By: Chujia Yu
One of the most important legal issues that startups face after incorporation is issuing stock to its co-founders. To avoid legal problems rising in later years, co-founders should consider: (1) how to allocate stock shares amongst co-founders; (2) when is the best time to issue stock; and (3) how to value stock after the business builds in value.
How to allocate stock shares among co-founders?
Many startups would automatically divide the equity equally among the co-founders without further consideration. This is a big mistake. Equity division is a significant decision for the corporation not only because it will assign certain percentages of ownership to each founder, but also because it is a good timing to clarify the roles and expectations of each founder effectively. Although there is never a “clean cut,” the co-founders should negotiate each of their respective percentage of the ownership based on the contribution of each co-founder and their short-term and long-term roles.
In addition, the startup should leave enough of its authorized shares unissued as a reserve for bringing on additional founders or investors, and for employee stock option plans. It is a good practice for the corporation to only issue 50% to 80% of its authorized shares of common stock to the co-founders at the time of incorporation.
When is the best time to issue stock to the founders?
One of the common mistakes that startups make is that co-founders think they have already split the ownership after they signed a founder’s agreement to divide the ownership of the future company. The co-founders will not readdress this issue after entity formation because they think they have already dealt with it. However, in order to acquire that certain percentage of ownership of the corporation, the founders need to pay the matching price of the shares. The basic rule about stock issuance is that whenever the stock is issued, it always needs to be priced at fair market value. At the time of incorporation, the corporation generally has no assets or revenue and thus is worth little. Founders need only pay for the shares at the price of par value (often at $ 0.0001 per share) of the stock set out in the articles of incorporation.
Failing to issue stock to themselves in this early stage will make founders suffer a lot economically. As time passes, the corporation will build in value quickly, especially when it begins to earn revenue and has attracted outside investment. Therefore, the fair market value of the company’s stock at this moment would be much higher. Although there are alternatives for founders to acquire stock than direct purchase, those alternatives have some disadvantages as well. One alternative is to grant the founders the right to purchase the stock at a discount, which seems like a good solution at first glance. However, founders will be required by Internal Revenue Service (“IRS”) to pay the income tax for the discount part. The other alternative is to grant stock options to the founders. However, since options do not carry voting rights, founders’ ability to influence the corporation prior to exercise of those options will be limited.
In addition, failing to issue stock at this stage would greatly hinder any attempts at fundraising down the line. In determining whether a corporation is worthy of the investment, high-quality investors would typically consider whether the corporation has established a vesting schedule for its founders and issued stock to the founders. Therefore, it is the best practice for the corporation to formally issue stock to the founders at the time of the incorporation, subject to vesting.
Stock valuation after the business builds in value
For those corporations that failed to issue stock to co-founders at the time of incorporation, they normally have two approaches to decide the purchase price. One approach is to randomly pick a number. However, doing so would trigger tax implications by IRS and would cause auditing problems. The other approach is to calculate the fair market value of the stock at that moment. The most theoretically sound method for stock valuation is the discounted cash flow model (“DCF”).
The discounted cash flow model is a type of absolute valuation models. Absolute valuation models aim to find the intrinsic or true value of the stock based only on fundamental elements, which include dividends, cash flow and growth rate of the corporation. In a sense, the discounted cash flow model uses the company’s discounted future cash flows to value the business (an investment now is worth an amount equal to the sum of all the future cash flow it will produce, with each of those cash flows being discounted to their present value). To use this model, the company is required to have positive predictable free cash flows, which requires the company to have more operating cash flows than capital expenditures in a given year.
The equation for this model is:
In the equation above, “DCF” is the sum of all future discounted cash flows, which is the fair market value of the corporation. “CF” is the positive cash flow for a given year. “r” is the rate of return to investors. “n” is the number of years. Take the following hypothetical to help illustrate the above equation. Suppose XCorp. has an annual growth rate of 10%, $ 10 million positive cash flows per year, and a compounded annual rate of return to the shareholders of 20%.
Thus, the discounted cash flow in all future years would be the first year’s cash flow of $ 10 million divided by 120% (1+20%), plus the second year’s cash flow of $ 11 million [$ 10 m *(1+10%)] divided by 120% squared (1.2*1.2), plus the third year’s cash flow divided by… In deciding upon the discounted cash flow method for stock valuation, co-founders can choose the variable “n” they deem to be suitable to represent the future growth of the company (some will choose to run the “n” to infinity using certain software, some will choose a certain number, e.g., 25 years). When co-founders get the number of DCF, they can divide the DCF by the number of authorized shares to determine the value of the stock.
To conclude, it is best practice for a corporation to issue 50% to 80% shares of common stock to the co-founders at the time of incorporation for lower price. Otherwise, they have to apply the complex DCF method to determine the fair market price of the stock in order to avoid triggering the tax implication by IRS.