Leave some room at the (cap) table, you’re probably going to need it.
This write-up was originally sent to subscribers as a part of our Mission Control weekly insights, a series where we share wisdom and quick breakdowns on topics from our entrepreneur support network.
Founders commonly make the mistake of issuing too many shares to themselves. If there’s not some wiggle room on the cap table, incentivizing key contributors gets unnecessarily complicated.
Key Takeaway:
For most startups, issuing between 60% and 80% of the total authorized shares of Common Stock is a good rule of thumb that balances founder ownership with flexibility to bring on additional contributors and minimizes Delaware franchise tax.
Ownership of the company is determined purely based on issued shares so, even if only 6M out of 10M shares have been issued, the holders of those shares are 100% owners of the company until additional shares are granted.
The Details
Let’s dive into the details of the common misconceptions and where they come from.
It’s not the end of the world when founders run out of authorized shares early on, but it presents an unnecessary distraction that has the potential to get expensive in a variety of ways.
The most common mistake is that founders will issue themselves all of the authorized shares because they think they need to to own 100% of the company. Another common miscalculation is thinking they won’t need anyone else to help accomplish the near-impossible task of getting their startup off the ground.
In both cases, when these founders find that elusive, magical, perfect-fit team member down the line they can’t offer them ownership to come on board because there isn’t any available (and we all know there’s no cash!).
In reality, handling this conundrum correctly isn’t that complicated or expensive. But, most founders haven’t navigated it before, they’re feeling urgency to close a critical contributor, and they’re scared to tag in their lawyer for fear of billable hours. This usually results in founders hatching complicated schemes to redistribute the shares they own through stock transfers or buy backs. Sometimes they might even suggest that maybe those original grants didn’t really happen?
Those complicated schemes can have equally complicated repercussions, mostly in personal tax liabilities for shareholders. Stock transfers can mean the new recipient won’t benefit from the huge capital gains advantages of QSBS. Stock buy backs suffer similar QSBS issues but have the added danger of disqualifying all shareholders—not something your future investors will look kindly upon. Pretending a grant didn’t happen? Be very careful when you re-issue shares to the grantee: there may be complications to their income tax liability and future questions about the company capitalization.
In most cases, the best way to handle running out of Common Stock is to authorize more shares by amending your Articles of Incorporation with Delaware. It will cost you a bit of time to prepare, authorize, and file the amendment and a few hundred bucks in filing fees. But, it’s a straightforward process and it avoids a rats nest of potential tax complications.
Gust's Mission Control can guide early founders through all sorts of complex startup hurdles, like cap table managment.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.