So, you have a great product idea and you’ve decided to start the company of your dreams.  If you develop your product idea and the market embraces your technology, you are on your way.  Perhaps your company won’t become the next Google or Facebook, but it can find its place among competitors, attract additional financing and grow … even go public.

Great!  Just don’t step off a cliff.  You will need to avoid a number of serious pitfalls as your company grows, succeeds and approaches the Valhalla of an IPO.  You must manage your stock allocation process.

As an early stage company, funds, that is to say, cash, likely, will be scarce as you invest in product development, marketing and sales, and growing a staff.  Because your product is complex and state-of-the-art, you will need expertise that may exist outside of your organization and that is too expensive to hire on a full time basis.  Such resources are expensive and create a great drain on cash resources.  Likewise, you need experienced, highly competent managers and executives, marketers and sales personnel, engineers and technicians and administrative support personnel.  All of these are expensive and also create a material drain on cash.

What to do?  Most founders think immediately of issuing company stock.  It’s cheap, requiring only some stock certificates and a quick review by a friendly lawyer.  Even though the value of stock options must, in a publicly-traded company, be accounted for as a charge to the company’s income, these rules do not apply to private companies.  Further, the accounting charges for stock options do not mean much to investors or employees.  Some publicly-traded companies even restate their earnings without these equity-related charges.  If full value shares, i.e., restricted stock shares or restricted stock units, are used instead of stock options, there is no accounting (or tax) consequences to the company until the restricted stock shares / units are vested or until other restrictions related to the restricted stock have lapsed.

A perfect solution for the start-up company that is short of cash?  Not so fast!

Repeated issuance of stock options or restricted stock results in the dilution of all who hold shares or options of the company’s stock.  So who cares about dilution?  A lot of people!

If the company has 100,000 shares of stock or stock options outstanding when it makes an after tax profit of $1,000,000, the earnings per share (“EPS”) of the company is $10 per share.  If the company has issued 500,000 shares of stock or stock options, that EPS for the $1,000,000 of after tax earnings is $2 per share.  Typically, companies are valued as a multiple of EPS.  For example, in early 2012, Google’s EPS was about 30 times earnings.  Shareholders were willing to pay 30 times after tax earnings for a single share of Google.  On the other hand, Zynga’s EPS at the same period is less than 1 times after tax earnings.

The impact of issuing too much stock has a number of ramifications.

Attracting and Retaining Key Personnel.  As the number of shares outstanding grows, employees quickly compute the steady diminution of the value of their stock, restricted stock or stock options.  In the above example, the early employee given stock options with a theoretical $10 / share now is looking at an option whose value now is $2 per share.  Not very motivating.  Does that employee start looking at other companies with better stock value? Probably.

Impact on Founders and Investors.  After the Microsoft IPO, both Gates and Allen still held the vast majority of the Microsoft shares.  Gates owned about 45 percent of the company’s then 24.7 million shares outstanding; Paul Allen, Microsoft’s co-founder owned roughly 25 percent of the shares for a total of approximately 60% of the company’s total shares outstanding held by its founders after the IPO.

On the other hand, Marc Pincus, founder of Zynga retained approximately 12% of Zynga’s stock after the IPO.  However, as a result of a special class of stock issued to Mr. Pincus, he controls 37 percent of the shareholder votes. All told, insiders holding B and C class stock will control 62 percent of the vote.  Ordinary shareholders have not been provided stock with other than one-to-one voting weight.  Generally, the investment community was not pleased with this arrangement.

Impact on Employees.  Too many shares outstanding can have the effect of frustrating the company’s goal to attract and retain key personnel. The issuance of an excessive number of shares has a number of ramifications.  The first impact is the reduction of value of the shares held by early stage employees.  Typically, such employees, often possessing very specialized skills and experience, come to a start-up because of the lure on a material pick-up in the value of the shares that they have been issued.  An excessive number of shares reduces the value of the options or full value shares eroding the dream of great riches from taking a major risk.  Issuance of excessive shares outstanding also creates a shortage of available stock to offer to later stage employees.

Founders, early stage investors and key personnel all are negatively impacted by the issuance of too many shares.

Recognizing that too many shares had been granted, some companies have asked, not required some employees to give up stock options previously granted.  In the field of compensation, it never is a good idea to ask an employee to give up something that was given to her.

Impact of the Company’s Capital Structure.  An excessive number of shares can warp the company’s capital structure making it difficult to obtain institutional funding.  This situation is further complicated at the time of an IPO.  With fewer shares, the shares being offered to the public are scarce, creating a perceived shortage to investors who wish to invest.  Also, with a large number of shares, the number of shares that must be offered in the IPO also are greater.  For example, Zynga needed to sell 100,000,000 shares of its stock to the public to raise $1-billion in capital.  In 2004, Google offered 7% of its shares to the public in its IPO to raise $2.7 billion of capital giving Google a market value of $27 billion.  Today, Google’s market cap is about $190 billion.

