A Story of Three Different Founders Getting Tripped Up by the Differences among “Authorized,” “Fully-Diluted,” and “Issued and Outstanding” Shares
In the past three weeks, I’ve had three separate conversations with three different founder-CEO’s who were all getting tripped up by the same question: “How many shares are on my cap table?” As I helped them get their cap tables sorted out, I realized that there were likely many other first-time cap table builders who could use similar guidance. Since I can’t take a call with everyone, I’d like to share what I learned during these three conversations.
In all three cases, the story was the same – the founding team had worked out percentages among themselves and any consultants. An investor was now wanting to look at the cap table and so the team was quickly trying to write one up. The founders were struggling to know how many shares to assign to everyone. And at the heart of their problem was that they didn’t fully understand the difference between “authorized shares,” “fully-diluted shares,” and “issued and outstanding shares.”
The first place all three founders looked for answers was in their companies’ Articles of Incorporation, which in all three cases stated that they were authorized to issue 10 million shares of common stock (the lawyers who write these docs tend to keep things pretty standard). Here is where the stories diverge and our founders got tripped up in slightly different ways:
Founder 1 believed this meant that his company was never allowed to issue more than 10 million shares . . . ever . . . full stop. So he began the difficult task of planning out the next five years of fundraising for his startup, estimating option pool increases, pre-money valuations, and new investment amounts up through his Series C round and then eventual exit. From there he tried backing into the current number of shares to issue, so that they wouldn’t ever issue over 10 million shares throughout the life of the company.
Founder 2 knew he had only issued about 6 million of the 10 million shares authorized. But he also knew that there was an option pool, and so he figured the last 4 million shares must all be in that option pool.
Founder 3 had negotiated percentages with different parties at different times, generally based off the incorrect assumption that there would be 10 million shares issued. Now that he realized he wanted to issue less than 10 million shares, he was struggling with how to adjust the percentages without making anyone mad.
Before I jump into greater detail on each of these three stories, let me give some helpful definitions:
Issued and Outstanding Shares: This is the number of shares a company has issued that are still outstanding. This includes options and warrants that have already been exercised, but does not include any unexercised portion. Shares that have been forfeited, cancelled, repurchased, or are otherwise no longer outstanding are not included in the number of shares “issued and outstanding.”
Fully-Diluted Shares: Of the three definitions, this one is the most difficult to conceptually understand. Depending on who you ask, he or she may define it differently, but generally speaking, it boils down to include three things:
- All of the issued and outstanding shares (as defined above).
- The number of potential shares the company has contractually agreed to issue via warrant and option agreements (but that have not yet been exercised)
- The number of potential shares set aside in the company’s equity plan (option pool) that have not yet been contractually assigned.
What about Convertible Notes and SAFE docs? Well, this is why people sometimes define “fully-diluted shares” differently. A minority of people sometimes feel they should show their cap table with all of these instruments converted into stock. This presents a couple of problems:
- The number of shares those instruments convert into is generally not an absolute; often, the exact number cannot be known until the actual date of conversion.
- When raising new money, the share price of the new round is derived by dividing the pre-money valuation by number of fully-diluted shares. For this purpose, convertible notes and SAFEs are not counted. Therefore, sending out your cap table with these extra shares on them can cause confusion.
With that being said, Convertible Notes and SAFE docs are important to a company’s cap table. I suggest displaying the amounts and terms of any convertible securities in an appendix or in a simple note below the cap table. Do not assume a conversion into shares.
Authorized Shares: This is the number of shares that a corporation is legally allowed to issue, as stated by the company’s Articles of Incorporation (AOI). If a corporation has multiple share classes, the AOI will also specify the authorized number for each class. The AOI can be amended at anytime by the board to increase the authorized number, but the company will incur legal fees and filing costs each time.
Based off these definitions, we can conclude that the following statement is always true:
I have used the “less than and equal to” symbol in order to be perfectly precise, but if you were to simply use the “less than” symbol, you would still be correct 99% of the time when it comes to venture backed companies.
To further clarify and cement these definitions, please see the following example of a fully-diluted cap table. The numbers highlighted in blue represent the “issued and outstanding” portion of the cap table. You’ll notice that the authorized number of shares is nowhere to be found. This information is frivolous in and irrelevant to most discussions. Lawyers are generally the only ones who care.
