SHARES AND OPTIONS

To allocate ownership of the company conveniently, the company is divided into shares (a.k.a. stock). Upon incorporation, a certain number of authorized shares are created. Authorized shares issued to shareholders are referred to as outstanding shares. Ownership in a company is calculated as a percentage of outstanding, not authorized, shares. If a company only has 1,000 outstanding shares, then 100 shares represents 10% of the company.

Ask your corporate attorney to register about 10 million shares at the time of incorporation. It will be easier to attract employees by offering them 10,000 shares out of 10 million than by offering 100 shares out of 100,000. Furthermore, investors like to buy cheap stock. A company with 1,000 outstanding shares valued at $1000/share has the same capitalization as a company with 1,000,000 outstanding shares valued at $1/share. Though the percent ownership is the same in both cases, paying $1000 for 1000 shares may feel like a better deal to some investors than paying $1000 for one share.

Upon incorporation, each share is assigned a nominal value, often $0.01 or less. The value of the shares thereafter is determined by the price others are willing to pay. If an investor is willing to give the company $5M for one million shares, each share becomes worth $5. If the company has a total of five million shares outstanding after the purchase, then the company's valuation is $25M. Next time the company raises money, an investor might be willing to pay $10 per share, setting an even higher valuation for the company and increasing the value of other shareholders' stock. If people are only willing to pay $1/share during a later financing, the value of everyone's stock will drop to this price.

A company will often reserve a pool of shares to incentivize employees and consultants. Rather than give away the stock, the company may grant options, which give the right to purchase stock from the company at a set price. There are many tax and accounting implications to granting options. Your corporate attorney and accountant can help create a valid stock option plan document, which the board of directors must approve.

When a new employee is hired, he might be offered options to purchase 50,000 shares at $1 each. Someday, when the company's stock is worth $10/share, the employee may exercise his options to purchase all 50,000 shares and then sell them, thereby increasing the number of shares outstanding. Therefore, make sure to account for the stock option pool when calculating dilution. If you own 1 million shares of a company with 4 million total shares outstanding, you own 25% of the company. However, if the company 1 million shares reserved for employee stock options, you will only own 20% of the company once those options are exercised. In this case, 20% represents your fully diluted share of the company.

There are two types of options: incentive and non-qualified. ISOs (Incentive Stock Options) have tax-favored status and may be granted only to employees. To qualify as an ISO:

• The exercise price must be at least equal to the FMV (Fair Market Value) of the company at the time of the grant,
• Be granted within 10 years of the plan's adoption,
• May not be granted to an employee who owns more than 10% of the company's voting stock unless the grant price is 110% of FMV and exercisable within 5 years of the grant,
• The aggregate FMV (as of the grant date) for which ISOs are exercisable for the 1^st^ time by the employee during any calendar year may not exceed $100,000 (excess over $100,000 is treated as non-qualified),
• Be exercisable within 10 years of grant date, and
• May not be transferable by the employee except upon death.

An NQO (Non-Qualified Stock Option) is not as tax favored as an ISO but provides the company greater flexibility. NQOs may be granted to consultants and advisors, in addition to employees. They may be granted at any exercise price, and any vested amount may be exercised. Table 4 illustrates the tax implications of each type of option.

Because shares have a monetary value, they must be purchased or, if granted, recorded as an expense by the company and as taxable income by the recipient. At startup, shares are only worth their nominal value; as a company matures, the share price will increase and the person may no longer be able to afford to purchase the shares or pay associated taxes. At this point, it makes more sense to grant options, which are essentially as good as shares. However, a tax form section 83(b) election must be filed with the IRS within 30 days after exercising NQOs or else the recipient will pay income tax rates (as opposed to the lower long-term capital gains tax rate) on the difference between the FMV on the vesting date and grant date. Needless to say, consult an accountant and attorney regarding tax issues and options.

VESTING

It does not make sense to grant 50,000 options to an employee on the first day of employment. The person might exercise the options after a month and then quit. Instead, the options are vested (become available to the person) in installments over time. After the first year on the job, the employee might receive 10,000 shares (one-year cliff vesting). Each month thereafter for another four years, more options will vest until the employee has all 50,000 options. At that point, the company may offer him another set of options on a new vesting schedule. If the employee quits or is fired, he will retain only the vested options and forfeit any claim to the remainder.

