Tech startup founders strive for and investors appreciate a “clean” capital structure for ventures that will eventually seek outside investment. There are a few terms you will hear when discussing the set-up of the capitalization structure for your business and here is what they mean:
The founders of a startup generally purchase shares at the time of incorporating the company at a nominal price per share, such as $0.0001 per share, paid in cash, since at that time the company will have no operating history, few assets and thus little value. These shares are referred to as founders’ shares.
Founders are the initial group of individuals who conceived the idea and/or the first individuals recruited to get the business off the ground. Founders are usually the one or two individuals who are the driving force behind the startup, but may be a larger group (usually less than six).
The founding group should objectively assess each individual’s expected contribution and allocate founders’ shares on that basis (rather than spread equally across the group). You’ll want to consider whether an initial equity issuance or stock options represents the appropriate incentive for an individual.
A founder may serve as a member of the tech startup’s management team; however, not all members of the management team are founders. Management will likely change over the life of the business and they are usually incented with a combination of cash compensation and stock options.
During start up, entrepreneurs should consider the number of founders’ shares and stock options to be issued in relationship to the current valuation of their business and/or the valuation they hope to achieve in the first round of investment from outside investors.
They need to determine how they wish to allocate the ownership of the business among the founders and to key employees, directors, advisors and contractors.
Consider the example below:
|Shareholder/option holder||Number of shares||Actual percentage owned||Fully diluted percentage|
|Founder A (CEO)||500,000||50%||42.5%|
|Founder B (CTO)||300,000||30%||25.5%|
|Founder C (Key Technical)||200,000||20%||17.0%|
|Issued and outstanding shares||1,000,000||100%||85%|
|Option holder 1||11,765||0%||1.00%|
|Option holder 2||3,000||0%||0.25%|
|Option holder 3||17,650||0%||1.50%|
|Total fully diluted shares||1,176,471||100%||100%|
If the founders had simply issued 50, 30 and 20 shares for a total issued capital of 100 shares instead of 1,000,000, the ownership percentage for the company would remain the same among the founders; however, the company would have difficulty splitting the 17.65 shares available for stock options among option holders, since legally, partial shares are not permitted.
If you have incorporated your business with a smaller than desirable number of shares, you can modify your capital structure by “splitting” the current number of shares issued. You should consult legal counsel who will assist you to seek the necessary shareholder approvals to make the change and to file revised articles of amendment, legally documenting the change.
What does a clean capital structure look like for potential investors?
- A limited number of classes of common shares are being used for equity issuances and stock option grants. Usually one voting common share class but sometimes a non-voting common share class may be established for stock option grants in addition to voting share class.
- There are a manageable number of shareholders, excluding insiders holding stock options.
- A stock option plan has been implemented, providing upside opportunity to all key employees who will continue to work with the business to build shareholder value.
- There are no obstacles to obtaining necessary shareholder approval for the company to issue shares to the new investor in exchange for cash investment and to amend any existing legal documents or the capital structure accordingly. This is usually achieved through having a Shareholders’ Agreement in place, a voting trust or other legal documents to ensure that minority shareholders will follow suit with the majority.
- Canadian investors generally prefer to invest in Canadian-Controlled Private Corporations (CCPCs). A CCPC is a Canadian-incorporated private corporation that is not controlled directly or indirectly by one or more non-residents of Canada or public corporations (or any combination thereof). CCPCs enjoy benefits including the right to claim refundable cash Investment Tax Credits under the Scientific Research & Experimental Development program as well as potential tax advantages for founders and employees on the sale of their shares or stock options. Companies should seek legal or tax advice as to how to maintain their CCPC status. However, some US investors may require the company to reorganize itself on a cross-border basis for their own local tax or operational reasons.
Tech startup entrepreneurs should seek professional legal advice when setting up or making changes to their capitalization structure, choosing legal counsel with experience in setting up early-stage ventures and working on investment rounds for their clients. Hiring a lawyer may seem like a big expense for your startup, but setting up your business incorrectly will cost you more in the long run.