Starting Shares

When incorporating a high-potential startup, one key decision is how many shares to authorize – and it is easy to optimize on the wrong number.

As I described in an earlier blog, when forming a high-potential startup that you plan to raise money to build, it is wise to incorporate in Delaware. Many attorneys will assist with a new startup’s incorporation process without requiring legal fees as part of a startup package, so be sure to ask whomever you are thinking of hiring as the corporate attorney for your startup.  

A critical decision you need to make when filing the paperwork for your new Delaware C Corporation is how many shares of Common Stock to authorize. Be warned! There is a lot of confusing information about how to make this decision.

When founding, a mistake many cost-conscious founders make is to seek to minimize the annual Delaware franchise tax using the Authorized Shares filing method with Delaware, with the lowest possible tax when you incorporate with less than 5,000 shares. However, absolute franchise tax minimization is a mistake if you are targeting building a high-growth startup.

Because you will be using your authorized shares to incentivize your early team strategically, you will want to think about the impact of a low number of authorized shares on the vesting schedules you will use to create the proper incentive structure to encourage team members to contribute over time and recover equity if anyone chooses to leave early on. Your investors will want to see this, so it is essential to think ahead – and strategically consult the attorney you hired to avoid mistakes. Your goal should be to initially authorize a number of shares that will make sure that you can make equity grants to co-founders as well as early hires with a high enough number of shares to divide the overall number of shares granted by a typical 4-year vesting schedule (usually in months) so that you do not run into the problem of trying to vest tiny numbers of shares. For example, if you want to grant 0.5% of your equity to an early paid contributor:

• If you incorporated only 5,000 authorized shares, the total 0.5% 4-year grant would be 25 shares (5,000 x 0.005). To vest over 48 months, you start dealing with fractional shares (25 shares/48 months = 0.5 shares per month), which becomes tricky if they leave before fully vesting. Rounding up or rounding down would materially impact the amount of the company granted to the employee.
  
  
• Alternatively, if you incorporated with 10,000,000 authorized shares, then the total 0.5% 4-year grant would be 50,000 shares (10,000,000 x 0.005), which would vest 1,042 shares (50,000/48 months) per month, and any rounding required upon departure would only be a negligible impact on the overall ownership granted.

Plus, it sounds much better to an employee to be granted 50,000 shares!

You might think it would be smart to start with a low authorized share count and increase it later when growing your team. However, any savings will quickly be swamped by the wasted time, legal fees, and filing fees for changing your number of authorized shares. Remember that increasing your number of authorized shares involves amending your corporate charter with the State of Delaware, a process that requires board actions, shareholder actions, and amendments, plus a Delaware filing fee. In addition, you will need to grant founders and existing team members new grants to get them back up to their intended ownership, which involves more legal paperwork, board approvals, 83(b) filings, and so on. As you can see, you will easily spend hundreds or thousands of dollars making changes correctly, and it will not be worth the few hundred dollars you might save in Delaware franchise taxes. By the way, if you have already incorporated with too few shares, collaborate with your attorney to get that situation fixed as soon as possible to minimize the cost and number of parties involved.

If you have not yet incorporated your startup, ten million shares is practically the industry standard for incorporating a high-potential startup because that allows grants of small ownership percentages with meaningful vesting schedules. While ten million shares might sound like a lot and cause worries about Delaware franchise tax expenses, be sure to consult that great corporate attorney you hired who can easily help you use the Assumed Par Value method of franchise tax filing and can likely get your annual obligation down to the $400 minimum, like the vast majority of startups who do not have significant assets. This will be far less expensive than changing your authorized shares outside the context of raising a funding round.