Cap Table Math for Startup Founders

“We want to give Barbara 4% of the company. How many shares is that?”

I get questions like that frequently, and once you understand the math, the solution is pretty simple. Hey, I’m a lawyer, and I can understand the math. If you are going to run a successful startup, you need to master your cap table and understand basic cap table math.

First, you have to decide what is the total universe of stock that you are talking about. Is it all the shares of stock that the company could have outstanding, or is it only the issued and outstanding shares? This can provide very different results, so it is really important to use the right language. My default is that our universe is the issued and outstanding shares, unless I’m specifically told to do otherwise.

So let’s imagine a typical early stage Delaware corporation startup, with 10 million authorized shares. There are two initial cofounders, and they collectively hold 7 million shares. Their 7 million shares are 100% of the total issued and outstanding shares. That’s our starting point. If you are going to issue Barbara enough shares so she has 4% of the total, then how many shares is that? Well, after you issue Barbara’s shares, whatever number that may be, the initial cofounders will hold 96% of the total issued and outstanding shares. So 7 million shares is now 96% of X, the new number of issued and outstanding shares. Divide 7 million by 0.96. That should give you 7,291,677. Subtract 7 million from 7,291,677, and voila! You have the number of shares to issue to Barbara.

That’s how I normally do it. However, let’s say that your universe is going to be all the shares that the company could have outstanding. Maybe someone promised Barbara 4% on a “fully-diluted basis,” meaning we assume that all stock vests, and all options, convertible notes, and warrants are exercised. This is going to be a higher number. If you have 7 million shares outstanding, and options and convertible notes for another 2 million, then our total universe is 9 million shares. So now you divide 9 million by 0.96, and you get 9,375,000. Subtract 9 million from that, and the different – 375,000 – is what you need to issue to Barbara. So, depending on how you define your universe, Barbara could get approximately 84,000 more shares.

One final tip: it’s better to say “I’m going to grant you X number of shares, which will be Y% at the time of issuance,” than to say “I’m going to grant you Y% of the company.” The reason is that when you say “I’m going to grant you Y% of the company,” the recipient hears “I’m always going to have Y%, and the company will have to issue new shares to me from time to time, so I can maintain my percentage.” They think they are getting anti-dilution protection, and you want to avoid that at all costs.

New Corporate Governance Subscription Service

Are you a founder, officer, or major shareholder of a c-corporation? If so, keep reading…

Corporate governance – nobody likes doing it, but it’s essential to maintaining your corporation’s liability shield. Also, if neglected or done incorrectly, it can be expensive to clean up, and can hold up important, time-critical transactions.

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  • Unlimited board resolutions throughout the year, to authorize a variety of actions – issuing stock and stock options, entering into contracts, etc.
  • Assistance with filing annual report and other periodic filing and reporting obligations
  • Reminders when annual meetings and filings are due

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  • Subscription fee is $129/month.
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New Company Formation Service Available

Customers for legal services are increasingly segmented, just like customers for any other product or service. Many consumers of legal services like to do things themselves, on their own schedule. In recognition of this fact, we now offer online company formation services for DIY-oriented consumers. You can now form an LLC or corporation online in any state, through our website.

Also, you will get a one-hour consultation with me, where you can ask questions about forming and running an LLC or corporation. Other online company formation services may not provide such an opportunity.

One thing to keep in mind is that this service is limited – you get your company formed, but essential post-formation documents are not included. For example, if you are forming an LLC, you really should have an operating agreement, particularly if you will have co-founders. Similarly, with a corporation, you will need resolutions appointing directors and officers, you will need bylaws, and other post-incorporation documents may be necessary. We can provide all of those, customized to your needs, but they aren’t included in the online formation pricing.

We also offer registered agent services in all 50 states, as well as compliance services in those states where annual report filings may be required (such as Delaware and California).

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The Myth of the S-Corporation

I often hear potential clients say things like, “I want to form an S-corp,” or “should I form an LLC, S-corp, or C-corp?” This illustrates a very common misunderstanding about the nature of an S-corp. In today’s post, I hope to clear up this misunderstanding, once and for all.

