As a business owner, the importance or working with a share cap table to record and plan a company’s existing and anticipated share structure and ownership as it grows cannot be understated. As we looked at in previous blogs on the subject, using a cap table helps founding shareholders see the Company’s shares as a constantly increasing pool rather than a static one, which is a common mistake. This is an important concept when dealing with investors as well as with employee stock plans (ESOP).
Another problem I come across occurs when founders promising share issuances to multiple recipients over a relatively short period, without taking into account the impact of cumulative dilution on the Company’s outstanding pool of shares.
Let’s assume the four founders, each with a 25% ownership in the company, have decided upon a different path forward than the examples used in the previous posts.
Rather than raising money from one large investor to buy the services needed to grow the business, they have convinced four service providers (who I will refer to as “contractors”) to each provide $50,000 of services in return 7.5% of the company. Let’s also assume the offers were made separately to each contractor over a 60-day period approximately 2 weeks apart. Finally, to keep the example simple, we will assume the offers were for 7.5% of the company post-money.
So, what is the problem?
On the one hand, based on the facts I have provided, the founders are likely anticipating giving up 30% of the company in share issuances for the services, as reflected below.
Unfortunately, if the founders did not map their strategy on a cap table and sent the contractor deals to their lawyers, one at a time, it is possible the paperwork prepared by their legal counsel will reflect a very different deal.
Uneven treatment of contractors
At the time contractor 1 is promised 7.5% of the company in return for its services, there are only 1,000,000 shares outstanding, and no other commitments. Contractor 1 will need to be issued 81,000 to own 7.5% of the company post-money. A few weeks later when contractor 2 is promised 7.5% of the company, the company is already committed to issuing 81,000 shares to contractor 1 and as a result, 1,081,000 shares should be seen to be outstanding, with the result that contractor 2 will need to be issued 88,000 shares to end up with ownership of 7.5% of the company post-money, and contractor 1 is diluted. This pattern repeats itself across all 4 grants, as represented in the table below.
The good news for the founders is that they have given up less equity then intended – 26.8% rather than the 30%. The bad news is that several problems have been created.
The first problem is the uneven treatment of the contractors. From the contractors’ perspective, each provided the same value of services at approximately the same time. However, because of the sequence in which each was approached, each ends up owning a different amount of shares. And the difference is significant – contractor 1 owns 22,000 fewer shares than contractor 4. This may create animosity among the group and put pressure on the founders to somehow ‘fix this.’
Drop in share price
The second problem is the share price. Companies are required by law to issue shares at fair market value and if you are building a business, you want the fair market value of your business to increase steadily over time. Since share price is supposed to reflect fair market value, a nice upward trend in share price is a sign of a well-managed business.
Unfortunately for our founders, their approach had the opposite effect on share price. Because the dollar value of the services provided by each contractor is fixed at $50,000 the need to continually issue more shares to each contractor to reflect its 7.5% ownership at the time of closing causes the share price to drop from $0.62 per share to $0.49 per share over the 60-day period. Because it is highly unlikely the real value of the company changed over such a short period, the drop in share price does not reflect a change in the value of the business – it is a purely mathematical result unintended by the founders.
What then, is the fair market value of this company? Is it $0.62 per share, or $0.49 per share, or maybe the average price of $0.54 per share? Perhaps it is even $0.47 per share which is the share price resulting from the founders’ original intention of granting the contractors collectively 30% of the company post money. All we know for sure is that the failure to plan properly has introduced uncertainty and if company valuation is an important component of the company’s next major transaction, it is now a problem that needs to be addressed.
There are solutions to this problem, and it begins with retaining a lawyer to help you plan your equity strategy, and using a cap table to map out your share strategies.