THE DREAM IN ACTION

Many of you followed the process of starting, building, then closing SocialDreamium. I’ve been learning and exploring over the past 3 or 4 months and I’m back on the startup bandwagon. I’m cofounding a startup that’s focused on social commerce (announcement soon) and I’ve been working on setting up that company. In the process of this formation there are some detailed questions that needed to be asked and some considerations that are critical in order to answer this question appropriately.

These are common startup questions who’s answers are dispersed around the web but I’ll aggregate much of that information here with resources that I found and some of the learning’s that I’ve acquired. As a disclaimer, don’t take my advice or learning’s as fact, just learn what you can from it, but seek further legal advice if necessary. I have consulted my attorneys in this process, and so should you.

So, as a bit of a background, I’ll address some of the questions and answers that led me to this question. First…

Why a C-corp, not an LLC?

To simplify, and likely over simplify, LLC’s don’t have shares, they have ownership percentages. Percentages get messy in divvying up, and it is also difficult to value the amount that a specific percentage is worth. So it’s much easier to say that 100 shares at $10/share = $1000, rather than saying 1% = X amount. Share values can change quickly, especially when investment is introduced.

Also, LLCs are a product of state laws and it is those laws that often make it impossible (or difficult) to do an IPO of an LLC. When VC’s invest they are looking for that company to do 1 of 2 things, be acquired, or go public, this is called an exit. If IPO’s (going public) are difficult or impossible, it makes perfects sense that VC’s would discourage this structure.

As David Cohen, founder of TechStars said on his ColoradoStartups blog, you can recover from forming an LLC and hoping to take investment, but it may not be pretty.

Of course anything can be fixed, so it’s far from fatal if you do set up an LLC. You can set up a C corp and have it buy the assets of the LLC. It just costs money and time. You end up with less money and the lawyers end up with more.
The other issue that people pointed out (in their arguments for LLCs) is that valuable losses can be passed through to the personal taxes of the investors and founders with an LLC. While this is also true under ideal circumstances, it turns out to not be true at all in most common cases.

So, if you’re looking to take outside investment in your business, you’ll likely want to startup out as a C or S – corp, not an LLC. Next questions…

What do you need to know before incorporating?

Pulling directly from the Wisconsin government website, which is where our startup will be founded (the reason for this is enough for a separate post), you’ll need to answer these (or similar) questions:

1.    Name: The proposed name of the new corporation.

⁃ make sure you’re name isn’t taken

2.    Registered Agent: The name of the registered agent and the registered office address.

3.    Number of shares of stock authorized: The number of shares of stock the corporation shall be authorized to issue. Some quantity of shares must be authorized.

⁃    Answered in next section
4.    Incorporators: The name and complete address of each incorporator.
⁃    Founders
5.    Drafter: The name of the drafter of this document. The drafter is the person who is completing this document.

6.    Signature: The articles of incorporation must be signed by one or more incorporators.

7.    Contact: The name, address, email address, and phone number of the contact person for this filing. All communication regarding this filing will be via the e-mail address of the contact person.

8.    Payment: You need a credit card (corporate or personal) to pay the filing fee. DFI accepts only MasterCard or Visa; debit cards are not accepted.

9.    Fees: Online Wisconsin Stock For-Profit Corporation filing fee is $100.00. This fee is not refundable.

So, how many shares should be issued, the cause of this post?

We will likely issue a total of 10 million shares of common stock. This will allow us to give 8 or 9 million shares to the founders (yes we know the details, but don’t wish to disclose), and have 1 to 2 million shares in an options pool, for a fully-diluted base of 10M. The point of the unissued shares are so that in the event more shared need to be issued, we have the “back-up”. This might be used as incentive for future early employees, but not co-founders.

As the startupcompanylawyer states on his blog:

From a purely mathematical perspective, it doesn’t matter whether there are 1 million or 10 million fully-diluted shares. However, when companies are granting options to new employees, even the smartest engineers feel better receiving options to purchase 100,000 shares as opposed to 10,000 shares, even if it represents the same percentage ownership of the company.

If the avg IPO is $20/share IPO price (just a guess), with 15 million shares outstanding (total shares available), that will mean you have a $300M market capitalization (total value). This is about the minimum amount needed to complete an Initial Public Offering and keeps you free of doing a stock split at the time of the IPO.

Update: The question of Par value of shares authorized also needs to be answered.

In this process Par value basically means the minimum value you’re promising to share holders that your stock will sell at. The fact is, it doesn’t mean much. Although you can’t trust everything on wikipedia, here is the excerpt that better explains the concept:

Par value is a nominal value which (a stock) has no relation to market value and, as a concept, is somewhat archaic. The par value of a stock was the share price upon initial offering; the issuing company promised not to issue further shares below par value, so investors could be confident that no one else was receiving a more favorable issue price. Thus, Par Value is a nominal value of a security which is determined by an issuing company as a minimum price. This was far more important in unregulated equity markets than in the regulated markets that exist today.

Par value also has bookkeeping purposes. It allows the company to put a de minimis value for the stock on the company’s financial statement.

Issued vs Authorized Common Shares

You might have caught that I stated above, about 8M to 9M shared would be issued, but a total of 10M common shares would be authorized. I’ll break down the difference here, and why the differentiation exists.

Most people own “common” stock shares. This is the most basic class of shares, but their are many and each come with different ownership “rights” associated with them. The ownership rights might include security, voting rights, access to company profits, among many other things. At the beginning, the stages that we’re in, we probably don’t need to worry about all these different stock classes, but as we evolve and becoming a house hold brand :) we will need to worry about these things. For example, in our goal to bring in outside investment, creating “preferred” shares will likely occur, or creating “voting” and “non-voting” shares might be valuable. At the point we are doing this we’ll definitely be using legal expertise.

At our stage, “early”, the shares will allow common stock owners to participate in ownership activities of the company, and in this case ‘issued’ shares are what’s important. Authorized is the allowable number in the future, but not actionable until issued.

Summary to Business Structure Decision

The reality of legal business structures are that there are no hard and fast rules for the equity structure of a tech company at its liquidity event, which means cash comes into the business via a sale or an Initial Public Offering. A relatively normal structure at an event like this would be something like 20% being retained by the original founders, 20% for all other management and staff combined, and 60% being held by investors (this assumes two or three rounds of financing.)

But we’ll worry about one investment at a time.

To Lawyers reading this…

If you find any fundamental mistakes in my understand I would genuinely appreciate any feedback but this is the best understanding I have on my conversations with my attorneys and the mass’s of content that I’ve studied on the web. Thanks for your help.