HOW SHARES ARE ISSUED: Learn the trail to set the right company valuation

This morning I had a good talk with an entrepreneur ready for planning the financing of his first multi-employee startup. His questions about how shares are issued gave me the impetus for this blog.  Here we go.

1. Incorporate. Do not do an LLC because you will have tax problems with intellectual property later when you need to move to a regular Corporation. You can incorporate yourself at low cash cost. Some do. But wise entrepreneurs use an experienced lawyer who will charge $2-$3K for the task and keep you out of the snares caused by the tax and legal authorities (there are many, e.g. ask about "83b and 409a".
2. Legally declare the corporation has the right to issue up to 50 million shares of common stock and 20 million of preferred stock. This is an action taken by your board of directors (you and any other founders) in a formal board meeting (take minutes of the meeting in a Word document and save it).
3. Sell the first common shares to yourself (and any other founder) (I recommend 5 million shares per founder) for cash ($1 of cash or whatever you put into the business to get it started, e.g. to pay the lawyer). Those are the first shares "outstanding". They total 100 percent of the outstanding shares. You own all of the company.
4. Then reserve shares for your employees to purchase when they exercise their stock options. I do that by estimating how many employees will be hired at what levels in the company for the next 24 months. Add up the shares, and presto! You can now "set aside", that is, reserve not-yet-issued shares. They are shares the employees will purchase when they are allowed to (i.e. when their shares vest over four years).
5. Then prepare to sell shares to investors. These will be preferred shares. Their terms (that make them special or preferred) will include conversion to common shares at a ratio of 1 preferred share for 1 common share. For more on preferred shares talk to your lawyer and read High Tech Start Up . These shares will be outstanding. Add them to the shares sold to founders and you have the total equal to 100 percent of the company. The stock option shares are not yet outstanding.
6. Learn how a "cap table" is calculated to set the value of your company. Here is one example: You sell shares to a VC for $2 million in a seed round. They end up owning 25% of the company. That means the "post-money" value of your company is $8 million. You and the investors agree to reserve 15 percent of the company for employees (options). That means you (founders) own 60 percent of the company. That is how a cap(italization) table works.
   1. Note the tricks with valuation: the smaller the stock option pool, the lower the valuation of the company but the higher the percent the investors will own.
   2. Figure out the arithmetic so you can move around the numbers easily. You will have to do that during your negotiations with investors.

BOTTOM LINE: Get fluent with your numbers on shares and options so you can set the right valuation for your company. The numbers affect the percentage you will end up with. Get it right at the beginning. You can't change it later. When you get fluent with the issuance of stock, you'll add a powerful element to your unfair advantage.

Comments

[John]

Bob, the danger is in the misunderstanding of how to control a startup. Preferred stock is common stock with special power rights attached to it (e.g. veto rights on the next round of financing).

So why use preferred stock? For one reason, the investors will insist on that. For another, that lets you price the preferred stock at ten times higher price per share (more privileges)than common stock (so you can then grant common stock options to employees at a very low strike price).

So you must be wise in what power you grant to the preferred stock holders. An experienced startup lawyer will help you choose wisely. Serial entrepreneurs will openly advise you.

Hope that helps clarify the situate a bit better.

[bob]

you suggest preferred to vc's yet your book pointsout that preferred often gives vc's toomuch control of the venture. if that's the case why do you suggest doing it ? your advice seems to be contradictory

[John]

Grant, the tips by Mathias are wise. You do need a credible story to get money. The suggestions made work in all parts of the world. I respond to questions around the planet, daily.

If you are uncomfortable talking to a bank about your story, try telling it to a good friend in private until you get confident it is ready for the bankers. Testing it that way can reveal places to add strength to a good story and make it excellent.

[Mathias]

Addison, how much have you (or will you) invested so far in the business?

Also, have you got any value built up inside your business (contracts etc) as of now?

The value you use when discussing with VC's is based on these two factors. It is rather impossible to put a value on a business from pure air. There needs to be something to base the value on. Something to base the pre-money value on. The value that is used against VC funding.

I am startup entrepreneur since 7 years back so I do this daily.

[Grant Cope]

Dear Sir
Can the above stated share capital proceedings be used in New Zealand,
The reason is that if you ask the questions to a bank manger he might smell a rat
Im needing to raise $100,000 to finance my venture

[John]

The company value today depends on what the value in the future will be when the investors get their cash returned with a profit.

A good rule of thumb is to value the future at at least 4 times sales in the year of the liquidity event.

Then decide on what the ROI of the investors should be. They will want at least 10 times their money.

Then you can figure out the percent the investors need today to get the ROI they need and presto, you have it all figured out.

For more details, try The Power of Unfair Advantage, it has lots more to help you.

I wish you the best!

[Addison]

I just signed the articles of inc for a ca corp...authorized to issue 10,000 common shares.

I need to raise 150,000 in vc how do I compute value of company. I will be the only principal and am not interested in stock options please advise thanks