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Planning a Company’s Ownership: Why Your Capitalization Table Matters

By Steven Keeler

Setting the “Cap Table” with the Future in Mind

A typical company life cycle starts with equity ownership being allocated to one or more founders. For the founders, later granting or selling equity to employees or investors is a double-edged sword. While the founders understandably want to preserve their own ownership and protect it from dilution, sharing equity with key employees and selling equity to investors is often worth the dilution as it enables the company to retain talent, attract capital and grow toward a successful exit. Because every company is different, its ownership plan (reflected at each stage in its equity “capitalization table” or “stockholder ledger”) should be tailored to its and its founders’ unique goals, needs and culture. The “best” ownership plans involve careful review of company ownership at each stage of the company’s life cycle, with future needs and the unexpected in mind, clean record keeping and paperwork, and legal documents which provide future flexibility, clear expectations and company protection. The following discussion applies equally to equity in “C” corporations, “S” corporations and limited liability companies or “LLCs”, although there can be differences in the income tax treatment of and approach to each that should always be considered in the planning after consultation with both the company’s tax and legal advisors.

Cap Table TIP: There are now various service firms that provide companies with software and clerical support and guidance in developing and maintaining capitalization tables and supporting schedules. In addition to the services provided by accounting and tax preparation professionals, these firms can provide invaluable assistance to a company in keeping its cap table and records accurate and avoiding numerical and recordkeeping mistakes that can be more difficult and expensive to fix after the fact.

The Founders’ Honeymoon and “Prenuptial Agreement”

If and when there are multiple “founders” in the mix, they typically receive “common” stock or equity with a relatively low value which is acquired for no or at a low purchase price and with no or no significant income tax consequences. The issues we see in structuring founder ownership include:

• “Class or Type of Stock”. Whether to issue the founders simple “common” stock, promissory notes for founder out-of-pocket contributions, and/or so-called special “founder” (popularly referred to as “Series F” or “Series FF” stock) stock with certain voting, conversion or liquidation rights (more similar to “preferred” stock) that might provide them with better voting or economic rights later when additional shares are issued to key employees or investors.

Founder Stock TIP: In our experience, special “founder stock” is relatively uncommon and can be viewed unfavorably by future investors.

• “Founder Percentages and Separation Terms”. Too many startups allocate initial company ownership among several founders either in equal shares or without due consideration of what are “fair” percentages (consider each founder’s contributions to and role in the company) and how ownership should be affected when people leave. Founders and the company are almost always better off if founder shares are subject to “vesting” and forfeiture or repurchase when a founder leaves. This not only protects the remaining founders, but also puts them in a stronger position to push back later if an investor requests for more onerous vesting terms. The company and founders should always enter into an agreement (popularly referred to as a “stockholders”, “stock purchase”, “restriction” or “buy-sell” agreement) governing voting, board membership,share transfers and purchases or forfeiture upon the occurrence of events such as termination of employment, death or disability or the commission of “bad” acts. The founders should also agree to subject their shares to reasonable transfer restrictions, “co-sale” rights and “drag-along” obligations, as these will certainly be requested by future venture capital or private equity investors.

Founder Agreement TIP: Every company with more than one founder or equity owner needs a “stockholder” or “buy-sell” agreement to address everyone’s expectations regarding everyone’s commitments and unanticipated future events that will require the company and management to pivot in a way that is fair to all stakeholders. Too many valuable companies run into costly founder deadlocks and disputes when, to save time and money or to avoid uncomfortable discussions, they fail to have an adequate agreement setting forth what should happen to their ownership upon unexpected future events.

Taking Care of Your Talent (and Your Company)

While awarding equity ownership to key employees or other service providers is seemingly not in the best selfish interests of the founders, the best talent often desires and expects to receive an equity stake in addition to their salary, incentive bonuses and benefits. The most common forms of employee equity grants are stock options and “restricted“ stock. These can be used by a corporation or an LLC (but only LLCs offer the unique “profits interest” alternative to taxable restricted stock), with some important tax planning differences.

• Tax and Vesting Considerations. Competent legal and tax advice regarding the “best” type of equity incentives to grant service providers will also include consideration of such things as determining the “fair market value” of the company’s shares, “Section 83(b)” election planning and the legal and tax implications of “vesting” of the options or shares.

Option TIP: Generally, a stock option must be granted with an exercise or purchase price per share equal to the then fair market value per share, unless the option is not exercisable until the later of termination of employment or a company sale.

• Business and Financial Decisions. Often, granting restricted stock to employees will be the simplest and, for the employee, most tax-efficient alternative. What’s best for a particular company and founders should be determined, first, by business, financial and legal considerations, and, then, tax implications

• Proper Paperwork is Key. In all cases, equity grants should be supported by sound legal documents providing similar company protections to the vesting and “stockholders” agreement terms mentioned in the previous section discussing founder equity. The company should ensure that employee equity plans work in concert with employee compensation plans and that all awards comply with “Rule 701 of Regulation D” under the securities laws.

Employee Option or Stock TIP: In addition to not making verbal promises you may not keep and getting the precise terms in properly drafted legal agreements, carefully consider the company’s rights to repurchase options or shares upon the termination of the employee or service provider.

