When you’re ready to incorporate, you’ll need to give some thought to the proper equity structure for your business. Because equity is a currency startups can trade for money or services, your company’s initial equity structure should take into account your plans for near-term growth. There are no hard-and-fast rules on the proper equity structure for a company, but here are a few things you’ll want to think about.
How many shares should be authorized? The number of shares “authorized” in the corporation’s charter is the maximum number the company can issue without amending its charter to authorize more. Authorizing too many shares is wasteful because state filing fees typically increase with the number of authorized shares. In Massachusetts, for example, a corporation can authorize up to 275,000 shares for the minimum filing fee of $275, but the filing fee increases by $100 for each additional 100,000 shares (or part thereof) the company authorizes. On the other hand, amending your charter to authorize more shares can cost anywhere from a few hundred to a few thousand dollars in legal and filing fees. Before settling on a number of authorized shares, consider (1) the maximum number of shares you can authorize for the state’s minimum filing fee, (2) the incremental cost of authorizing additional shares versus the cost of amending your company’s charter, and (3) how much equity you expect to issue before you need financing. Note that an angel or VC financing will usually require a charter amendment to specify the rights of the equity the investors are purchasing, so you can authorize additional shares for the financing at that time.
How many shares should be issued? Issued shares are those held by the company’s stockholders. The number of shares initially issued to the founders depends, again, on how much equity you expect to issue before you need financing. For example, if you want to reserve 20% of the initial equity ownership for employees and consultants, you would initially issue to the founders no more than 80% of the authorized equity of the company.
What should be the “par value” of shares? The “par value” of a share of stock is the minimum price a shareholder must pay to acquire the stock. Par value is an archaic concept and some states, including Massachusetts, no longer require that stock have a par value. Nevertheless, par value is still commonly used in large part because Delaware, that hub of American corporate law, still uses par value to calculate a company’s annual taxes (Delaware permits no-par stock, but the effective rate of tax is typically much higher than for stock with par value). When used, par value is typically very low – often a tenth of a penny ($0.001) or even a hundredth of a penny ($0.0001) per share – so that shares can be issued for a minimal capital contribution.
Should the company have multiple classes of stock? Classes of stock give one group of shareholders different rights than another group with respect to, for example, voting and dividends. The most common example of a class of stock with special rights is the preferred stock issued to angels and VCs in an equity financing. Creating multiple classes of stock is tricky (read: more legal fees) because of the need to carefully define the interplay between the rights of each class, and therefore it is usually best for startups to stick to one class of stock (i.e. common stock) until they raise angel or VC financing.
A good rule of thumb when setting up your company’s equity structure is: Keep It Simple. An unduly complicated equity structure will be costly to set up and can be a hindrance to corporate governance. Your legal advisor can help you determine an equity structure that’s appropriate for your business.