Unfortunately, too often I hear founders say things like “I promised her options for 2% of the company,” or worse, we see statements to that effect in employee offer letters or other agreements. In the worst cases, founders will even expressly agree to issue an investor or service provider a “fixed percentage” of the company’s ownership going forward.
What’s the problem? Although percentages can be a useful measurement of a person’s share of a company’s economic value or such person’s voting control at a fixed moment, percentages are a poor metric for defining someone’s proportional ownership of a company over time, especially if the company plans to add new equity owners by issuing stock to raise capital. The problem with negotiating and agreeing to ownership interests in terms of percentages is that the parties often fail to clearly state (1) when the percentage is measured and (2) whether the parties intend for the percentage to remain fixed over time. If these two key components are not clearly understood, then the company could find itself stuck with an employee or investor claiming a fixed percentage ownership in the company for an indefinite period. The best way to avoid this situation is to always discuss company ownership in terms of shares of stock.
The economic value of a share of stock is primarily a function of (a) the total value of the company and (b) the total number of shares of stock that are “outstanding” (i.e., held by stockholders). The greater the value of the company and the less the total number of outstanding shares, the greater the value of an individual share. For example, a share of stock in a fledgling startup worth $100,000 with 100,000 outstanding shares is worth only $1.00, but a share of stock in that same company one year later, when the company is valued at $1 million and has 200,000 outstanding shares, would be worth $5.00. Note, though, that the ownership percentage represented by that one share of stock would have decreased over the same period, from 0.0001% to 0.00005%. To maintain the same ownership percentage (0.0001%), the owner of that share would have had to purchase (or be granted by the company) his pro rata portion of the additional 100,000 shares issued in the interim (one more share of stock), and the total value of the two shares would be $10.00.
So the decrease in ownership percentage that occurs when a company issues stock to raise capital or compensate employees, often called “percentage dilution,” is not necessarily a bad thing, so long as the proceeds or services provided for the stock provide adequate value to the company. When, for instance, a company sells new shares at a price equal to the value of the company divided by the total number of outstanding shares, an existing stockholder’s percentage ownership will decrease, but the value of his stock will stay the same, because the stock will share proportionately in the value of the money coming into the company. If, however, the company sells shares for less than the current per-share value of the company’s stock, the existing stockholders will experience “economic dilution”—the value of each of their shares will be proportionately decreased by the shortfall in the value of the shares being sold.
If an existing stockholder has a contractual right to maintain a certain ownership percentage of a company, then to maintain that percentage the company must issue that stockholder additional shares (or transfer shares from other existing stockholders) whenever the company sells stock to new investors. While the stock issued to the new investors may be sold for adequate value (the cash invested in the company), no value is received for the stock issued or transferred to the existing stockholder with the fixed-percentage-ownership right, which instantly causes economic dilution of all of the other stockholders, including the new investors if the stock is issued by the company.
Obviously, such a situation is a windfall for the stockholder with the fixed-percentage-ownership right, a detriment to the other stockholders of the company, and a significant disincentive to future investors. Companies with stockholders that have fixed or undefined percentage ownership agreements are usually unfundable until such companies find a way to settle those stockholders’ claims, which can come at significant expense. Therefore, when coming to terms on company equity, whether for investment in the company or employee stock incentives, always do so in terms of numbers of shares of stock (or membership units, if the company is a limited liability company) in order to avoid the problem of percentages.
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