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Re-allocating Equity in Your Startup

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

We have previously written about considerations for founders in splitting initial equity in their startup.  No matter how thoughtful founders are in dividing their initial equity, it is common for founders to realize after a period of time operating their company that their initial equity allowances do not accurately reflect the actual contributions or value from each team member.  Founders often believe they can simply create their own document redefining their split of equity %’s.  In the case of an LLC, founders often try to simply amend the cap table exhibit to their Operating Agreement.  While these steps are better than nothing, reallocating equity %’s involves transferring shares (for a corporation) or units (for an LLC) and therefore could trigger some tax and securities issues.  Additionally, it is important to generate clear documents, signed by all involved parties, in order to avoid later disputes over the number of shares/units held by individuals (especially when those shares/units hold more value).   Just as importantly, maintaining a clean and clear cap table is really important for early stage startups.  Investors will typically want to see clear documents showing the issuance from the company to each shareholder of shares that correlate to the numbers of shares indicated on the cap table.   This post provides a few specific methods for properly reallocating equity in an early-stage startup.  The specific approach will spend on the specific governance documents and circumstances for your startup, so please consult your attorney.  This post assumes a few important things:

  • the company is pre-financing and it can issue equity at a nominal valuation (in the case of a corporation, at or near par value of $.0001 or $.00001).
  • all stockholders are remaining involved with the company, in other words, no one is terminating an employment or contractor arrangement with the company.
  • the company’s board of directors (for a corporation) or board of managers (for a manager-managed LLC) are remaining the same.
  • the company has implemented standard vesting procedures for all founders (to learn more about vesting, see this primer on vesting.)

Calculating the Adjustment

The first step in reallocating equity is to figure out how much stock (for corporations) or units (for LLC’s).  Presumably, you have determined your new desired %’s.  You might think about your desired outcome in terms of %’s, but in order to get there, you need to think about the number of shares or units held by each individual.  For example, assume three individuals (Founders A, B, and C) currently own respectively 40%, 40%, 20% of the issued equity in a company, reflected by having been issued 2M, 2M, and 1M shares respectively.  They’ve decided to reallocate equity so that the three founders will own 30%, 30%, 40% of the issued equity respectively.

There are a variety of ways to achieve this outcome.

1) Issuing More Shares/Units to the Founders Desiring to Increase Their %.

For example, the company could simply issue Founder C more shares so that Founder C holds 40% of the new total.  In the above example, this would mean issuing Founder C 1,666,667 shares so that Founder A and B would still each own 2,000,000 shares and Founder C would own 2,666,667 shares and the equity would be divided 30%, 30%, 40% respectively.

When issuing more shares to Founder C, if the startup is a corporation, it would ensure it does not exceed the number of authorized shares in its Certificate of Incorporation.

The following documents would typically be used to execute the above:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,666,667 shares/units to Founder C.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,666,667 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.

2)Repurchasing Unvested Shares/Units from Founders Desiring to Decrease Their %.

Another way to reallocate equity using the above example, is to repurchase unvested shares from Founders A and B.  Using the above example, the Company could repurchase 1.25M shares/units from each of Founders A and B, so that they would each own 750,000 shares/units and Founder C would still own 1,000,000, providing the desired 30/30/40 split.  Note that repurchased shares go into the Company’s treasury (ie., as authorized but unissued shares).  They effectively disappear into the ether, which allows Founder C’s % to increase even though she maintains the same number of shares/units.

The following documents would be used to execute the above:

  • A Board consent (signed by all directors in the case of a corporation or managers in the case of an LLC) authorizing the company to repurchase 1.25M shares/units from each of Founder A and B.
  • Repurchase Agreements between the Company and each of Founders A and B.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

3) Combination of #1 and #2 Above.

Another way to reallocate equity in the above example would be to repurchase 500,000 shares/units from each of Founders and and B and issue 1,000,000 new shares/units to Founder C.  This would keep the number of issued shares/units constant at 5,000,000.  This method might be preferable if the startup didn’t have enough authorized but unissued shares/units to issue Founder C without repurchasing some from Founders A and B (making method #1 impractical because it would require amending the Certificate of Incorporation for a corporation), Founders A and B didn’t have enough unvested equity to repurchase the necessary shares/units (making method #2 above impractical), or the startup otherwise wanted to maintain the existing number of issued shares/units.

To implement this approach, the Company would use the following documents:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,000,000 shares/units to Founder C and the company to repurchase 1.25M shares/units from each of Founder A and B.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,000,000 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • Repurchase Agreements between the Company and each of Founders A and B where the Company repurchases from Founders A and B 500,000 shares/units each.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

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