what happens to equity stake when a company goes public

Business organization Nuts for Engineers by Mike Volker

Equity: Dividing the Pie

Contact: Mike Volker, Tel:(604)644-1926, Fax:(604)925-5006

E-mail: mike@risktaker.com

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I'd rather have a modest piece of a big pie than a large slice of nothing! (M. Volker)

Why Do Yous Need a Partner?

If you are very vivid, very tenacious, and financially well endowed, then you can kickoff a company which you lot own in its entirety and in which you can hire a bright, capable, highly motivated and well-paid direction team. Still, if y'all do not fit this description entirely (I might add that, if you practice not possess at least ane of these attributes, you might want to re-think starting your own business organization), then yous will likely have to bring "partners" into your visitor by giving them equity, i.e. some share buying. Apparently, investors who bring money to fuel the growth of your company deserve some buying. Similarly, fundamental people who join y'all on your squad, or who beginning the company with you, will desire some course of ownership if they are making a valuable contribution for which they are not being fully paid in cash. Others who contribute their skills, experience, ideas, or other assets (such as intellectual holding) may be given shares in your visitor in lieu of being paid in cash.

How do y'all bargain in New Partners?

Valuation is the issue. What is the new partner'due south contribution worth in relation to the whole pie? At that moment in time, what is the visitor worth and how is that worth adamant? Bringing in new shareholders always means "dilution" to the existing shareholders. If a new investor is to receive a 10% stake in the company, and then a shareholder who previously held 40% of the equity, will now hold 36% (i.e. 90% of 40%). You never actually never give upwardly your shares when new people are dealt in. Yous simply effect more shares (the same way governments print coin). Issuing more shares is what causes the dilution. If you have 100 shares and yous want to requite someone 10%, y'all'd have to event 11 new shares (11/111 x 100 = 10%, approximately).

Unless you are greatly concerned most control issues, each time y'all dilute you should be increasing your economic value. If you dilute your buying from xl% to 36%, you still concur the same number of shares, but the per-share value should accept increased. For instance, if you entice Terry Mathews (of Newbridge and Mitel fame) to your board by paying him 10%, it is quite probable that your shares will double or triple in value (i.e. marketplace value for certain and hopefully also intrinsic value considering of strengthened leadership). If your 40% was worth $1 1000000, your resulting 36% may now be worth $3 million!

If you bring in a new VP of Marketing and give her 5% as a signing bonus, how do you lot know that her contribution will be worth 5%? How exercise you measure out someone's reputation? Unless the person is well known or has a proven record, it may non be so easy. That'southward why vesting (described later) may be appropriate.

There is only ane way to bring in new partners: carefully and with deliberation. A partner may exist with yous for life. It may exist more hard to cease a business concern partnership than it is to obtain a marital divorce. So think about information technology!

Who Should Get What?

What pct of the visitor should each partner in a new venture receive? This is a tough question for which there is no like shooting fish in a barrel answer. In terms of percentage points, what's an idea (or invention or patent) worth? What'southward 5 years of low salary, sweat and intense commitment worth? What is feel and know-how worth? What'southward a buck worth? "Who should get what" is best determined by considering who brings what to the table.

Suppose Bill Gates said he'd serve on your Board or give you some help. What share of the company should he become? Just recollect almost the value that his name would bring to your visitor! If a venture capitalist idea your visitor was worth $1 million without Gates, that value would increase several-fold with Gates' involvement. Nonetheless, what has he "washed" for you?

Often, company founders give picayune idea to this question. In many cases, the numbers are determined by what "feels expert", i.e. gut-feeling. For example, in the case of a brand-new venture started from scratch by four engineers, the trend might be to share every bit in the new deal at 25% each. In the case of a single founder, that person may choose to continue 100% of the shares and build this venture through a "bootstrapping" process, in club to maintain total buying and control past not dealing in other partners. It may be possible to defer dealing in new partners until some later fourth dimension at which indicate the business has some inherent value thereby allowing the founder to maintain a substantial ownership position.

The answer to the question "who should get what" is, in principle, unproblematic to answer: Information technology depends on the relative contributions and commitments made to the company past the partners at that moment in time. Therefore, it is necessary to come up with a value for the company, expressed in either monetary terms or some other common denominator. It gets trickier when there are difficult avails (greenbacks, equipment) contributed by some parties and soft assets (intellectual property, know-how) contributed by others. Allow's await at a some examples for analogy.