Why Does This Happen?  The primary reason for issuing too many shares is the founders’ or board of director’s failure to plan for the use of the company’s equity.  Google sold 19,605,052 shares worth $1.67 billion for the public.  Its initial market capital was $23.1 billion and the share price was $85.  Today, Google’s market cap is about 8-times that of its IPO.  However, not all companies realistically can anticipate an increase of this magnitude.  Therefore, it is imperative that you be extremely realistic about the present and anticipated value of your company.  As a start, you can profile your company against similar, competitors.  What is their market cap?  At what rate has it increased (or decreased)?  How many shares are outstanding? What percent of total shares outstanding do the founders hold?

In addition to tracking the realistic value of your company, you need to guard against common pitfalls in grant equity.  These include:

Friends and Family Financing.  You start by issuing yourself 1,000,000 shares of the company’s common stock.  Capital is dear in the early stages of your company.  Sometimes, the only available sources of financing are your immediate family.  So, you borrow $10,000.00 from Aunt Jane, and, in return, issue her 100,000 shares based upon a value of $0.10 per share.  Uncle Harry, a few months later, “invests” $20,000.00, and receives 200,000 shares based upon a value of $0.10 per share.  300,000 total shares doesn’t seem much when you are in great need of capital, but … without much thought, you have issued stock equal to over 15 percent of your company’s total shares of 1.2 million for $30,000 of capital.  If the company later issues more than an additional 2 million shares of stock for an investment of $20,000,000 from a venture capital firm, Aunt Jane’s and Uncle Harry’s ownership will have been reduced to about 7 percent.  They might not be happy.  But, then again, they may be ecstatic depending upon the ultimate value achieved by the company.

Key Employees.  The potential success of your company depends upon the technological expertise of two key engineers and a senior marketing executive.  All of these people, known to you from previous employment, are critical to the success of your company.  You can’t match their current salaries so you make major stock grants to each of them.  Based upon Aunt Jane and Uncle Harry’s stock grants, you issue options for 100,000 (approximately 10 percent of the now 1,400,000 total shares outstanding, including these grants) to each of these key employees.  Your ownership position now has been reduced approximately one-third to about 70 percent of total shares outstanding.

Service Providers.  The development of your product is proceeding well, but you’ve experienced a couple of technical hurdles that you and your staff are having difficulty overcoming.  You know the industry’s best “guru” so call him to help with the product development.  His hourly rate is $300 per hour and his estimate of the cost of the work to be done is $60,000.  You don’t have $60,000 to pay the guru but need his expertise.  He agrees to work for his expenses and a stock grant of 250,000 shares ($60,000.00 / $0.25 per share).  The Guru now owns over 2.5 percent of the company’s now 1,650,000 TSO.

Similarly, you realize that the company needs a good lawyer.  You contact an old friend who agrees to serve as your corporate counsel for a retainer of $20,000 per year plus 50,000 stock options per year. Total shares outstanding after the grant stand at 1,700,000; your ownership of the company is now about 59 percent.

Board Members.  You quickly realize that you need high level strategic guidance, so you assemble a board of directors.  You elect your Chief Marketing executive and convince two well-known people in the industry to join your board.  Since you are very short on cash, you grant each new outside director stock options equal to 0.5 percent of total shares outstanding or 10,000 shares each.  TSO after these grants stands at 1,720,000.  You now own about 58 percent of the company’s total share.

More Employees.  As the development of your product progresses, you hire eight more engineers at levels from senior to associate.  Because the pay that you can offer is below the level being offered by larger competitors, you are required to offer each a relatively large stock option grant.  In total, for eight new employees, you grant options for a total of 50,000.  Your TSO is now 1,770,000.  Your ownership share of your company now stands at about 53 percent.

Financing.  You’ve sold the four unit income property that you bought with the proceeds from your employer’s stock options two companies ago.  The banks will loan only small amounts that must be paid back almost immediately.  However, the prototype of the product is finished and has been demonstrated to several large companies who have indicated a strong interest in buying the product or including it in one of their product lines.  One company had expressed a strong interest in investing $5,000,000 in your company over an 18 month period.  What to do?

Rather than accept the offer of the interested company, you work nights and with your board to prepare a pitch for venture capitalists.  You diligently send your business plan to over 50 VC’s and get responses from four.  Three of the VC’s actually call to make an appointment for you to present your business plan.  [Guidance on preparing your pitch is beyond the scope of this article.  There is excellent guidance on several websites, including BusinessIndsider.com.]

You put on your best Brooks Brothers blue oxford button down shirt, Polo chinos and set off for Silicon Valley.  The pitch goes well.  One of the VC’s wants a lot of additional information about the product, your team, and the company’s capital structure.

After several months of negotiations, revisions of your business plan, and revised financials, one VC has indicated an interest in making a $20,000,000 investment in your company.  The cost?  Ownership of 60 percent of total shares outstanding and voting control of your board of directors through the issuance of stock with preferred 7-to-1 voting rights relative to the common stock that you own.  This entails issuing an additional 2,600,000 shares to the venture capital firm.  TSO now stands as 4,370,000.  You now own about 27 percent of the company.

