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.

When a company is formed...

And subsequently by the actions of the company,

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:

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

Go To Angel
and discussing it with us in your follow-on call...

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.

Copyright(c) Fred Cohen, 2022 - All Rights Reserved