The first thing to understand is this: LLCs and C-corps are things, and an S-corp is a choice. The best way to understand this is to go to any state’s website for forming businesses, and look at the different kinds of business entities available. For example, California allows you to form corporations, LLCs, limited partnerships, general partnerships, and limited liability partnerships. Under the category of corporations, you have for-profit corporations and non-profit corporations. Nowhere is forming an S-corp a possibility. The same is true for Delaware, too. When you are looking at the different kinds of business entities, an LLC is an entity, and a C-corp is an entity (although it will simply be called a “corporation”), but an S-corp is not an entity. So what is an S-corp?

An S-corp is a tax election that you make with the IRS. When you form a business at the state level, you have to choose a kind of entity – for example, an LLC or a corporation. Those two types of entities are taxed in different ways, however, and that’s where the S-corp tax election comes in. An LLC is a pass-through entity, meaning that the LLC’s net taxable income or loss is passed through to the owners in proportion to their ownership percentages, and the individuals report the income or loss on their personal tax returns. In the case of a corporation, the corporation itself must pay taxes on its taxable income, and its shareholders only incur tax liability with respect to corporate income that is distributed to them as a dividend. This is often referred to as “double taxation,” one of the most dreaded things since, well, peanuts in an elementary school.

If a corporation wants to be taxed more like an LLC, meaning it wants to be treated as a pass-through entity, it can make an S-corp election. There are some restrictions – the corporation can only have one class of stock, cannot have more than 100 shareholders, and in general, all shareholders have to be individual persons and US citizens or permanent residents. A corporation that has a stockholder who is a Chinese citizen and resident, therefore, would be disqualified from making an S-corp election. The fundamental thing to understand here is that you have two layers – the entity layer and the tax treatment layer. At the base is the entity layer – that’s the corporation. Laying on top of the entity layer is the tax treatment layer – that’s the S-corp election.

As further illustration of how this all works, an LLC can make an S-corp election too. You might ask, “since an LLC is already a pass-through entity, why on earth would it want to make an S-corp election?” That’s an excellent question. The reason is that when an LLC makes an S-corp election, its owners (the LLC members) can become employees of the LLC, so they can have taxes withheld from their paychecks, saving them the hassle of quarterly estimated tax payments. Also, they will pay a reduced self-employment tax on the money they take out via distributions, vs. if they had not made the s-corp election.

One final note: the S-corp election is not written in stone. You can inadvertently blow your S-corp election, by taking on a disqualifying shareholder or exceeding the 100-shareholder limit, for example. You can also voluntarily give up the S-corp treatment, when it no longer is advantageous, or when it interferes with bigger goals, such as when a tech startup needs to take on venture capital investment.

Why Should I Use You Instead of Legalzoom or Clerky?

“Why should I use you to set up my business, instead of Legalzoom or Clerky? You cost more money.”

I get that question occasionally from clients, and I usually answer by explaining that all those sites do is provide documents, which may or may not suit your needs. You may not know whether the documents are good quality, and nobody is available to explain every single sentence in the documents, much less make changes. I, on the other hand, provide legal services. And those legal services that I provide include advice on what is best for your business, as well as providing customized documentation to ensure that we are meeting your needs.

Well, last week a prospective client asked me that question, and as I started to formulate an answer, I went to the website of the document provider – incorporate.com, to see what it offered. In this case, we were talking about forming a multi-owner LLC. Incorporate.com didn’t specify as to whether the operating agreement was designed for a single-owner LLC or a multi-owner LLC. There’s a big difference in complexity, as well as in the kinds of issues you need to address, so it was a significant area of confusion on the website. Then I notice a convenient live chat function, so I decided to dig deeper. Here’s the transcript, and I think you’ll find it quite illuminating.

Thank you for choosing incorporate.com. A representative will be with you shortly. You are now chatting with ‘Jaron’

Jaron: ‪Hello, how are you?

you: fine, thanks. So I’d like to know, for your LLC formation package, is the operating agreement a single-member or multi-member operating agreement?

Jaron: ‪The operating agreement can go either way

you: Well, which is it?

Jaron: ‪Is this something you are looking to have set up today?

you: maybe

Jaron: ‪It is whatever you need it to be

you: and does it include transfer restrictions?

Jaron: ‪like heir to heir?

Jaron: ‪Or ownership?

you: like a right of first refusal if my co-owner wants to sell to an outside party

Jaron: ‪Yes, you can include that in the operating agreement. We also provide a guidebook with further instruction on that as well.

you: and all of this is the same price, regardless of what I want included? regardless of whether it’s a single-member or multi-member?

you: all for $385.95

Jaron: ‪YEs

you: How many drafts of it will you do for me, to ensure it’s the way I want it?

