When companies start, the founder is often the sole owner—maybe even the sole employee—with 100 percent ownership. As the business grows, additional staff may be needed, but there may be limited cash to pay them. Therefore, founders may want to offer stock options in lieu of cash. But what happens to the founder's ownership stake in this situation?
Choosing to offer stock options in lieu of cash can be a great strategy—necessary work gets done, the company's valuation may increase and all of this can get accomplished using little cash.
However, as you provide stock to employees, it will reduce your ownership percentage, which is called dilution.
(Note: Corporations (S Corp and C Corp) have stock while LLCs and partnerships have units. I use "stock" and "stock options" as generic terms for all these entity types.)
The following is a series of events involving company stock that I see replayed many times.
From Sole Owner to Co-Founder: How the Decision to Offer Stock Options Can Affect Ownership
At the outset you are the sole owner of the company. You own 100 percent of the common stock.
Assume you start with 10 million shares at a penny per share. (You can make these amounts whatever you want.) Therefore, your 100 percent ownership is valued at $100,000 (10 million shares times $0.01 per share).
You determine that you need to bring on two co-founders—Ben and James—to develop software and platforms, or to undertake a large and creative go to market strategy or just to jumpstart the creation of your management team.
You provide Ben with 10 percent of the common stock and James with 5 percent. As there has been no change in the company's value, the current value has been allocated among the now three owners.
Since you started with 100 percent, your ownership after these grants will be 85 percent—made up of 8.5 million of the original 10 million shares. Since they are still priced at the penny per share, your total amount is now $85,000. Ben's and Jame's shares are valued at $10,000 and $5,000 respectively, so the total remains at $100,000.
To further incentivize Ben and James to perform, you offer them each 5 percent more equity if they meet certain milestones. Assume they do and you provide this additional equity.
Again, there is no increase in the company's value so this grant will again come from your ownership and your percentage ownership will now be 75 percent, made up of 7.5 million of the original 10 million shares. And since they are still priced at the penny per share, your total amount is now $75,000. Again, Ben at $15,000 and James at $10,000.
But consider this: You did not pay any cash for the work accomplished.
What Happens to Stock Options When Your Company's Valuation Changes?
Now your business is growing and you need cash to reach the next level. Assume the best place for acquiring this new capital is from angel investors.
You raise $1 million through a convertible preferred stock offering and you agree with the investor that the company's valuation is $4 million prior to receiving the new cash infusion. (This valuation is called “pre-money" valuation.)
You also want to offer stock options. You set up a stock option program to provide incentives to current and new employees. You agree with the angel investor to make it equal to 10 percent of the common shares.
The first step is to value the common shares, since they have dramatically increased from the penny per share when you first started. Using the agreed $4 million pre-money valuation and the 10 million shares, each is now valued at $0.40, compared with the initial $0.01.
In setting up the stock options program at 10 percent of the the common stock shares, it will be 1 million shares and the three owners will be diluted proportionately, since the total number of shares has not changed from 10 million. So now you own 6,750,000 shares, but they are valued at $0.40 each and your total amount is $2.7 million—a big increase from the start. Likewise, Ben's and James's value has increased.
In this example, the angel investor will own all the convertible preferred stock.
To get the current ownership picture of the company, combine the common stock and preferred stock ownerships, which is referred to as the fully diluted basis.
With this, your ownership is now 54 percent, but of a company with a “post-money" valuation of $5 million ($4 million before the angel invested, plus her $1 million). Your share is worth $2.7 million. Compare this with your starting position of 100 percent ownership, but of almost no value. If you take on more investors to fund your company growth, your ownership position will continue to decline, but at higher company valuations.
With this in mind, I encourage entrepreneurs to consider holding off as long as possible before raising funds that will dilute their ownership. With each milestone achieved, with each partnership entered into, with each contract won and with each sale made, the company has higher intrinsic value and raising the same amount of funding will cause less dilution.
Issues about ownership percentage are generally not about value, as shown here, as a smaller percentage ownership of a larger company may be a higher value. The issues are more related to governance. Do you want or do you need to have a controlling ownership stake in the company—to make sure votes (e.g., your tenure and compensation, getting a bank loan, making a large purchase, etc.) go your way?
In many cases, having over 50 percent ownership will ensure control. Depending on the number of shareholders, their holdings and alignment and any investor protective provisions, you could have effective control with less than 50 percent ownership.
That's why it's important to plan ahead regarding granting equity to co-founders and employees. There may be a series of events that reduces your ownership stake and you may want to retain a controlling interest well into the future.
Read more articles on partnerships.
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