How to Allocate Shares in a Startup When One Founder is Also an Investor

February 5th, 2010

I frequently talk to entrepreneurs starting a company where one founder is putting up seed capital while the others are putting in sweat equity alone.  The founders want to divide the company ownership according to some formula they have figured out, and then ask me how to document it properly.  This are several variables required to do this correctly.  Here is how I think about it:

Percentage Ownership
The founders have figured out an ownership ratio that makes sense to them.  Let’s say there are 3 co-founders, all of whom will be active day-to-day.  One founder will invest $100,000 in seed capital and the others will invest only nominal cash.  The founders have agreed that each of them should get 33.33% of the initial shares.  For simplicity let’s say that each founder gets 1,000,000 shares.

Stock Price
We always want to keep the price of common stock low so that as new employees, co-founders or others come along they can buy stock (or get stock options) at a low price.  I usually like to start with a founder stock price of $0.001 per share.  Stock should always be bought for cash, so we immediately have a problem matching the 1/3-1/3-1/3 ownership ratio with the varying amounts of cash being invested.

Using our hypothetical numbers, Founders A and B are getting 1,000,000 shares at $0.001 per share, which means they need to put in $1,000 each.  If Founder C is buying the same type of stock, also at $0.001, his $100,000 will buy him 100,000,000 shares; he will own 99.99% of the company.

Preferred Stock to the Rescue
My recommendation here is to treat Founder C an investor as well as a sweat equity founder.  By this I mean that we can issue some of his shares as common stock like the other founders, and some of it as preferred stock, which lets us set a higher per share stock price.

Preferred stock is “worth” more because it has rights preferential to common stock.  The rights can vary a lot, and in this case I would provide only a nominal step-up in rights compared to the common stock, so that if our company gets sold Founder C would get his money back before any money is distributed among the common stock holders.  If the company is sold in an extreme fire sale, it is possible that Founder C would be the only one to get any money out, but with luck we will be able to sell this company for more than $100,000.

Stock Repurchase Right
The last important piece here is that all founders should have their sweat equity shares subject to a company repurchase right.  The stock “vests” so that if a founder leaves after a year or two, she only gets to keep the equity she has earned through service.  In my view, all of the common stock should be subject to the repurchase right, but since the preferred stock is purchased for a cash investment, it should not have a repurchase right attached.

In this example, 100% of Founder A and B’s shares are subject to repurchase, but 90% of Founder C’s are not.  This might be the right outcome- or we could adjust the Preferred Stock price and the relative amounts invested for common stock and preferred stock so that Founder C owns more common stock, and has more stock subject to repurchase.  There are a no “right” answers here and it is just a matter of finding the set of conditions that best represents the founders’ relationships.

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  • finsrud

    Doesn't setting up preferred stock for a founder “muddy up” the cap table, particularly if the company's going to raise capital? Why not just structure the founder's investment of seed capital as debt (convertible or otherwise)?

  • http://blog.jparkhill.com Jay Parkhill

    This is a terrific question. Debt can work too, but it will impact the
    balance sheet. If a company gets outside investment and gives preferred
    stock to the investors, “regular” debt would sit ahead of the investor's
    stock in right of repayment, so we haven't made the picture of the company
    any clearer.

    Convertible debt is a good idea, although then we have one founder on both
    the common and preferred “sides” of the company so the financing needs to be
    large enough relative to the founder investment that the investors can still
    control the preferred series. Also note that it will be hard to make sure
    that equity is divided in a specific ratio among all the founders- the
    investor/founder could end up with a much higher or lower equity percentage
    compared to the other founders depending on the valuation of the preferred
    round.

    If the company does a substantial financing there is a decent argument that
    the founder's preferred stock should be converted to common pre-closing
    based on the (substantially) increased valuation and the new dynamic.
    Alternatively the founder's stock could be called Series AA and rank behind
    the new investors but ahead of the common.

    There are a lot of ways to manage it and no clear “right” answers.

  • finsrud

    Doesn't setting up preferred stock for a founder “muddy up” the cap table, particularly if the company's going to raise capital? Why not just structure the founder's investment of seed capital as debt (convertible or otherwise)?

  • http://blog.jparkhill.com Jay Parkhill

    This is a terrific question. Debt can work too, but it will impact the
    balance sheet. If a company gets outside investment and gives preferred
    stock to the investors, “regular” debt would sit ahead of the investor's
    stock in right of repayment, so we haven't made the picture of the company
    any clearer.

    Convertible debt is a good idea, although then we have one founder on both
    the common and preferred “sides” of the company so the financing needs to be
    large enough relative to the founder investment that the investors can still
    control the preferred series. Also note that it will be hard to make sure
    that equity is divided in a specific ratio among all the founders- the
    investor/founder could end up with a much higher or lower equity percentage
    compared to the other founders depending on the valuation of the preferred
    round.

    If the company does a substantial financing there is a decent argument that
    the founder's preferred stock should be converted to common pre-closing
    based on the (substantially) increased valuation and the new dynamic.
    Alternatively the founder's stock could be called Series AA and rank behind
    the new investors but ahead of the common.

    There are a lot of ways to manage it and no clear “right” answers.