As a Phoenix attorney that has represented a number of local and out of state startups, I can tell you that one of the Top 10 questions I get is some variation of, “How many shares should the startup company authorize at formation?”
How many shares is my Startup required to authorize?
First off, at least here in Arizona where I practice at least, there is no law or regulation that requires a startup to have a minimum or maximum number of shares that need to be authorized or to founders or set aside in an equity incentive program. With that said, there are practical and operational limits, which we explore in this post.
Typically, with technology-oriented startups at least, I recommend that the newly formed company authorize anywhere between 10,000,000 to 15,000,000 shares of common stock in its articles of incorporation (as it’s called here in Arizona, although it may also be called something like organizational charter or certificate of incorporation, depending on where you are incorporating).
For other, non-techy businesses my Phoenix small business law firm helps advise, we often advise authorizing a much lower number, like 100,000 or 1 million shares, depending on the circumstances.
Does the amount of shares authorized actually matter?
From strictly the math standpoint, no, it doesn’t matter whether you have initially authorized 100,000 or 10 million shares.
However, when it comes time for your startup to grant equity to new employees or consultants, having large numbers can save you some time, expense, and delay in having to call a special meeting to have your shareholders (and, ultimately, Board of Directors) vote to amend your articles of incorporation to allow for the increase in number of shares.
In addition, let’s assume that your startup only authorizes and issues 1,000 shares initially, and subsequently issues 80% of this, or 800 shares, to the founders, while reserving 20% of this amount to the option “pool” for new hires and consultants. If you were then to attempt to lure a developer with a grant of options totaling, say, 1%, this would amount to 10 shares and, in addition, take up 5% of your pool.
If, on the other hand, your initial issuance was even 1 million shares of common, that same grant to the developer would amount to 10,000 shares once exercised. Yes, it’s just appearances, but as a prospective employee considering multiple offers from startup employers, which offer would you rather have?
Along these same lines, the other practical effect of avoiding a smaller initial issuance is to create a lower price per share. Key employees or advisors your startup hopes to lure with equity may perceive a greater benefit when getting stock options for a large number of shares (with a lower exercise price) as opposed to getting an option for a smaller number of shares with a higher exercise price. Again, this is the case even though both options represent the same percentage of the company.
Lastly, there is value in keeping the price per share lower from the standpoint of attracting outside investors. The price/share in an equity investment round is equivalent to the valuation of the startup before the round (aka its “pre-money” valuation) divided by the number of shares outstanding and reserved for issuance before the round. Angels and venture capital investors in a company’s first round of equity financing ordinarily like to think they are getting in on the ground floor, or something close to it. The lower price/share helps to achieve this.
Do authorized but unissued shares affect my ownership as a founder?
Generally speaking, no. Upon forming up, a startup typically has a very clean “cap” table. In other words, its structure from the capitalization standpoint is very simple—no options, warrants, or other securities capable of conversion to stock. As long as this is the case, actual ownership of the company would turn on the allocation of the shares issued. The authorized but unissued shares will have zero effect on ownership of the company.
Note that the number of shares authorized can have an impact on your Delaware state taxes. A startup formed as a Delware corporation typically issues a significant portion of its authorized shares because leaving a large percentage of shares unissued can have an effect on Delaware franchise taxes owed.
Founders who are considering incorporating (or who have recently incorporated) their startup should consider retain legal counsel as soon as possible to discuss this all too often misunderstood and ignored aspect of the startup formation process. In many instances, the advice of an experienced attorney can help avoid significant or costly delays related to corporate governance, hiring of key employees, and even availability of outside investor funding. To schedule a consultation with our Phoenix startup law firm, call our office today at (602) 222-5542 or send us an e-mail through the online contact form to the right.
Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property, Internet and digital media matters, and complex corporate M&A and technology transactions. Ben can be reached at (602) 222-5542 or by e-mail at firstname.lastname@example.org