Subsequent rounds of financing as your product is developed and marketed, likely, will bring up to $100,000,000 of additional capital into the company.  These additional rounds of financing will entail issuing 3,000,000 additional shares.  Although the company has become more valuable, the TSO is 7,370,000 and your ownership position is 23 percent.  That’s before an IPO.

You are positioned for an IPO and the stars are properly aligned, so you make the move to sell your company’s stock to the public.  Your underwriters advise that the IPO offer 2,500,000 shares at a price of $25.00 per share to raise $65,000,000 for the company.  Your ownership after the IPO will be about 10 percent.  Assuming that the company’s market cap after the IPO is $250 million , the value of your interest in the company is $25 million[1].  Not bad, but not what it could have been with better management of your company’s equity.  Further, these values are theoretical as you have material restrictions on the sale of your stock as an insider in a publicly-traded company under SEC Rule 144[2] that restricts the timing and amount of stock that an “insider” in a public company may sell at any time.  Further, insider trading rules place material restrictions on the times that an insider may sell any stock.

What To Do?

There is a lot that you can do to enhance your ultimate return from starting your new company.

Develop an Equity Plan.
This plan should anticipate the major stock granting needs of your company over the period from its creation to, at least, its IPO.  Rather than granting specific numbers of shares, you always should reference what percent of total shares outstanding any grant represents … now and as you grant equity for various purposes, i.e., funding; employees and service providers; IPO.  As crazy as it sounds, you need to put a post-IPO value on your company when you start it.

Aunt Jane and Uncle Harry’s 300,000 shares after the IPO are worth more than $30million.  Nice for them, but, 250 times their investment is far more than their $30,000 investment justifies.  Further, because they are not insiders, they can sell their stock when they wish and go to Majorca.  Similarly, the 250,000 shares granted to your guru are worth nearly $6.25 million after the IPO.

In particular, your Equity Plan needs to anticipate the dilution that existing shareholders will suffer when venture capital financing is made available.  As noted above, typically, VC’s get 60 percent of the company’s equity and voting control of its governance.

Use Outside Data on Equity.  While data of this kind are difficult to obtain, simply tracking the market capitalization of generally comparable companies is a good start.  Further, proxy analysis services such as Equilar[3] provide ready access to the specific holding of the key (“named”) executives of comparable publicly-traded companies.  Such data will provide guidance for granting equity to key employees, service providers and financial resources.

Use Performance-Based Grants.  Full value shares, i.e., restricted stock and restricted stock units, typically provide ownership to the grantee upon the lapse of restrictions over time, i.e., vesting.  However, you also can impose performance standards on such shares under which the restrictions on some or all of the full value shares granted lapse only when targeted results are achieved.  If product development or sales are behind schedule, the holders of these full value shares get only part of their initial grants.

In general, you should consider extensive use of performance standards for granting stock options and imposing performance standards on the full value shares granted.  The greater the person’s contribution over time, the more stock she receives.

Use “Clawback” Provisions. A clawback provision is a contractual arrangement made as part of performance-based compensation contracts. It allows the company to take back all or part of compensation paid if future events show that some or all of the compensation was excessive according to the intended terms of the contract.  For example, a long-term cash incentive could have been used instead of all or part of the stock options granted to your Chief Marketing Officer.  If revenue goals specified in the incentive plan were not met, the Chief Marketing Officer would have been required to return part or all of the incentive award paid.

Use a Variety of Classes of Stock.  Rather than losing control of your company to the venture capital firm that provided its major financing, you could have granted yourself a stock with preferred voting rights, say 7-to-1 against common stock.  Mark Pincus of Zynga retains a vast majority of the company even after the IPO, thanks to the creation of a third class of stock.  Pincus holds all of those shares, with each having 70 votes at shareholder meetings. (VC investors get seven votes per share in their stock class, while the public who buy stock as part of the IPO will get just one vote per share.)[4]

Get Help.  Rather than going it alone in these uncharted waters, get help.  Early on, establish relationships with start-up lawyers and consultants.  (They understand and will wait to be paid!)  Typically, a telephone call will suffice to answer an equity granting question.

Authored by Mel Croner and Garth Gartrell

To discuss your company’s equity planning, please contact Lisa Dyakovski, Director, Consulting at the Croner Company, at (415) 485-5526 or lisa@croner.biz.

Sources:

1.  Raymond James, 2011 Technology IPO Year-End Review.  45 technology IPO’s in 2011 raised a total of $12.8B, creating$74.5B of market capitalization.  Average market capitalization of 2011 technology IPO’s was $248,510,217.
2.  Securities and Exchange Commission, Rule 144: Selling Restricted and Control Securities.
3.  Equilar, 1100 Marshall Street, Redwood City, CA 94063, telephone (650) 286-4512 / www.equilar.com.
4.  Gamasutra, Zynga, Rovio And The IPO Issue by Chris Morris, October 19, 2011.  www.gamastutra.com.