1. Professor Goldblum has adult a new production for decreasing the cost of automobile fuel consumption. He decides that in social club to bring this innovation to market, he will need a business partner to help him with a business plan, and so manage and finance a new company formed to exploit this opportunity. He recruits Sam Chocolate-brown, anile 45, who has a proficient record equally a local entrepreneur. They concur that Sam volition go xxx% of the visitor for contributing his experience, contacts, and runway record plus the fact that he will take a $50K/year bacon instead of a "market" salary of $100K for the get-go two years. Furthermore, they hold that Sam will commit his total-time attending to the business firm for 5 years and that should he leave, for any reason earlier the total term, he would forfeit 4% of the equity for each yr under the 5 year term. The Professor takes 60% for contributing the intellectual property and for providing on-going technical communication and back up. The Professor "gives" the University a token ten% because according to University policy, the University is entitled to "some share" of his intellectual property because of its contribution of facilities even though, under its policy, the intellectual property rights balance with the creator. Although these numbers are somewhat arbitrary, they are seen by the parties as existence fair based on the relative contributions of the parties. Every bit a taxpayer, one might advise that the University got the brusque end of the bargain, but that's a moot point.

2. Three freshly graduated software engineers decide to class a new software visitor which volition develop and sell a suite of software development tools, bearing in mind the paucity of software talent plaguing the manufacture. They all get-go off with like assets, i.e. cognition of software, and comparable contributions of "sweat equity". Heidi takes on the role of CEO of the new venture and they dissever the pie as to 40% for Heidi (because of her greater responsibilities) and 30% each for the other ii. They are happy campers for now. Some fourth dimension subsequently, they make up one's mind to recruit a seasoned CEO with relevant experience and bring in a Venture Uppercase investor to fund the promotion of their then-developed and shipable suite of software products. They volition so take to wrestle with the issue of what their company is now worth and how much ownership they will have to trade for these new resources. This will be determined by the venture capital suitor(south) in lite of current market investment conditions and the attractiveness of this item deal.

3. Four entrepreneurs who have recently enjoyed financial windfalls from their businesses, decide to get into the venture capital concern. They decide to form a visitor with $x meg in investment capital. Harry provides $3 million, Bill provides $2 million, and the other two each provide $two.5 one thousand thousand. How much of the new company will each of them own? (This isn't a fob question.) For assets as basic as cash, it is piece of cake to determine "off-white" percentages.

In the case of the second example in a higher place, we have a situation in which a company is established and has some value by virtue of its products and potential sales in the marketplace. The visitor's Board decides to bring in an experienced CEO (this as well makes the venture capitalist happy) to develop the business to its next stage of growth. Although it may be possible to hire such a person and pay him/her an bonny salary, it probably makes more sense to bring in such a person as more than of a partner than a hired mitt. In this example a lower-than-market salary could be negotiated along with an equity stake. One way of doing this is to apply the departure between market rate and the actual bacon over a period of time, say five years, to an disinterestedness position based on a company valuation adequate to the founders. If a venture capital investment has been made or is being negotiated, this may set the phase for such a valuation. For example, Louise was earning $125,000 per twelvemonth working as the CEO of an American company's Canadian operations. She agrees to work for $75,000 per year for 5 years. She is essentially contributing $250,000 up front (in the form of equity that does not have to be raised to rent her). If the company has been valued at $2 million, she ought to receive something in excess of 10% of the company. All the same, her shares would "vest" over 5 years meaning that each yr she would receive i-5th of the shares from "escrow". She would forfeit any shares not and then released should she suspension her delivery or should her employment be terminated for cause. In this example, Louse'south bacon is really $125,000 per year but she is investing a portion of this in the company's disinterestedness (on a revenue enhancement-advantaged basis, I might add together!).

For more mature companies and especially for publicly-listed companies, it is possible to provide managers with incentive stock options as an boosted incentive in the class of a reward if the company performs well and if the stock price reflects this performance. Nonetheless, this is not the same equally ownership and should exist viewed as part of a salary package.

Important Betoken: Don't misfile equity (i.e. investment and ownership) with income (i.east. salary)!

Shares vs Per centum Points

Sometimes people will get hung upwardly on percentage points. For example, if a new visitor is created which consists of many people, it may non be possible to dissever that fixed 100% into 20 or xxx meaningful chunks of ten%. It just won't piece of work. Some people may receive only iii% and may experience slighted by what appears to be an insignificant corporeality (although I sure would like to accept had i% of Microsoft when it got started). It's too bad that merely 100 pct points are available. Nonetheless, there is no limit on the number of shares which can be issued. And then, let's result ten meg shares and give our three% person 300,000 shares. We all know that someday these shares might be worth $5, $10, or $50! Work information technology out! It suddenly becomes more than palatable.

