When a company is created, the founders of the company must determine who owns the company. Often the founders also become the first shareholders of the enterprise. The first, and most important, step in getting a company organized, is to determine who owns how many shares. This is usually expressed as a percentage of the total number of shares and it is this percentage that is very important to each founder.
Over time, the ownership of a company will change as new participants, e.g. managers or investors, are dealt in. It is never easy to figure out how should get what share of ownership. It usually boils down to a matter of negotiation among those involved. For some assistance on how to establish relative share ownership positions, Get Your Free Consultation.
When the founders have agreed on the ownership percentages (i.e. percentage of common shares issued), they can then determine how many shares in total to issue. This number is usually kept small at the beginning, e.g. 100 or 1000. This number can be “split” (multiplied by 2, 10 or whatever) as required. If the company plans to eventually become a public company, the number of shares and the price paid for these shares becomes more important and proper structuring at the outset (with appropriate counsel) is advised.
What Price Paid?
It is a good idea to have each shareholder actually buy and pay for the shares which are acquired. When companies are formed, they have no immediate real value. Shares can be issued for a penny (again, if the plan is to go public soon, this should be carefully explored with expert help). A “subscription agreement” is recommended. This is a simple document (even a one-page memo may suffice) which clearly shows that a certain number of shares are being purchased for a specified price. It is a good idea to actually write a cheque to the company for this amount as a matter of record. It may help in proving ownership in contentious situations and it establishes the share cost for future tax calculation purposes. It is important to NOT issue shares for time or services provided. Such issuances can be viewed as compensation and may be subject to normal income tax.
In the case of founders of a company, shares are being issued at a nominal price because the founders are committing their know-how and expertise to the company. But, what if a founder receives 10% of the shares of the company and then quits or gets killed? Is it fair that she or her survivors end up with shares that were given in return for something not yet realized? For this reason, a vesting schedule may be useful, i.e. shares are fully “vested” over a number of years. If the holder departs from the company, some or all (the rules are up to the founders) of these shares should either be cancelled or subject to re-purchase rights by other shareholders or by the company itself.
Issued vs Authorized Common Shares
The most common form of ownership in a company is “common” shares. There are many types and classes of shares which can be defined for a company each of which carry certain rights with respect to security, voting privileges, participation in profits, etc. As companies evolve, there may be valid reasons for creating new classes of shares, e.g. creating “preferred” shares in order to bring in investors or differentiating between “voting” and “non-voting” shares. This can become quite involved and will require expert counsel. At the very beginning, though, there is usually one class of share defined, i.e. a basic common share which allows its holder to paritipate in the ownership and decision-making of the company based on the percentage common shares held by that shareholder. This percentage is determined from the total number of shares which has been issued by the company, not the number which has been authorized (the number authorized is simply some maximum allowable number. In some jurisdictions like B.C., this is required. In others, like the Federal Government, this can be an unlimited number). The authorized number can be changed by filing the appropriate amendments. It is a good idea to make this number as large as possible (it doesn’t matter what it is).
Common, and BIG, Mistakes
One of the biggest and most common mistakes made by founders is the lack of attention to future tax consequences arising from decisions made early on. The attitude often expressed is: “when I make a few million, having a tax problem will be a nice problem to deal with”. Yeah, right! There are many basic rules which can be followed to avoid future problems. These are legal and straightforward. Agressive financial advisors may suggest exotic arrangements such as off-shore holdings or trusts as other ways to avoid future taxation. Some such advice may be very accurate and reliable. Others run the risk of being tax evasion schemes subject to serious penalities. Tax avoidance is OK, evasion isn’t! In fact, tax avoidance has become a national sport that we all enjoy playing (or should learn to play).
Stock vs Stock Options
Stock options are a common technique for getting employees and managers involved in a company as potential owners. Options give their holder the right to buy or acquire shares in the company over a specified time period at a specified price. They are used extensively by publicly listed companies. In the case of privately held companies, options may not be as useful as some form of direct ownership, especially when tax considerations are taken into account. Another alternative might be to simply be given (or purchase) shares with certain strings attached, e.g. vesting over time so that if an employee should leave the company, the shares could be re-purchased or cancelled. This may have the same effect as options but may be desirable from a tax and pyschological perspective.
The Last Word
Be sure to get some good professional advice. But before doing so, you should know what you and your fellow shareholders’ goals are and what your vision is for the company – then you can properly “structure” the company to help you achieve these goals.
For more assistance on how to structure your startup, Get Your Free Consultation.