When launching a startup, founders have to decide how many shares to issue at incorporation. While most startups authorize 10 million shares, the number of shares issued to founders will depend on factors such as the size of the employee pool, the need for additional reserves and the number of founders. This post explores how to determine the right number of shares to issue and the implications of that decision. It also provides some background on what shares in a startup represent and how they work.
Shares In a Startup: What They Are and How They Work
Shares in a startup represent ownership in the company. Issuing shares means dividing the ownership of the company into smaller pieces that can be bought and sold. The more shares someone owns, the larger percentage of the company they own.
Founders, employees and investors are typically issued shares in a startup. Founders receive a large number of shares because they started the company and did the initial work to get it off the ground. Employees may also receive shares as part of their compensation package, giving them a stake in the company’s success. Investors provide funding in exchange for shares, with the expectation that their investment will grow as the company becomes more successful.
Most startups launch with one class of common shares that are issued to founders and employees. Investors generally receive preferred shares, which give them certain rights and privileges over the common shareholders. Note that most pre-seed funding is conducted via Simple Agreement for Future Equity (SAFEs). SAFEs don’t convert into preferred shares until the first round of equity financing, which is typically Series Seed or Series A. At that point, the certificate of incorporation will be amended and re-filed with the Secretary of State to include a new class of preferred shares.
Until then, most startups are issuing the common shares they authorized at incorporation.
Authorized vs. Outstanding Shares
Authorized shares are the maximum number of shares a company can issue. When a startup incorporates as a corporation, it authorizes a certain number of shares in the certificate of incorporation. These authorized shares are the total amount of shares in the company. That number cannot be changed unless the certificate of incorporation is amended and re-filed in the state of incorporation.
Outstanding shares, sometimes referred to as issued shares, are the total number of shares currently issued to shareholders. This number must be equal to or less than the total authorized shares.
How Many Shares a Startup Should Issue to Founders
Most startups authorize 10 million shares in their certificate of incorporation. Out of that 10 million, how many shares should be issued to founders? Here’s a step-by-step process to determine what’s right for your startup:
- Employee Pool. First, determine the size of your employee pool. A typical employee pool will range from 10%–20% of authorized shares, or 1 million to 2 million shares. An employee pool, sometimes referred to as an option pool or employee stock ownership plan (ESOP), is a certain number of shares of common stock set aside as compensation for employees, advisors and contractors. The goal is to incentivize employees to commit to the company long-term and to perform well. To learn more about employee pools, click here.
- Additional Reserve. Second, you may want to reserve a small portion of shares, no more than 10% or 1 million shares, that are not in the employee pool and not issued to founders to have a buffer. These shares would be issued to additional founders/early executives that you hire prior to your first round of equity funding or accelerators.
- Founders. Split the remainder among the founders.
For example, let’s say our startup Gregarious Games Inc. has three founders and has authorized 10 million shares. They want to set aside 15% of authorized shares for the employee pool and set aside 10% as an additional reserve.
- Employee pool: 1.5 million
- Additional reserve: 1 million
- Founders: 7,500,000 / 3 = 2,500,000 per founder
What Happens If the Additional Reserve Does Not Get Issued
The additional reserves are technically authorized-but-unissued shares. Sometimes they are referred to as treasury stock. These shares are held by the company and are not owned by any one person. They don’t impact voting, dividends or liquidation, which are all determined based on the number of issued-not-authorized shares.
To continue the example from above, let’s say Gregarious Games issues all the shares in the employee pool, but never ends up issuing any of the additional reserve and they don’t take on any investors. Then there are 9 million shares outstanding of the total 10 million authorized. So, 9 million will be the denominator to calculate percentage ownership. Therefore:
- Employees own 16.67% (1,500,000 / 9,000,000)
- Founders own 83.33% (7,500,000 / 9,000,000)
There is no downside to not issuing the additional reserves. However, if you didn’t set aside additional reserves and you run out of shares to issue, then you’ll have to amend and refile the certificate of incorporation to increase the authorized shares. That process will cost you additional time, filing fees and legal fees.
Bottom line: It’s better to set aside a few extra shares rather than be short a few shares.
In conclusion, determining how many shares a startup should issue at incorporation involves a multi-step process that takes into account factors such as the size of the employee pool, the need for additional reserves and the number of founders. While most startups authorize 10 million shares, the number of shares issued to founders will depend on the specific circumstances of each startup. It is important to strike a balance between issuing enough shares to attract and incentivize employees, while also not issuing too many shares and diluting the ownership too much. By following these guidelines, startups can set themselves up for success and avoid costly legal and financial issues down the road.