Stock Related Agreements: Understanding Equity
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
Welcome back to our deep dive into the specifics of stock-related agreements. Before we get down to it, it’s important to fully understand how equity or stock works within a company. As founding teams look at how to allocate stock in the company, it’s key to understand the mechanics of how stock is acquired.
What is the difference between shares and equity? Think of shares as tangible property that a company gives to an individual. That individual is the only person that can possess those particular shares. Those shares can’t be transferred to someone else unless certain conditions are met.
Some people have a cloudy idea of what equity means, so let’s get an idea of what equity is not. Do not think about equity as shares the company gives to someone that can be freely transferred or sold. A person with shares can not take some portion of those shares and trade them to other founders, other investors, or even sell a portion to a third party. Often, people coming into the private company context for the first time think that freely transferring shares is a valid tactic. Private company stock is different from publicly traded stock. Publicly traded stock is freely transferable, more liquid, and fungible.
However, startups are private companies. Their stock is not freely transferable or fungible. It’s not like having a bunch of marbles that a founder or shareholder can then sell off as they want to change the cap table or ownership structure. If a company is going to change its ownership structure, there are legal and tax implications to issuing or transferring shares. If you find yourself in the early phases of a company’s history saying, “We’re just going to take from this person and give it to that person,” then you’re likely on the wrong track. Generally speaking, there are better solutions for settling ownership changes than transferring shares (such as having the company repurchase shares and issue brand new ones).
That being said transfers are not illegal in all contexts, but they need to be done properly. Transfers lead to a messy cap table and a messy ownership record. Transfers can also indicate that the company took investors that weren’t quite the right fit, or that there’s some kind of bad relationship involved between different parties. To investors, this looks problematic. Most importantly, it conveys that a founder doesn’t quite understand how the game of angel or venture capital is played. Having improper transfers can reflect poorly on both the company and the founders as they start the process of acquiring third-party investors.
To reiterate, shares are not things that you just trade from one party to another. A company cannot adjust people’s percentage interests on a whim (check out this post on tax consequences for founders). In a corporation, everyone is diluted in proportion to one another. There are no special factors where you would dilute one person’s stock over diluting another. An investor will notice these flaws, so it’s important to have everything smoothed out before you even seek funding. That’s why it’s important to think about dilution and ownership structure early on in the company’s lifecycle. Check out our cap table tool which helps founders model out scenarios for future fundraising and potential exits. This can help founder avoid being in the position where unexpected transfers are necessary.
If you have any more questions about how equity and stock should work at your startup, we’ll be happy to answer them on any of our social channels. Stay tuned as we continue to give you more tips on successfully managing your company!
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
Welcome back to our deep dive into the specifics of stock-related agreements. Before we get down to it, it’s important to fully understand how equity or stock works within a company. As founding teams look at how to allocate stock in the company, it’s key to understand the mechanics of how stock is acquired.
What is the difference between shares and equity? Think of shares as tangible property that a company gives to an individual. That individual is the only person that can possess those particular shares. Those shares can’t be transferred to someone else unless certain conditions are met.
Some people have a cloudy idea of what equity means, so let’s get an idea of what equity is not. Do not think about equity as shares the company gives to someone that can be freely transferred or sold. A person with shares can not take some portion of those shares and trade them to other founders, other investors, or even sell a portion to a third party. Often, people coming into the private company context for the first time think that freely transferring shares is a valid tactic. Private company stock is different from publicly traded stock. Publicly traded stock is freely transferable, more liquid, and fungible.
However, startups are private companies. Their stock is not freely transferable or fungible. It’s not like having a bunch of marbles that a founder or shareholder can then sell off as they want to change the cap table or ownership structure. If a company is going to change its ownership structure, there are legal and tax implications to issuing or transferring shares. If you find yourself in the early phases of a company’s history saying, “We’re just going to take from this person and give it to that person,” then you’re likely on the wrong track. Generally speaking, there are better solutions for settling ownership changes than transferring shares (such as having the company repurchase shares and issue brand new ones).
That being said transfers are not illegal in all contexts, but they need to be done properly. Transfers lead to a messy cap table and a messy ownership record. Transfers can also indicate that the company took investors that weren’t quite the right fit, or that there’s some kind of bad relationship involved between different parties. To investors, this looks problematic. Most importantly, it conveys that a founder doesn’t quite understand how the game of angel or venture capital is played. Having improper transfers can reflect poorly on both the company and the founders as they start the process of acquiring third-party investors.
To reiterate, shares are not things that you just trade from one party to another. A company cannot adjust people’s percentage interests on a whim (check out this post on tax consequences for founders). In a corporation, everyone is diluted in proportion to one another. There are no special factors where you would dilute one person’s stock over diluting another. An investor will notice these flaws, so it’s important to have everything smoothed out before you even seek funding. That’s why it’s important to think about dilution and ownership structure early on in the company’s lifecycle. Check out our cap table tool which helps founders model out scenarios for future fundraising and potential exits. This can help founder avoid being in the position where unexpected transfers are necessary.
If you have any more questions about how equity and stock should work at your startup, we’ll be happy to answer them on any of our social channels. Stay tuned as we continue to give you more tips on successfully managing your company!
