A Tutorial on Capitalization of a Startup Corporation
4 min readWhen you create your corporation and make it a legal entity in the principal State of Business, Nevada, or Delaware, one of the requirements is to Capitalize your company to give it value.
What this means is to create a number of shares (stock) in the company and give it a "par value" (which may be no par value). You are taxed based on this value until you start making revenue, etc.
We recommend that you Capitalize your company, at start up at 10,000,000 shares, with a par value of $ 0.0001 or $ 0.00001 (depending on the State you are incorporating in). This level of stock does a few things for you.
First, it gives you a great large pool of stock to work with in issuing stock to key players, and in getting Friends / Family and Angel Investors involved, and with time, Venture Capitalist.
Second, it allows for real prices at share growth as each new person comes on board and buys stock.
Let's break down a new company startup:
The company is being created and started by a CEO, CFO and CTO (three people), with the CTO being the predominant person behind the company and the CFO and CEO are past business associates of the CTO. CTO wants controlling interest in the company and the other two both want equal shares to each other, giving the CTO control.
10,000,000 shares at a par value of $ 0.0001 valuates your company at a net worth of $ 1,000 for tax purposes.
The CTO takes 20% of the total value of the company, which is 2,000,000 shares. At this point, with no other shares being issued yet, the CTO owns 100% controlling interest in the company. These shares can be issued on the basis of work done to date, start up cash put into opening the company for business, and the release of IP to the company.
The CEO and CFO each get 750,000 (or 7.5% of the company Capitalization each). At this point, the CTO now owns 57.2% controlling interest in the company.
500,000 shares are put aside for bringing in new employees. We have now allocated 40% of the capitalization of the company to be issued, and 35% is actually issued.
You now have 1,000,000 shares put aside for you Friends / Family / Angel's. (Another 10% of the company, taking the total allocated position to 50% of the Capitalization of the company.)
It is felt by your Executive Team that you need to raise $ 1,500,000 in Friends / Family and Angel money to get the Proof of Concept completed and to get ready to for your first (and if you listen to us last) Venture Capital Round that will take you to revenue and positive cash flow. You now go to your friends, family, pocket, Angels and offer them shares at a dollar per share. You sell 1,000,000 shares and have your money to get the product developed and proven.
The DAY you close the last part of that money, you begin courting your Venture Capitalist for what you feel will take you to cash positive revenue. Let us say that will be $ 5,000,000.
You have 50% of the company Capitalization that is allocated, with 45% (plus what ever stock you have issued to new employees since you raised the Angel Funding) being issued, giving you 5,000,000 shares available for you to barter with the Venture Capitalist.
Your goal is to give away no more than 20% of the company for that $ 5,000,000 (2,000,000 shares). If you are able to do that, you have taken the value of the company from $ 1.00 / share to $ 2.50 / share, making your initial investors happy, their stock went up in value already, and leaving room for future sales if need be.
The Venture Capital is probably going to come to you offering you $ 5,000,000 for 51% of the company or more. In that you are coming to them from a position of power (you still have money in the bank, and are able to work on the product), you should be able to get them down below the 50% level.
Let us say you get them to invest the $ 5,000,000 at 20% (2,000,000 shares). The ownership of the company is as follows, assuming no shares are issued to any other employees at this time:
CTO = 2,000,000 shares / 20% of the capitalization of the company or 30.77% control of the company
CEO = 750,000 shares / 7.5% of the capitalization of the company or 11.54% control of the company
CFO = 750,000 shares / 7.5% of the capitalization of the company or 11.54% control of the company
Friends / Family / Angels = 1,000,000 shares / 10% of the Capitalization of the company or 15.39% control of the company.
Venture Capitalist = 2,000,000 shares / 20% of the Capitalization of the company or 30.77% control of the Company
Often the concern of the Founder (CTO in this case) is that they will not have "ownership" of the company, and it looks like it here. In fact though, assuming that they have a good relationship with the Friends, Family and Executive Staff, they have control of the controlling interest in the company by pooling the shares of those loyal to them. (This of course assures that what they want to do is not against the best welfare of the company and stock holders and the stockholders agree with them. Remember, the 1,000,000 shares in the Friends / Family / Angel round is typically not in one person's hands, but several peoples hands.)
If your calculations were off mid way through the spending of the $ 5,000,000 (and you still have about $ 2,500,000 in the "bank") and you are going to need another round of Venture Capital, you have 3,000,000 shares left over to raise capital with potentially at $ 4.5 plus share, again making everyone happy, and reducing the amount of share that go out for each round.
Many companies do not follow this plan, but base their offerings based on "outstanding shares" versus Capitalization of the company. Good Venture Capitalist will be looking at total Capitalization and not "outstanding shares" for their percentage of the company.
This also assumes that only Common Stock will be issued in the company, which is what we recommend, giving equal rights to all shares.
