 | Business Basicsfor Engineers by Mike Volker |
Getting Organized
When a company is created, the founders of the company must determinewho owns the company. Often the founders also become the first shareholdersof the enterprise. The first, and most important, step in getting a companyorganized, is to determine who owns how many shares. This is usually expressedas a percentage of the total number of shares and it is this percentagethat is very important to each founder.
Over time, the ownership of a company will change as new participants,e.g. managers or investors, are dealt in. It is never easy to figure outhow should get what share of ownership. It usually boils down to a matterof negotiation among those involved. For some assistance on how to establishrelative share ownership positions, the reader is referred to another articletitled: "Dividing the Pie".
When the founders have agreed on the ownership percentages (i.e. percentageof common shares issued), they can then determine how many shares in totalto issue. This number is usually kept small at the beginning, e.g. 100or 1000. This number can be "split" (multiplied by 2, 10 or whatever) asrequired. If the company plans to eventually become a public company, thenumber of shares and the price paid for these shares becomes more importantand proper structuring at the outset (with appropriate counsel) is advised.
What Price Paid?
It is a good idea to have each shareholder actually buy and pay forthe shares which are acquired. When companies are formed, they have noimmediate real value. Shares can be issued for a penny (again, if the planis to go public soon, this should be carefully explored with expert help).A "subscription agreement" is recommended. This is a simple document (evena one-page memo may suffice) which clearly shows that a certain numberof shares are being purchased for a specified price. It is a good ideato actually write a cheque to the company for this amount as a matter ofrecord. It may help in proving ownership in contentious situations andit establishes the share cost for future tax calculation purposes. It isimportant to NOT issue shares for time or services provided. Such issuancescan be viewed as compensation and may be subject to normal income tax.
Strings Attached?
In the case of founders of a company, shares are being issued at a nominalprice because the founders are committing their know-how and expertiseto the company. But, what if a founder receives 10% of the shares of thecompany and then quits or gets killed? Is it fair that she or her survivorsend up with shares that were given in return for something not yet realized?For this reason, a vesting schedule may be useful, i.e. shares are fully"vested" over a number of years. If the holder departs from the company,some or all (the rules are up to the founders) of these shares should eitherbe cancelled or subject to re-purchase rights by other shareholders orby the company itself. These apsects ought to be dealt with in a "shareholdersagreement".
Issued vs Authorized Common Shares
The most common form of ownership in a company is "common" shares. Thereare many types and classes of shares which can be defined for a companyeach of which carry certain rights with respect to security, voting privileges,participation in profits, etc. As companies evolve, there may be validreasons for creating new classes of shares, e.g. creating "preferred" sharesin order to bring in investors or differentiating between "voting" and"non-voting" shares. This can become quite involved and will require expertcounsel. At the very beginning, though, there is usually one class of sharedefined, i.e. a basic common share which allows its holder to paritipatein the ownership and decision-making of the company based on the percentagecommon shares held by that shareholder. This percentage is determined fromthe total number of shares which has been issued by the company,not the number which has been authorized (the number authorizedis simply some maximum allowable number. In some jurisdictions like B.C.,this is required. In others, like the Federal Government, this can be anunlimited number). The authorized number can be changed by filing the appropriateamendments. It is a good idea to make this number as large as possible(it doesn't matter what it is).
Common, and BIG, Mistakes
One of the biggest and most common mistakes made by founders is thelack of attention to future tax consequences arising from decisions madeearly on. The attitude often expressed is: "when I make a few million,having a tax problem will be a nice problem to deal with". Yeah, right!There are many basic rules which can be followed to avoid future problems.These are legal and straightforward. Agressive financial advisors may suggestexotic arrangements such as off-shore holdings or trusts as other waysto avoid future taxation. Some such advice may be very accurate and reliable.Others run the risk of being tax evasion schemes subject to serious penalities.Tax avoidance is OK, evasion isn't! In fact, tax avoidance has become anational sport that we all enjoy playing (or should learn to play).
Stock vs Stock Options
Stock options are a common technique for getting employees and managersinvolved in a company as potential owners. Options give their holder theright to buy or acquire shares in the company over a specified time periodat a specified price. They are used extensively by publicly listed companies.In the case of privately held companies, options may not be as useful assome form of direct ownership, especially when tax considerations are takeninto account. Another alternative might be to simply be given (or purchase)shares with certain strings attached, e.g. vesting over time so that ifan employee should leave the company, the shares could be re-purchasedor cancelled. This may have the same effect as options but may be desirablefrom a tax and pyschological perspective.
The Last Word
Be sure to get some good professional advice. But before doing so, youshould know what you and your fellow shareholders' goals are and what yourvision is for the company - then you can properly "structure" the companyto help you achieve these goals.