A significant number of founders do not understand the above definitions. They do not realize that the number of issued shares does not have to equal the number of authorized shares. And as I’ve just explained, in 99% of cases, the number of issued and outstanding shares is less than the authorized shares.
So why not issue 100% of the authorized amount to the founders? Well, because generally you will quickly want to bring on some new employees and grant them stock or options. If you have already issued 100% of the authorized amount, you cannot do this without having to amend your Articles of Incorporation, which can cost a few thousand dollars.
In addition to setting aside an option pool, you may want to leave some authorized shares unissued so that you can issue some common stock to early investors. It’s not uncommon to raise money by selling some common stock in a “friends-and-family round.”
Now I’d like to finish up by going back to the stories of our three befuddled founders and explaining in greater detail what each of them failed to understand:
Founder 1 was trying to figure out the number of shares to issue today so that he would never exceed the authorized share count during the entire life of his company. He actually did understand that the issued and outstanding number could be less than the authorized, but he failed to understand that the authorized number could be increased.
When he did realize that it could be increased, he still wanted to keep the issued number low in order to save on lawyer fees. At this point, I explained that after each new financing round the Articles of Incorporation (AOI) were going to have to be amended anyway.
With each new financing round the AOI must be amended in order to create the new security class and state its voting rights, liquidation preferences, etc. So he was going to incur these future legal costs no matter what.
Once Founder 1 grasped this, he was good to go. He now understood that he just needed enough cushion to get him to the Series A round.
Founder 2 was trying to set aside an option pool and he failed to understand that the option pool is not simply the difference between the issued shares and the authorized shares. With 10 million authorized shares, he could issue 6 million and then set aside 1 million for the option pool, for a fully-diluted cap table of 7 million shares. He did not have to create an option pool of 4 million shares in order to reach an authorized share count of 10 million.
On a broad note, a lot of early founders don’t understand that the option pool should be legalized through an official “equity incentive plan document.” The plan document will then state the number of options/shares you are legally able to issue out of it (among many other things). Your lawyer can draft one for you, and, like your Articles of Incorporation, it can be amended by the board at any time, in the case you need to make changes.
Founder 3 made the common mistake of basing everyone’s negotiated percentages off of the authorized number. The idea is that the percentage negotiated for (15% of 10 million shares) will be the final percentage the person receives once all shares are issued.
The idea seems simple, but I’ve found that it just causes mass confusion for everyone (as it did for Founder 3). I’ve had to have the following conversation with several founders:
Founder: So it’s me and one other individual on the cap table. I have 5 million shares and I promised the other person 15% ownership of the 10 million shares.
Me: So that other person owns 1.5 million shares.
Me: So they currently own 23% of the cap table.
Founder: No, I just told you, it’s 15%.
Me: Well, if you are the only two on the cap table, and you own 5 million shares and he owns 1.5 million shares, then that is a total of 6.5 million shares. 1.5 divided by 6.5 equals 23%.
Founder: Oh, I see now.
Negotiating based on an arbitrary, set share count is just asking for trouble. Your cap table is fluid. No one is ever guaranteed to maintain their initial percentage ownership throughout the life of the company. New hires, new investors, strategic partnerships and other events will inevitably require you to make changes to the cap table. Just count on it.
It’s much better to negotiate based on current share counts, and then explain to all parties that everyone will get proportionally diluted by future hires and investors.
And that concludes the story for our three founders. None of their mistakes had ruined them, but they did have to deal with some unnecessary headaches.
In order to help you avoid these same headaches, here are a few thoughts to remember:
- Issued and Outstanding Shares < Fully Diluted Shares < Authorized Shares
- Don’t get too focused on the authorized number. A good rule of thumb is to issue 50%–75% of that number to the founding team, and you’ll have enough cushion for an option pool and a few small investors—enough to get you to your Series A round.
- By the time you are bringing on employees, you should have legally formalized your option pool with an “equity incentive plan document.”
- Negotiate ownership based off of the total shares found on the “Fully-Diluted” cap table and not off of the number of authorized shares.
- When investors look at your cap table, they want to see the “Fully-Diluted” version like the one shown up above.
- If you ever have questions about your cap table, you should speak with your lawyer. We at Capshare are happy to answer questions, but we tend to speak to generalities and not to specifics, as we don’t know what you have legally issued in the past (and your lawyer should). This is doubly true if you are just coming to us for the first time.