Other Peoples’ Money (Angel, VC or PE Investors)

After a company has issued common equity to its founders and common stock options or restricted stock to key people, it may eventually consider bringing in outside investor capital from early-stage “angel” investors, “VCs” or even strategic corporate investors. The universe of investor types ranges from “friends and family”, “angels” and “family offices” to venture capital and private equity funds, lender or “mezzanine” funds and corporate VC arms, among the many other debt and equity financing sources. The types of “securities” or equity or “equity-like” shares of company ownership issued to raise capital typically include some or a combination of the following, and each has dramatically different impacts on the company’s capitalization table:

• Convertible Notes. These are popular because they allow the company to raise capital and put off the subjective process of valuing the company. A convertible note is debt with a multi-year repayment term and interest which automatically converts to equity upon a future equity capital raise. Many convertible notes convert the principal and accrued interest balance into a number of shares of the same class issued in the future round based upon a “conversion price” equal to a discount (e.g., 20%) off of the price paid in the future equity round and, more common today, subject to some conversion price “cap”.

Convertible Note TIP: Always make sure that any notes which convert into preferred stock sold in a future round are only entitled to a “first out” or liquidation preference (discussed below) equal to the amount they paid for the note.

Convertible Note TIP: Always make sure that any notes which convert into preferred stock sold in a future round are only entitled to a “first out” or liquidation preference (discussed below) equal to the amount they paid for the note.

• SAFEs. These “simple agreements for future equity” are a relatively modern alternative to convertible notes and stock “warrants” that have developed to save time and legal work. They are not actually debt nor equity. They are arguably a better and “safer” deal for the company than the investor.

• “Seed” or “Series A” Preferred Stock. “Preferred” stock is simply a class of stock that is “senior” or “superior” to the “common” stock held by the founders, employees and any early common stock investors. Preferred stock typically entitles the investor to be repaid its total invested amount before any distributions or dividends can be made to the common stock. “Seed” preferred is usually issued in earlier-stage capital raising rounds to angels and others and has simpler and more company-favorable terms than the “Series A” preferred typically sold in larger “institutional” or “VC” rounds led by a VC fund. Preferred stock is also sometimes issued to private equity fund investors (who typically take larger ownership stakes in and often ownership control of more mature companies). Preferred stock terms, including “first out” or distribution and liquidation rights, and the right to have board membership and special “veto” rights over certain major company actions, vary widely. The most important thing for the company and founders to consider when first and later issuing preferred equity is the impact the terms may have on future company operations, management and future capital raising, as it may be hard to change these terms later.

Convertible Note TIP: Get experienced advice as to what preferred stock terms are “market” or fair to the company, including whether the preferred is convertible, participating (or so-called “double dip”), whether the preferred will accrue a “preferred return” similar to interest on a note, and what voting (or “veto”) rights the preferred investor has over company operations or major future events or transactions.

• Notes with Warrants. Depending on the company’s profile, financial position and needs, some investors who typically prefer debt investments will negotiate a loan evidenced by a loan agreement and promissory note having a variety of terms and perhaps a higher-than-bank interest rate, coupled with a warrant to purchase company equity shares to provide the lender with additional upside or a “kicker”. The economics of a note and warrant are dramatically different from a convertible note or preferred equity. Because, like an option, the warrant represents the right to purchase stock in the future but, unlike an option, often at a “strike” or exercise price lower than fair market value, the legal documents supporting the warrant should address many of the issues discussed above around share ownership, transfers and the like.

Warrant TIP: Pay particular attention to the terms of the warrant agreement, including whether the lender or investor can force the company to cash it out at some point in the future (a “put” right) and the company can repurchase the warrant prior to exercise (a “call” right), whether it can be transferred to another party and how future company equity issuances might cause “anti-dilution” adjustments to the exercise price, and, if the company is an LLC, the tax implications to the company and its other owners of a warrant exercise.

Cap Table Impact of a Company Sale

Properly planning and documenting your company’s ownership will make a company sale much easier to navigate.

• Founder or Management Equity Rollovers. If your company is sold to a financial or private equity buyer (versus a strategic, competitive or corporate buyer), the founders and some management equity holders may be required to retain and “roll over” a portion of their equity into equity of the buyer. Any equity that is not rolled over will participate in the sales consideration, which may include a combination of cash, buyer note or earn out.

• Notes, options and warrants will most often be paid out in cash upon a company sale or “change of control.” Options will typically be paid through payroll as their payment will constitute compensation subject to withholding taxes.

Cap Table Sale TIP: Perhaps the greatest benefit and value of a properly and accurately planned and maintained cap table, supported by organized and signed legal documents, is the comfort it will provide a buyer of the company during their due diligence review of the company’s legal structure, documents and records.

It Was Your Company, Now It’s Yours and Theirs

The ownership of a company should be thoughtfully considered from the outset (when it is still simple and can be reasonably controlled by the founders). When the company’s ownership structure needs to be changed or future personnel recruitment and capital raising require additional equity sharing, the company and its founders should approach the process with the interests of all stakeholders and future flexibility in mind. The only certainty in company strategic, succession and growth planning is that the unexpected will happen. A properly planned “cap table” and adequate legal documents willnot only protect the founders and incentivize the entire team, but make future capital raising and an eventual company sale of the business, more smooth and successful.

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