Requisite disclaimer: While this guide has been reviewed by an attorney, this article does not constitute legal advice. You should consult a lawyer about any decisions that you make concerning stock and options. This doc was written for learning purposes, and not as legal advisement.
Most startups lack basic understanding of corporate structure. The following are the basics you need to understand as a startup founder, in order to make wise decisions on how to structure your company.
In order to prepare to scale, and be investable, a startup must form a proper corporate structure.
Represents ownership in a corporation. In most corporate structures, a majority vote of shareholders is needed for certain important actions (like selling the company, electing Board members, etc), so if you own 51% of a company, you are said to own a controlling interest. Stocks determine decision-making authority in a company. The more stock you own (as a percentage) the more of the company you ‘control’. There are different ‘classes’ of stock: preferred and common, as well as non-voting (see below).
A true corporation has a Board of Directors, whose job it is to govern by setting policy and acting in the best interests of the shareholders. A Board has a legal obligation to act in it’s shareholders’ best interest, even if that interest is in conﬂict with their personal interest. That is called a ﬁduciary duty. Shareholders have a right to elect a different Board if they’re not being represented properly. The CEO, in turn, operates the business at the pleasure of the Board; the Board appoints, compensates, reviews, and ﬁres the CEO. The Board meets regularly (at least once per year) to review the accomplishments of the organization, and vote on important matters concerning the company.
A Board has a Chairman whose business it is to direct the meetings of the Board. This can be the CEO or another board member.
A Board should ideally have an odd number of members, to avoid a “tie” in votes. It’s common for the lead investor in a round of ﬁnancing to ask to have a seat on the Board, so a typical conﬁguration for a company that has raised two major rounds of ﬁnancing from different funds or ﬁrms, would be to have two seats appointed by Common Stock (usually the CEO and a founder), one seat from the ﬁrst round (Series A), and one from the second (Series B). An “outside director” is someone that has been agreed on by both the founding team and investors.
A Board may also have any number of people who have the right to sit in on (but not vote in) meetings: these people are called observers. Some investors, particularly those investors who are not leading a round, may ask for observer rights. Observers can be excluded from what’s called a closed session. This can be helpful for candid discussions of the company’s performance or legal issues.
Quorum & Minutes
In order for a Board meeting to be legal, advance notice needs to be given (usually 24-48 hours beforehand) and a majority of Board members (called a quorum ) must be in attendance (often done by Conference Call / Skype / or Google Hangout). Minutes from Board meetings tend to cover only the minimums in abbreviations of important points, such as exactly what was decided. To minimize liability, few details of the discussion are typically included. (Minutes example “A vigorous discussion of the state of the company ensued.” and “Company ﬁnancials were discussed.”) Minutes should focus on key decisions, and outcomes – they do not record every small detail that was discussed or mentioned.
Ownership in a company is often called equity. The total number of shares issued deﬁnes the total ownership (equity) of the company. Corporations are required to keep track of who owns what stock; the spreadsheet that states exactly who has exactly what kind of ownership (or capital) in the company is called a Capitalization Table, or cap table. It’s generally considered extremely private information. This is also outlined in Universal Shareholder Agreements (USAs). With a Board’s permission, the company can issue new stock, which makes everyone else’s shares smaller as a percentage of the company. This reduction in ownership is called dilution.
Common vs Preferred Stock
Unless it has special provisions attached, shares of stock in a company are classiﬁed as Common Stock. If you were to buy a share of stock on the public market, for instance, you’d become a Common shareholder of that Corporation. When institutional investors acquire ownership in a private company like a tech startup, they usually want some special rights concerning their investment. These extra rights are negotiated by the company’s management team and Board at the time of investment. Shares that grant special rights are called Preferred Stock, although what exactly those rights are, are open and can be written into the Term Sheet, and also into the Universal Shareholder’s Agreement.
Seed Round Funding
This is the first small round of (Often of Preferred Stock) that helps a company build technology or gain proof points of traction. What’s referred to as Seed Capital is usually under $2,000,000.
A raising of capital, typically between $2,000,000 and $5,000,000 of funds, though there are smaller and larger exceptions.
Series B, B-2, and C
These come later and are for continuing purposes of growth in order to maximize shareholder return profit. You may also hear the term inside round, or bridge, which refers to in-between financing.
