Stock states: Authorized, Allocated, and Issued

The way stock in a private company works is a bit tricky and most early stage founders don't really understand it very well. This is aided by lawyers who specialize in the area and seem to me to be unable to explain it. Or perhaps they don't know either. Or perhaps they are unclear because the law is unclear. In any case, I will try to explain it in the way I currently understand (probably mis-understand) it.

It's about the exit

Current holdings of issued stock at any given time dictate, subject to provisions of private placement memoranda and subsequent board and shareholder actions identifying preferences, rights and responsibilities of shareholders. I'm going to parse that for you.

• Current holdings: The set of all current (at the time of the event) ownership of all shares of stock. Not just what you own but what everyone else owns.
• Issued stock: The stock has to be actually issued, which is to say, ownership transferred from the company to the shareholder through a formal issuance process.
• Provisions of private placement memoranda (PPM): This is the contract that issues the shares and is the agreement between the company and the shareholder.
• Subsequent board and shareholder actions: Usually, the board of directors through formal processes, and/or the shareholders (owners of issued stock) through votes on such actions can change the terms of the PPM.
• Preferences: I wrote an article on this in this series some months ago. Basically whatever all those pesky words in the PPM said.
• Rights of shareholders: What the shareholders can do, get, etc.
• Responsibilities of shareholders: What the shareholders must do or have others do to them.

When a company is formed...

And subsequently by the actions of the company,

• Authorized: Some fixed finite number of shares is authorized. These are portions of ownership that may be issued over time. As an example, we will say that there are 100 shares authorized representing 100% of the potential future ownership of the company.
• Allocated: The company, through actions of the board and shareholders, may allocate these shares for different purposes. For example, they might authorize 10 shares for founders, 15 shared for workers, and 75 shares for investors. These shares may also be associated with preferences so that, for example, the 10 founders shares might have disproportional voting rights coming to 50% of all voting shares with another 25% of voting rights for employees and the remaining 25 percent for investors.
• Issued: As the company starts, the founders shares might be issued to the founders.

  Subsequently, employees may be issued shares out of their authorized pool (of 15 shares) as partial compensation for their efforts on behalf of the company.

  Over time, as the company gets investors, each investor might buy some number of the investor pool of shares.

Thinking ahead:

When you form a company, you should be thinking ahead of the future states of affairs with regards to equity (shares) and who owns what and is able to do what.

Most founders imagine they will run the company until it goes public or is acquired and own most of it. Mostly that's not how successful companies end up.

So let's start with the exit and work our way backwards:

Exit: At exit, which is to say, when the founders are no longer owners and get their investment and gains returned to them, the company value is turned into cash (or shares in another company, or whatever liquid form the exit comes in). Suppose, for this example, at exit the company sells for $100M in cash after 10 years of operation. Suppose at that time, the total issued shares comes to 50 of the 100 authorized shares. Then each share is worth $2M. The founders get $20M for their 10 shares, and everyone else gets their portion of whatever is left.

HOWEVER, if the total issued shares come to 100 instead of 50, each share is worth half as much. Decisions before exit: Since voting rights (the right to vote with your shares in company decision-making) dictate decisions about the company (like hiring and firing the CEO, issuing stock, preferences, etc.), even though the founders might only own 10 shares at exit, they might want to retain control over the company to assure they don't get their value deprecated by other investors.

HOWEVER investors who put $30M of the final value of $100M into the company, might feel as if the founders, who put in $0.1M at founding and never worked at all after year 3, don't deserve $20M of the exit value. So they might not be willing to invest under those conditions, particularly if they have no effective control over the decisions of the company along the way.

So what really happens is that there are negotiations along the way. If you want my $30M, you will give me voting rights that, for example, allow me an one of the independent board members to veto any board-level decision.

And then there are the law suits

If your company fails after investors put in a lot of money, you might get sued. And if your company succeeds wildly after investors put in a little money you likely will get sued, unless they make a whole lot of money. The only way I know to avoid being sued is to take a little money, have a lack-luster performance over many years of trying, and eventually fail or exist at a relatively low valuation but still a profit to the investors. OK - just kidding. You can get sued then as well.

As a fundamental, thinking through these things in advance and being fair to everyone by being transparent and allowing people to vote based on their contributions (monetary and otherwise), providing rational valuations with provided basis, and performing according to plan (by planning with a range of contingencies in mind including changing the plans over time) is the best way to work through these issues.

I have sought advice from lawyers on this

I am not a lawyer of course, and thus cannot give legal advice. But I can give regular business advice. So I advise you to discuss legal issues with lawyers who specialize in the field of interest, in this case securities law and tax law. Yes - both... because there are ridiculously complicated tax implications on all of these stock-related things.

I have sought legal advice on this stuff, and I have found that I get different advice from different lawyers. No surprise there. But the real value I find from lawyers in issues like those in this article is that (1) they give me alternatives I hadn't thought of, (2) I propose approaches they haven't perhaps considered, and they tell me whether I can legally do things, the likely implications of doing those things, and (3) they show me how to do them properly by having the right terms and conditions and wordings in place in my agreements.

A call to action

If you are forming (or have recently formed) a company and are struggling with the issues of equity, you might benefit from presenting at

In summary

This stock thing is often complicated and confusing, it's easy to make mistakes, and you get different advice from different lawyers. For help clarifying it, you could probably use some experienced advice before you decide.