Back to Basics: Consider the Number of Shares to be Issued When You Form Your Startup

Authors: StartupPercolator

There is no required minimum or maximum number of shares by law that must be issued to founders or reserved in the equity incentive (stock option) pool in a startup.  Of course, what does matter is the percentage of the company each individual stockholding represents.  A startup may issue 100 shares or 100 million shares at formation, and  50 shares in the former or 50 million shares in the latter still represents 50% of the equity of the startup.  A typical equity pool is between 10% and 20% of the total number of shares issued and reserved for issuance.

So, does the actual number of shares issued to the founders and reserved in the equity pool matter?

Effect on future employees

As noted above, a rational individual would focus on the percentage of the equity of the Company that an equity award, such as a stock option, represents.  However, employees may perceive a benefit when receiving a stock option for a large number of shares with a lower exercise price when compared to receiving an option for a smaller number of shares with a higher exercise price, even when both options represent the same percentage of the startup and are based on the same enterprise value of the company.  Would you rather receive an option to purchase 50,000 shares at $0.03 per share or an option to purchase 500 shares at $3.00 per share (if they both represent the same ownership interest in the company)?

Effect on Investors

The price per share in an equity investment round is equal to the valuation of the Company (prior to the round) also known as the “pre-money” valuation divided by the number of shares outstanding and reserved for issuance (prior to the round).  Because investors in a company’s first round of equity financing want to feel like they “are getting in early and cheap”, a target price per share in such round probably should not exceed $1.00.  Similarly, the price per share probably shouldn’t be below $0.10 per share to avoid the perception of increased risk (ingrained from experiences with the public markets) that a small drop in valuation would render the shares worthless.

The Math

Based on the perceived benefit by employees and effect on investors, and assuming a 20% option pool and a typical Series A valuation of $1-5 Million, we regularly suggest that startups initial issue a total of 8 million shares to the founders and reserve 2 million shares for issuance from the option pool (assuming a 20% option pool).  An employee who is targeted to receive a 0.5% option grant would receive an option for the perceived not-insignificant amount of 50,000 shares.  The initial price per share in an equity round with a $1M valuation would be $0.10 per share and in an equity round with a $5M valuation would be $0.50 per share.

Of course, the number of shares issued can always be split or reverse-split at any time (keeping all stakeholder’s proportional interests the same), so any decisions regarding the actual number of shares issued or reserved for issuance can be revisited at any time.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.