Common Pitfalls Issuing Equity
Issuing equity is a big step for any startup. It’s complex and can shape your company and affect everyone involved. While it’s exciting, it’s also packed with traps that can mess up your company’s structure and shareholder relations if you’re not careful. Let’s dive into some common mistakes founders make when handing out shares.
Pitfall #1: Failing to issue equity
Founders believe they issue equity simply by entering into a contract arrangement with the new hire (typically a founders’ agreement, employee offer letter, advisor agreement, or independent contractor agreement). In reality, the issuance of equity requires at least the board’s approval for the amount, vesting schedule (if applicable), and entry into the relevant award agreement or stock agreement. Practitioners differ on whether an award is issued and outstanding once approved by the board or entry into their relevant stock or award agreement.
Pitfall #2: Issuing equity at a fixed percentage of the company
Early hires will often ask for shares representing a fixed percentage of the company. However, some founders will provide in the onboarding paperwork that the new hire will receive a fixed percentage of the company. This is disadvantageous to the company since the number of shares issued and outstanding in a company will vary in the company’s history. If the board fails to authorize the grant in a timely fashion, the grant will result in more shares awarded to the new hire than originally contemplated by the founder.
Founders also confuse the percentage of shares to be issued as tied to the number of shares authorized in the company. Authorized shares refer to the number of shares that are available for the company to issue. However, the percentage used to determine an individual’s holdings in the company is the number of shares actually issued and outstanding.
Take, for example, a company that has 10,000,000 shares authorized in its certificate of incorporation. If a founder issues himself 6,000,000 shares and no other equity is issued and outstanding, then he will hold 100% of the company’s stock. Suppose the founder strikes an agreement with a cofounder for 20% of the company’s stock, then they will need to issue a number of shares that will keep the current founder’s stake of 6,000,000 shares equal to 80% of the company. The cofounder will need to be issued 1,500,000 shares, which represents 20% of the total 7,500,000 shares issued and outstanding.
Pitfall #3: Failing to issue awards from a stock plan
Stock plans allow a company to issue equity from a number of shares already set aside for new hires and independent contractors, ranging anywhere from 10% to 20% of the company’s shares. If a founder fails to state where those shares are coming from at the board approval stage, then it is assumed that any shares of common stock to be issued will be outside of the plan. Issuing equity outside of the plan results in dilution to the company’s current stockholders, while the number of shares available under the plan will be untouched.
Pitfall #4: Failing to set an appropriate strike price for option grants
Internal Revenue Code Section 409a requires that the exercise price per share of option grants be set at least the fair market value at the time of grant. The threshold may be higher depending on the number of shares the holder has or will obtain.
The board of directors has the discretion to set the 409a valuation of the shares of common stock at the level they deem appropriate. Alternatively, the board can rely on a valuation set by an independent, third-party appraiser. While these reports may be costly, reliance on such reports provides a safe harbor to startups for purposes of IRC 409a.
Failure to adhere to 409a, or failure to set an appropriate fair market value on the shares of common stock, severe tax consequences may arise for the service provider. Specifically, all amounts deferred may be recognized as ordinary income and subject to an additional 20% federal tax (in addition to any premium interest). Note that restricted common stock grants are not governed IRC 409a, meaning that the board may award a grant at less than the fair market value per share of common stock. However, the spread between the fair market value and the amount actually paid per share of common stock will be recognized as ordinary income as such stock vests.
Pitfall #5: Issuing equity in the middle of a financing
409a valuations need to be refreshed at least once every 12 months. However, the fair market value of common stock may change upon material occurrences for the company, such as when a new market valuation is set for the company, upon a bona fide financing done for capital raise purposes, or amassing material amounts of revenue. For this reason, founders should confirm whether their 409a valuation is still current and hold off on issuing new equity awards until after a financing has completed.
Handling equity issuances carefully is crucial. You’ve got to really understand all the ins and outs to avoid pitfalls. Staying sharp and cautious helps keep your company on track and ensures everyone is treated fairly.