Before venture capitalists invest significantly into a company, they may insist that founder's stock be subject to vesting. Founders who have already been with the company for several years may find themselves stripped of some or all of their stock and have to work it back again. The VCs want to make sure everyone remains highly motivated. Additionally, the employment agreements that founders sign may have a mandatory buy-back clause that can force you to sell your vested shares back to the company if you quit or are fired for good reason. You will not be in a position to dictate the buy-back price, either.

Vesting may be accelerated if a founder is terminated without just cause, resigns for a good reason, or suffers death or disability. The individual typically may receive shares/options that would not have otherwise vest for another year, depending on the extent of acceleration. Acquisition or merger may also trigger accelerated vesting of all unvested shares, though VCs will often negotiate for only partial acceleration so as not to suffer extra dilution.

COMMON VS. PREFERRED STOCK

Shares of the company that do not come with any associated rights are considered common. Preferred shares, on the other hand, offer certain advantages. A company can issue more than one series of preferred stock, each with its own provisions.

Although preferred stock cannot be traded in the public markets and its value is independent of the value of common stock, preferred stock is almost always convertible to common stock. One preferred share will usually convert into one common share, though anti-dilution provisions may increase this conversion ratio. An investor with preferred stock will hold onto it as long as he feels he needs the protection the preferred stock offers, but when the price of the common shares is attractive enough, he may decide to convert his preferred shares to common and sell then those shares. When calculating shares-outstanding, only the common shares count. A company with 1 million common shares and 100,000 preferred shares, each convertible into 10 common shares, essentially has 2 million shares outstanding on a fully diluted basis.

Founders almost always receive common stock, whereas investors want the protection of preferred stock. In the event of liquidation, preferred shareholders are paid back first. If the preferred stock also comes with a cumulative dividend right (a dividend is money paid per share by a company to its shareholders), investors are allowed to collect their original investment and accumulated annual dividends (typically 5%-8%/year) before common shareholders have a chance to salvage their investments.

Investors can also negotiate for participating preferred stock, which allows them to double-dip when a company is sold. Following sale of the company, these shareholders take out the amount of their initial investment plus any accumulated dividends, then convert their participating preferred stock into common stock and split what remains of the sale proceeds with the rest of the common shareholders, sometimes with a cap (e.g. the preferred shareholders might limit their total proceeds to a multiple of their original investment). In the simplest case, consider a company with one million common and one million participating preferred shares that is sold for $10M. The common shareholders might think they are entitled to 50% of the $10M. However, the participating preferred stockholders will first collect their original investments, say $5M, and then split the remaining $5M with the common stockholders. The preferred investors therefore receive $7.5M and the common stockholders will only receive $2.5M from the sale proceeds, half of what they expected. Truly aggressive investors may negotiate for participating preferred stock with dividend preferences.

Furthermore, entrepreneurs do not always realize that owning a majority of the company may not necessarily give them control over the company. Preferred stock can stipulate that the shareholder, such as a venture capital firm, has the right to elect a director to represent its interest in the company. The preferred stockholders may also negotiate "drag along" rights. This means that they can compel the other shareholders to sell their stock if the preferred shareholders wish to sell their shares to an outside party. The investors may also require that the company obtain permission before hiring a new employee, purchasing an expensive piece of equipment, or entering into a merger agreement; so called negative covenants are fairly common in VC financing agreements.

Each financing usually involves a new series of preferred stock. Investors participating in the first financing will receive Series A shares, those participating in the next financing receive Series B shares, and so on. These shareholder agreements may stipulate that with respect to certain decisions, management must receive approval from a majority of the investors of each series. Therefore, a small investor who represents the majority of a small series may be able to obstruct management and a majority of other investors while owning only a tiny fraction of the company.

The entrepreneur should evaluate the terms of any preferred stockholder agreement carefully with his attorney to appreciate these issues of control.

LIQUIDATION

Shareholders of a private company do not have many options when it comes to selling their shares and converting their "paper money" into real money. The ideal exit involves an IPO or acquisition of the company.

Investors may negotiate for preferred shares with Redemption rights. This provision allows the investor to demand that the company purchase his shares within a certain period (typically 5 years) if no other exit option exists. The investor would receive his original investment plus any accrued dividends. Venture capitalists will rarely exercise their redemption right since the financial burden of repurchasing stock can easily bankrupt a company. Instead, the VCs may extend the deadline for redemption in anticipation of a more profitable exit and, as "payment" for doing the company this favor, may demand an increase in their preferred-to-common conversion ratio.