So, how many shares should be issued? Small public companies usually have between v and 15 million shares outstanding. Larger public companies may accept 100 million or more shares issued. Individual companies, large or minor, accept fewer shares issued - anywhere from one to perchance a few one thousand thousand. The number is non really of import for private companies considering these shares do not trade in a public market. When companies go public, i.eastward. list their shares for trading, there are frequently stock splits such that 5 or ten new shares are traded for each existing share in club to give a company a "normal" number of shares and a "normal" price range.

The number of shares which y'all will issue when you kickoff start out should exist determined by how many partners you wish to have. If but a scattering, then you could simply issue 100 shares with the percentage points being equivalent to the number of shares. It might make you and your partners feel improve to increment this number by a few orders of magnitude. That's OK, besides. If y'all have many partners, it helps to have many shares - even if just for psychological reasons.

Novice entrepreneurs may think, "Gee, it would be prissy to own v million shares in a company." Truthful, but it may cause complications if you lot accept too high a number. For example, if you start with 10 million shares and so deal others in so that yous stop up with 15 one thousand thousand shares and then you decide to go public, resulting in over twenty million shares, this may exist too large a number and you may accept to exercise a roll-back or consolidation (encounter next paragraph).

Stock Splits and Stock Rollbacks

You accept probably heard of a "stock split". This happens often with publicly traded companies when their share prices become "likewise loftier". Microsoft, for instance, has split many times. That's why Bill has 270 1000000 shares. Microsoft does this when the share price appears too expensive for the average investor. After all, who wants to pay $500 for one share? If you split 2 for ane, and so the price per share would be $250, but if y'all split v for i, the price per share would now be $100. When companies split their shares, they do so simply past exchanging new shares for old shares with all the shareholders.

Stock rollbacks or share consolidations as they are sometimes called are the opposite of stock splits - but with one notable difference. When a rollback is done, ane new share is issued for 2 or 3 (or whatsoever the Board decides) quondam shares. However, the new shares are issued nether a new corporate name meaning that the company must change its legal name. Often the change is small, such as from Superlative Corp to Acme Inc or from Acme Corp to Acme 2000 Corp. This is done then that the new shares are not as likely to be confused with onetime shares. This is non the case for splits, assuming that shareholders volition want to trade in their old shares for new shares whereas in the case of consolidations shareholders volition not exist eager to trade their one-time for their new.

Why a rollback? If a share toll is too low, the visitor may appear similar a "penny stock" or nickle-and-dime outfit. So, if a stock is trading at $.x per share a 1 for 10 rollback, will give the stock a more respectable dollar advent. Besides, if a smaller, more inferior company has 500 1000000 shares outstanding (which tin can happen), it may be ameliorate, for market reasons, to have a tigher "float" (i.e. number of issued shares trading on the market).

In terms of what is advisable, hither are some ballpark numbers to consider. Private companies, closely held (i.e. few shareholders) would take a pocket-size number of shares, regardless of their size. Individual sompanies with a larger number of shareholders (say upwardly to fifty) could have a few k or even a few million shares issued. Small public companies (with annual sales below $10 million) such as those trading on a junior stock exchange, like Vancouver, would take between 5 and 10 million shares issued. Senior companies (with annual sales in excess of $100 million) such every bit those trading on Toronto, might take more fifty one thousand thousand shares issued. The really mammoth corporations with sales in the billions of dollars will probable have more 100 million shares issued. Microsoft has almost 600 million shares issued as at March, 1997.

Implications of Buying

Ownership means sharing risks and sharing rewards. It implies a sure caste of control (i.eastward. risk management) insofar every bit the shareholders appoint the direction team and information technology implies a sharing in the value of the visitor - withal measured (i.e. profits, the internet worth, market value, etc). These are 2 distinctly different concepts. The astute entrepreneur might inquire herself if she wants to exist a wealthy, independent owner or if she wants to be a very busy manager! Well-nigh owners, especially founders engage themselves as the senior managers. And, they have this right. But, I'd rather be rich than busy or poor. The well-nigh important attribute of share ownership is that as the value of the visitor increases, i'south share of the value also increases. Bill Gates doesn't actually take billions of dollars. What he has is a fraction (ane-quarter, roughly) of a business organization worth many billions of dollars. Your adventure is the investment you put in, other forgone opportunities, and possibly reputation (if the deal sours). Only the reward may exist unlimited. That's why equity is and then bonny. It is not uncommon for a founder of a high tech venture to ain a 1000000 shares (which toll him very petty in the form of cash) and see these shares appreciate to a value of several million dollars in a relatively short time frame. There are literally thousands of examples of this - Gates being the most prominent i.