The Return For Investors and Shareholders
The corporate share structure must be in place to incentivize all parties. This is what all your investors and employees are counting on. All parties will profit accordingly upon one of the following events.
If your startup does well, another company may want to buy it. There are two common kinds of acquisitions in tech startups, a technology acquisition, and a talent acquisition. One buys for the product, and one for the personnel, and of course these motives are mixed in most acquisitions.
When an acquisition happens the most common transaction is for the acquiring company to offer a certain cash price for every share of the company. As a shareholder, your “illiquid” shares (shares you can’t turn into other assets) thus become “liquid” cash. This is called a liquidity event.
Going Public / IPO
The other common way for a shareholder to get liquidity is if the company gets permission to publicly sell its stock. Unlike any other major federation, Canada does not have a securities regulatory authority at the federal government level. Each province has one, such as the Ontario Securities Exchange. The OSC has regulations to make sure that unsophisticated members of the general public are not defrauded by companies selling ownership, so this is a long and process and does not usually make sense unless your company has revenues of at least $50M / year and is growing quickly.
When the company “goes public”, that event is called the “IPO / Initial Public Offering”. IPOs create some new Common stock that it sells to investment banks called underwriters that in turn sell the stock to members of the general public or other investors. Done well, this process generates large amounts of cash that the company can use to grow further.
Alternate Paths To Liquidity
There are several other ways to show a return on stock, starting to become more popular with tech startups. Most of these “alternate paths to liquidity” require the company to be doing very well ($10m+/year revenues, near-doubling year-over-year, etc). The ﬁrst is to sell the stock on a private market (also called a secondary market) only available to selected or accredited investors. Several such markets exist. Companies do not need to “go public” to sell shares in these markets. If you want to learn more about these, additional research is required.
When a company has a liquidity event, it may or may not actually be a good thing for all: different people are paid in different order when a company is sold; the order in which people are paid is called seniority. Debt-holders are always ﬁrst by law in most regions, followed by the Preferred shareholders, followed by Common. I mentioned above the special rights Preferred Stock has over Common Stock. Two of the most important rights are a liquidation preference (which means that the Preferred Stock gets its invested money back before anything goes to Common Stock).
ISOs and NSOs
Most employee options are given as Incentive Stock Options, (taxed on the stock sale) and most non-employee options are given as Non-qualified Stock Options (which may receive long-term capital gain tax treatment).
All ISOs need to be issued under an ISO Agreement. NSOs do not. ISOs are used to incentivize key support for your startup. For example: I’d suggest granting advisors 0.1% to 2% of your company, depending on your stage and how valuable the advisor is. This is the common method in organizations that see the most success. You may also hear of Employee Stock Purchase Programs (ESPPs), these are very useful in creating incentive, but these are rarely seen during the Seed Capital stage.
This is a way of providing an incentive of future stake in your startup, should a party meet certain milestones, or remain active in the venture over a certain time period. It’s a way of granting non-forfeitable rights, and can be structured, and written into an agreement however you wish. This is a very useful tool in providing an incentivizing stake in a company, should the party meet certain requirements.
This term is best explained with an example: an acquiring company is unlikely to be very interested in a startup’s advisors. Smart advisors know this and ask for “full acceleration on change of control”, also called Single Trigger acceleration. This means that if your company is acquired, all of the options you granted to the advisor will be completely vested, as if time had skipped ahead, or accelerated, to the end of the vesting period. Employees’ grants can also be similarly accelerated; it’s not uncommon to add in a “50% acceleration” clause that immediately vests half of an employee’s unvested options when a company is acquired.
Even more common is a Double Trigger acceleration, which provides employees full acceleration of their options in the event that the company is acquired. It can be dangerous to write-in full Single Trigger acceleration for all of your employees, as this sends a clear message to acquirers that the day after the acquisition, the team may plan on leaving. Given that most acquisitions are based in good part on acquiring a team, a structure that nearly guarantees employee departures post-acquisition could negatively impact a company’s value to a potential buyer.
Here are some maxims to stand by in good governance practice: People earlier on and founders that are taking a risk should receive much larger grants. Splitting ownership evenly all ways is extremely unwise as it sends a signal of an unsophisticated corporate structure to any potential investor. People with relevant connections, insight, skills, contribution and dedication, should see that reﬂected in their grant size.