Capitalization structure for an early-stage technology company

 

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 of your business. Here is what they mean:

• Initial equity: At the time of incorporation, the founders of a business generally purchase shares at a nominal price per share, such as $0.0001 per share, paid in cash, since at that time the company has no operating history, few assets and thus little value. These shares are often referred to as founders’ shares.
• Founders: This refers to 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 business, but may consist of 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.
• Management: A founder may serve as a member of the management team; however, not all members of the management team are founders. Management will likely change over the life of the business and these individuals are usually incented with a combination of cash compensation and stock options.

Entrepreneurs should consider the number of founders’ shares and stock options to be issued in relation 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 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%
Unallocated   options	144,056	0%	12.25%
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 shares, the ownership percentage for the company would remain the same among the founders; however, the company would have difficulty splitting the 17.6471 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. Consult legal counsel to assist you in seeking the necessary shareholder approvals to make the change and to file revised articles of amendment, legally documenting the change.

What do potential investors see as a clean capitalization structure?

1.   A limited number of classes of common shares being used for equity issuances and stock option grants. In addition to a voting-share class for equity issuances, sometimes a separate voting or non-voting common-share class may be established for stock option grants.
2.   A manageable number of shareholders, excluding insiders, holding stock options.
3.   Implementation of a stock option plan that provides potential financial advantage to all key employees who continue to work with the business to build shareholder value.
4.   No obstacles to obtaining shareholder approval to issue the new investor shares in exchange for cash investment, nor to obtaining amendments to any legal documents or the capital structure accordingly. This is usually achieved by having a shareholders’ agreement, a voting trust or other legal documents to ensure that minority shareholders will follow suit with the majority.

Note that 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 U.S. investors may require the company to reorganize itself on a cross-border basis for their own local tax or operational reasons.

Entrepreneurs should seek professional legal advice when establishing or making changes to their capitalization structure. Choose legal counsel that has 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 start-up, but setting up your business incorrectly will cost you
more in the long run.

References

Houston, Thomas, Andrea Johnson, and Eric Smith. (September 15, 2006). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Fraser Milner Casgrain. Retrieved May 21, 2009, from http://www.fmc-law.com/Publications/Technology_Startup_Guide.aspx.

Tags: capitalization-structure, early-stages, investors