Prospective investors negotiating a shareholder agreement may include a clause granting them "piggy-back" registration rights. This means that if the company registers its shares for a public offering, investors have the right to include their shares in the offering. Typically, the clause obliges the company to pay for the associated registration costs.

A shareholder of a private company may try to sell his shares to an outside buyer, but there are often clauses that require that these shares first be offered to other shareholders. Investors may require co-sale rights that allow them to also sell a portion of their shares in the event that a founder tries to sell shares. Such bureaucracy may ward off prospective outside buyers.

After a company does an IPO, there is a lock-up period of 6 months during which the pre-IPO investors may not sell their shares. Before legally selling (or buying) stock, company insiders with significant equity stakes must register their shares with the SEC, thereby letting the market know of their intention to sell. Outside investors may interpret this as a vote of non-confidence in the company's future. Consequently, the stock price may drop between the time an insider declares his intent to sell and the actual time of sale.

ANTI-DILUTION PROVISIONS

Even before financing, you may need to offer stock to people who will not want to risk dilution. For example, a technology licensing office (TLO) may give you a license to a technology in exchange for some payments, royalties, and 5% equity. However, they stipulate that they want to own 5% of the company after it has received financing. If the investors value the company at $3M dollars pre-money and invest $3M, the investors will own 50%, the TLO will own 5%, and the founders will own a total of 45% of the company post-financing. Had the TLO not demanded the anti-dilutions provisions, it would have owned 5% of the company before financing and then only 2.5% after financing, leaving the founders with 47.5%. Using anti-dilution provisions, the TLO passes the burden of dilution to the founders.

An investor can also request Pre-emptive Rights, which guarantee the investor the right to purchase enough stock at each subsequent round so that he can maintain his original stake in the company. A modified form of this anti-dilution provision is called Pay-to-Play, which requires that an investor continue to invest in the company in order to maintain certain rights, including Pre-emptive Rights. Both these clauses may make it difficult to raise money from VCs. If you try to raise $5M in a second round of financing, there may be a number of VC firms interested in making an investment of this size. However, if you only need to raise $3M after all the investors from the first round exercise their pre-emptive rights, then some VC firms will decide that making such a small investment is not worth their time. On the other hand, it is always reassuring to new investors when old investors want to put more money into the company.

Investors in a given round will often demand provisions that ensure that their investment will not be excessively diluted if a company subsequently goes on to sell shares at a lower price. Such provisions increase the preferred-to-common conversion ratio.

For example, a company has 1.5M shares outstanding. In Round 1, VC1 acquires 40% of the company by paying $2/share for 1M newly-issued preferred shares, each convertible to one common share. After Round 1, there are 2.5M shares outstanding. In Round 2, VC2 purchases

2.5M newly-issued preferred shares at $1/shares. The fair market value of the VC1's investment is now only

$1/share, or half of the original price.

• Without any anti-dilution provisions, there would be 5M shares outstanding after Round 2. VC1 would own only 20% of the company (1M of 5M shares).
• Full-ratchet anti-dilution provisions in VC1's term sheet would issue him enough additional common shares upon conversion to adjust his price/share from $2 to $1, the same price VC2 paid. In this case, the conversion ratio would be adjusted to 2 common shares per preferred share, entitling VC1 to 2M common shares. Full-ratchet would set the VC1's ownership stake at 33% (2M out of 6M after the second round), much better than the 20% he would own without any anti-dilution provisions.
• Weighted-average anti-dilution would adjust VC1's effective price/share to an average of the Round 1 and Round 2 price/share weighted according to the number of shares purchased by each. The formula is as follows: ($2/share x 1M shares + $1/share x 2.5M shares) / (1M shares + 2.5M shares) = $1.29. The new conversion ratio is calculated by dividing VC1's original share price by the new effective price ($2/$1.29 = 1.55). Therefore, after Round 2, VC1 would be entitled to 1.55M shares and would own ~28% (1.55M out of 5.55M shares).

Full-ratchet favors VC1 while weighted-average favors the entrepreneur and new investors. Of course, most entrepreneurs would prefer to omit anti-dilution provisions altogether, but investors will almost always demand them.