What are the different types of startup stocks?
Marc Hoag via Midjourney
This is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.
Understanding the intricacies of stock options in a startup is more than a mere exercise in finance or law; it's a roadmap to your company's very architecture. Whether you're a founder, an employee, or a potential investor, your knowledge—or lack thereof—of these options can profoundly impact both your immediate choices and long-term strategy.
Common Stock: Fundamental Unit of Company Ownership
At the core of any startup's equity structure is common stock. These are the shares that provide foundational ownership and voting rights. Common stock is often what employees receive when they are granted stock options as part of their compensation package. Unlike preferred stock, these shares don't come with special privileges like guaranteed dividends or priority during liquidation. However, they do allow holders to have a voice in company decisions through voting rights.
Founders, Employees, and Restricted Stock
The term "founders' stock" is often used, but it's nothing more than a Silicon Valley buzz word, not a different class of stock. Don't forget, despite the bragging rights that come with the title, founders are just employees. So founders’ stock is just common stock; moreover, it’s usually subject to a vesting schedule, too, making it restricted stock.
Employees who join the startup may be granted restricted stock too, which also typically vests over time. The vesting conditions serve as a commitment mechanism, ensuring that those who hold restricted stock are invested in the company's long-term success.
So net-net, founders’ stock is almost always a type of restricted stock which is in turn a type of common stock.
Preferred Stock: Special Rights for Investors
Preferred stock is an entirely different class of shares that often comes with a range of special rights and privileges. These could include guaranteed dividends, voting rights that might be different from those attached to common stock, and priority during liquidation events. This type of stock is often attractive to venture capitalists and institutional investors who seek both financial upside and a measure of protection for their investment.
Options, Dilution, and Cap Tables
An option pool is a pre-allocated pile of shares set aside specifically for future employees, advisors, or even contractors. The pool's size, usually ranging from 10-15% of the total shares, can have long-term implications. Not only does it dilute existing ownership, but its size can also be a negotiation point during fundraising rounds.
Dilution occurs when a company issues additional shares, reducing the ownership percentage of existing shareholders. This is a critical concept to understand, as dilution affects everyone from the founding team to the latest hires. Future investment rounds, the issuance of shares from the option pool, or any other increase in total shares will dilute existing ownership percentages. However, it's worth noting that while your percentage of ownership may decrease, the goal is that the value of the company—and thus your shares—will increase.
A capitalization table, or cap table, is a dynamic document that provides a snapshot of all the company’s securities and their ownership percentages. It includes details on common stock, preferred stock, options, and any other form of ownership. As your company grows and changes—through new investment rounds, hires, and other events—so too will your cap table. Keeping this document accurate is crucial for understanding the company's current equity structure and for future fundraising efforts.
These topics are thoroughly unpacked in this discussion on SAFEs.
Tax and Legal Implications: Navigating the Complexities
The tax treatment of stock options can be complex and varies depending on the type of stock. One crucial element for those receiving restricted stock is the 83(b) election. This tax provision allows you to pay taxes based on the stock’s fair market value at the time it's granted, not when it vests. This could result in significant tax savings if the company appreciates in value. Alongside tax considerations, each type of stock comes with legal requirements, from stock option agreements to shareholder contracts, that must be meticulously maintained for compliance. This is an extremely important election so be sure you understand it.
Convertible Instruments: Flexibility for Future Fundraising
Convertible instruments like Convertible Notes and SAFEs (Simple Agreements for Future Equity) are often used in early-stage fundraising. These financial tools provide a mechanism to secure investment without immediately issuing stock, offering flexibility in how a startup manages its equity in the early days.
Equity management in a startup is a complex task that requires a deep understanding of various types of stock, legal frameworks, and financial implications. This knowledge is not just for compliance; it's a strategic imperative for any founder. Always consult with legal and financial experts to navigate these intricate matters effectively.