these Convertible Securities so that you can calculate how the acquisition proceeds will be split among all of the owners of your company.

4.   Fully-Diluted Shares

Calculation: 4,850,000 shares (B + C + E + F + G)

Explanation: The stock concept of Fully-Diluted Shares provides a complete snapshot of what the possible stock ownership of your company would be, if, in our example, stock options covering the entire Stock Option Pool are granted and all of the Stock Options granted (E) and Common Stock Purchase Warrants (and any other Warrants) (G) are exercised into shares of Common Stock.  Using the above example, the remaining shares available under the Stock Option Pool (F) are added to the equation to complete the equity capitalization picture.

Key Concept: Many equity Investors will want to understand the complete equity ownership of your company so that they can determine what their eventual ownership stake may become after their investments.  Also, by factoring in all of the Fully-Diluted Shares when pricing their purchase of shares in the company, the equity investors will obtain better (lower) pricing for such purchase of shares.

Also, for this reason, more sophisticated investors often require that the size of the stock option pool be increased, so that the extra potential stock ownership from the increased stock option pool is factored into their financing transaction, resulting in better pricing and avoiding the potential dilution that would result if the stock option were increased after the financing transaction is closed.

Easy as pie?  Startup equity ownership can get complicated after a few financing rounds, but the above explanations and key concepts should provide a solid foundation for you to talk the talk.  This terminology really does matter as it will affect future stock ownership calculations and therefore real stockholder value.

Your Turn:

We welcome your comments about the above stock concepts and how that have affected your startup companies.  Please share your input and questions, so that other entrepreneurs can benefit from your startup experiences.