Ownership does not imply whatever additional obligations nor liabilities. One time an equity stake is purchased, or "vested", it belongs to the owner forever. It also entitles the owner to vote for the company's board of directors, its governing body. Depending on the relative shareholding, a shareholder may have very little control every bit in the case of a large public company or very substantial control as in the example of a pocket-size company in which he has more than than l% of the votes or in which he may have less than fifty% of the votes, but however have corking influence by virtue of a shareholders' agreement.

A very successful founder once said, "I'm not really very smart, but I sure do have a lot of smart people working for me!". This person understood the difference between ownership and management.

What's a Company Worth? (and When?)

How is value added to a business over a period of time? All companies get-go off being worth just the incorporation expense. As soon every bit people, coin and assets are added or developed, a company will appreciate in value. If the management team comes upwards with a quantum engineering science, that may exist worth millions of dollars! The development of products and customers adds value. The management team itself is worth something past virtue of its amass feel, skill, contacts, etc. Value is best measured in terms of potential, not in terms of historical earnings or fiscal track record - but in terms of future performance possibilities. Value increases both through internal actions and growth likewise as through external contributions (e.g. greenbacks and people) which facilitate such growth.

For founders and early investors, the upside potential is the greatest. In its early on stages of evolution a company may exist worth very little, especially to outsiders. All of the value may be dormant within the team - awaiting development. Those who contribute at this early on stage deserve to bask enormous gains considering they are the ones who are bold enough to take the initial risks. An "affections" investor who provides a University faculty member with a small amount of get-go-upwards funding, say $l,000 to prepare an invention for exploitation, may easily deserve x or twenty% of that concern. After a concept is more fully adult, this initial position may be viewed as a "steal", only then again, nearly such "steals" end up existence worthless deals!

It is both unhealthy and unrealistic for an entrepreneur to begrudge the stake held past his or her early backers. Sometimes there is a tendency towards seller'south remorse. For example, an entrepreneur who sells 20% of his firm for $50,000 may experience cheated ane year hence when a serious investor is willing to pay $500,000 for xx%. This is flawed thinking. Without that intial $l,000, this visitor may never take survived its get-go yr. In this analogy, the founder initially had 100%, and then 80%, then ended upward with 64%. The angel had twenty%, then ended up with sixteen%. The rich investor ended upwardly with twenty% - at least until the adjacent round at which time they volition all again endure a dilution. Ideally, every bit time marches on, the value of the company increases dramatically such that subsequent dilutions go less and less painful to existing stakeholders. Sometimes, when milestones are non achieved, the early on investors and founders must swallow a bitter pill past enticing new investors with large equity positions with major dilutive consequences. But, that's business!

The value of a concern is all-time ascertained by what an investor is willing to pay for information technology (i.e. its shares) or what a potential strategic acquisitor (i.e. an investor (or competitor) who wants to buy it for strategic business organization reasons) is willing to pay for it.

It is prudent management philosophy to always exist thinking in terms of making a business attractive to such suitors by building a solid foundation and by nurturing and growing information technology. The business concern should always be in a condition to sell it.

Other Alternatives

Let's be creative. You don't always have to give up shares in your visitor if you tin't pay cash. Besides, it gets messy (from a corporate governance perspective) having too many, peculiarly small-scale, investors. You might be able to negotiate a deferred payment system, mayhap with interest. If you need to learn a tangible asset, yous can likely obtain bank or third-party financing. For soft avails like intellectual property, you lot could consider entering into a royalty arrangement, i.e. for every unit of measurement sold embodying said intellectual holding, you pay a v% royalty on sales to the provider of the asset. And remember, equity is expensive. Giving someone a 5% pale, means that that political party owns v% of your firm'southward cyberspace worth and profits forever! And then, tread charily.

Summary

Dividing the pie is non easy. In the terminate, or to put information technology more correctly - in the beginning, it is important that all equity partners accept the deal. Each shareholder would like to own a bigger percentage - that just makes sense. Only, unfortunately, all the "percents" accept to add together upward to 100. That'due south why it's nice to be able to issue 10 1000000 shares. It sounds a lot ameliorate to own 100,000 shares in the side by side hot software bargain, than to just own a mere one percent!

At the time you lot sell some or all of your shares in the visitor, remember that it is dollars which you put into your bank account, not percentage points.

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Copyright 1997 Michael C. Volker
Email:mike@risktaker.com - Comments and suggestions will be appreciated!
Updated: 971015

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Source: https://www.sfu.ca/~mvolker/biz/equity.htm

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