Jaron: ‪I can also provide priority handling at no extra charge.

Jaron: ‪Yes

you: how many?

Jaron: ‪Let me double check. Bare with me [spelling error his, not mine – another nice touch from the experts]

you: double check on all those questions, please

Jaron: ‪Sure… one moment [long delay]

Jaron: ‪You can supply the operating agreement after writing it out. We provide the template. You can update it at anytime with written consent. The only time there is a fee is if you have a third party update it

you: So you provide a basic template, and I have to make all the changes? You don’t write these in for me?

Jaron: ‪We do not. You will write them up, we will file them internally

you: So the transfer restrictions and all that aren’t in the agreement you provide. I have to write all that up for you?

Jaron: ‪Correct. We file it for you, you provide the structure that you want.

you: What do you mean, you file it? [note: you don’t file an operating agreement with anyone; it’s a contract between the business owners and the LLC]

Jaron: ‪You will supply us with the language and draft of the operating agreement. Once you notarize it and send it in, we can update it to your liking at anytime [another tip – you don’t have to notarize an operating agreement]

you: Well, if I have to write the operating agreement, why do I pay you?

Jaron: ‪We provide the template. If you want to submit it yourself without our template, than I can customize a package for you to save you money without the operating agreement

you: I want the operating agreement, but you told me you could customize it with whatever I want, and now you are saying that you can’t, that I have to provide the customized language. Is that correct?

Jaron: ‪Yes, meaning you can make the operating agreement anyway you want it. There is no structure that you are stuck to.

Jaron: ‪If you need to update or make changes, we can do that. No fee

you: But I provide the language

Jaron: ‪Yes

Jaron: ‪We provide a template. You can use it if you wish

Jaron: ‪Or provide your own language [kind of like going to a restaurant, but bringing your own ingredients and cooking them yourself]

you: One last question. On your website, you say the Ohio LLC filing fee is $125 plus a $5 document retrieval fee. But the LLC filing fee in Ohio is $99. Why the difference?

Jaron: ‪I will get you the breakdown, one moment [long delay]

Jaron: ‪Sorry for the delay

you: Yes?

Jaron: ‪$125 is the LLC filing fee of for Ohio anywhere

you: Not according to the Secretary of State’s website.

Jaron: ‪You will have to go to the Secretary of State yourself to retrieve the documents without the $5 fee in addition

Jaron: ‪Yes I see the $99

you: I’m not talking about that. I’m asking why you charge $125 for the basic filing fee, when according to the Ohio secretary of state website, the filing fee is $99 [note: the Ohio Secretary of State actually lowered the filing fee from $125 to $99 several months ago, something other states should consider doing. I’m talking about you, Illinois, Texas, and Massachusetts]

you: so please explain

Jaron: ‪I am really sorry about the confusion. I am not sure why the fee is more. All of the service companies charge the $125 rate… I honestly do not know why but I will happily discount it for you.

you: No, I’m just concerned that you wouldn’t know what the correct fee is. Aren’t you the experts?

Jaron: ‪Yes, most times there are things like “Walk in fees” that are built into the price. I think that may be the case here but for some reason it is not listed. Most of our state fees include the full breakdown. I am not sure why Ohio does not. I apologize

you: There’s no walk-in fee. Ohio lowered the filing fee several months ago, and you just don’t take the time to ensure that you are charging the correct amount.

So let’s note a few key things from the chat:

  1. The representative wasn’t very knowledgeable. That’s always a troubling sign.
  2. The representative started out by promising that I could get anything I wanted (at that low price), but quickly had to backtrack when I pressed him on the issue. By the time we were done, I was going to have to write the operating agreement myself!
  3. The company’s website was out-of-date when it came to the Ohio filing fees, and when I asked about it, the representative basically made up an answer out of thin air (or pulled it out of his ###, if you prefer). If I hadn’t forced the issue, they would have overcharged me.
  4. The representative was also completely wrong about the $5 document retrieval fee. Some state’s charge to download documents, but Ohio isn’t one of them. This is an unnecessary and dishonest fee, and you shouldn’t have to pay it.

I hope you have a better idea now of what you get with these document services, and why I charge more money.

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