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- In a corporation, two types of stock exist: common and preferred. Common stock is often issued to employers, strategic advisors, and the founders. Preferred stock is generally reserved for investors.
- Common stock is a financial asset, otherwise known as a security or a particular class of equity. One share of stock represents a sliver of ownership in the company.
- Calculating the price for a startup's common stock is often difficult as the business is new, without a track record of sales or other financial indicators of success. However, early startups' common stock can be priced.
- When granting common stock in your startup, you give it to yourself as a founder and other co-founders. Additionally, you may provide common stock as a reward or incentive to your employees or strategic advisors, especially those early employees and advisors.
- Both common stock and preferred stock give equity or ownership in the company and voting rights. Preferred stock carries additional rights not conferred to common stock. For example, startup preferred stock comes with preferential treatment in dividends, returns, payouts, mergers or sales, and voting rights.
- Because preferred stock carries these additional rights, it is usually reserved for investors, encouraging them to invest in your startup. With preferred stock, investors are paid back first, before common stockholders.
- Restricted stock is a type of common stock. When you impose a vesting schedule on common stock, it becomes restricted. Until the vesting schedule is satisfied, the stock is at risk, subject to forfeiture.
- Another form of startup ownership or equity is a stock option. Unlike other ownership options, stock options are not actual shares of stock. They represent the right to purchase startup stock at a fixed price.
When thinking about raising cash for your company, many business owners think about "debt financing," such as borrowing money from a bank. However, many businesses, including those in the startup world, use "equity financing" to raise capital.
When pursuing equity financing, a company receives capital, or money, from selling shares of the business. Essentially, the company is selling ownership in exchange for capital funding.
So, what does this mean? To understand capital funding, we need to return to the basics. In this article, we're going to break down the two types of stock shares a company can sell: common and preferred.
Further, because capital funding often comes down to the valuation of the startup, which directly impacts the pricing of the company’s common shares, we'll also explore the ins and outs of common stock for startups, including the pricing of such stock, comparing it preferred stock, restricted stock, and stock options.
How Does Startup Common Stock Work?
In a corporation, two types of stock exist--common and preferred. Common stock is often issued to employers, strategic advisors, and the founders. Preferred stock, which we address later in this article, is generally reserved for investors.
First, let’s look at common stock in a startup. Common stock is a financial asset, otherwise known as a security or a particular class of equity. One share of stock represents a sliver of ownership in the company.
The term "common stock" comes from the fact that these pieces of ownership (or equity) "trade on the common--or public--market and are, well, more common than other types of shares or equity stakes," according to Business Insider. At any point in time, "millions of common stock shares are being traded."
For publicly traded companies, common stock is bought and sold on a stock exchange, such as the NASDAQ or the New York Stock Exchange. However, private businesses--such as startups--can have common stock if organized as a corporation under applicable state laws.
Common stock is created when the company is formed, serving as the standard stock. The most common attributes of common stock include:
- The payment of dividends, usually quarterly;
- The ability to vote on major company issues, such as appointments to the board of directors; and
- The long-term appreciation of an asset.
How is the Startup Common Stock's Price Calculated?
Calculating the price for a startup's common stock is often difficult as the business is new, without a track record of sales or other financial indicators of success. However, early startups' common stock can be priced. To understand how, we'll first explore some key terms that you need to know.
A "pre-money valuation" is the value of the startup before any investment. Different calculation methods exist for determining a company's value, such as the scorecard method, the Berkus method, and the risk factor summation method. Although these methodologies differ, they all examine similar factors to determine a startup's value, such as:
- Sound business idea
- Size of the opportunity
- Management team experience
- Strategic partners
- Go-to-market strategy
- Existing competition
- Potential for a profitable exit
By determining the pre-money valuation, startup founders convey their company's current value, along with the potential opportunity, to investors. However, it also sets a value for each issued share of common stock.
The post-money valuation is much more straightforward than a pre-money valuation determination. A post-money valuation is the sum of the pre-money valuation and any financing (such as a bank loan) or investment (such as a capital injection received by investors).
Alternatively, according to Priori Legal, you can calculate the post-money valuation "by dividing the new investment amount by the number of shares received for that investment and then multiplying that per share valuation by the number of total issued shares post-investment."
Both valuations are essential to your startup. Taken together, they determine what your company's worth, including each share of common stock. Once you determine your company's value--and, in turn, common stock pricing--then you must identify the percentage of your company that each stockholder has, including founders, employees, strategic advisors, and investors.
Who Should Receive Common Stock?
Typically, when granting common stock in your startup, you give it to yourself as a founder and any other co-founders. Additionally, you may want to provide common stock as a reward or incentive to your core employees or strategic advisors, especially those early employees and advisors.
When granting common stock to founders, employees, and advisors, you can impose vesting requirements, encouraging your key, early team members to stay with the company. Additionally, in granting common stock, you want to offer such equity in proportion to the value that person brings to the company.
Preferred vs Common Stock in Startups
Although both common stock and preferred stock give equity or ownership in the company, often along with voting rights, preferred stock carries additional rights not conferred to common stock. For example, startup preferred stock comes with preferential treatment in dividends, returns, payouts, mergers or sales, and voting rights.
Because preferred stock carries these additional rights, it is typically reserved for investors, encouraging them to invest in your startup. With preferred stock, investors are paid back first, before common stockholders, usually at a guaranteed rate of return or dividend.
Here’s a simple example:
Say you “raise $5 million at a post-money valuation of $20 million. You are giving up 25% of your company. If there is no other dilution and you sell the company for $100 million, you’d pay out $5 million to return the principal to the investor, plus dividends outstanding. Then split the remaining monies 25/75.”
Because preferred stock creates a more advantageous investment for investors, it mitigates their investment risk by giving them a greater claim to the startup's assets. Investors today typically will not invest in your startup in exchange for common share ownership.
When determining how much equity or ownership to set aside for investors, the typical percentage is 20-25% of your startup. However, this may ratchet up or down based on your startup's business model, products, services, or technology.
What is Startup Restricted Stock?
Restricted stock is a type of common stock. When you impose a vesting schedule on common stock, it becomes—well, restricted. Until the vesting schedule is satisfied, the stock is at risk, subject to forfeiture. In other words, the stockholder does not indeed have ownership or equity in the startup until the vesting requirements are satisfied. If the employee, for example, leaves the company before the satisfaction of the vesting requirements, that employee would have to forfeit (or give up) those shares of common stock.
Vesting periods can be structured over several years, conditioned on the individual's performance or that of your startup, or contingent upon the founder, employee, or advisor staying with the company for a set period, such as five years. Further, if the founder or employee leaves before the vesting schedule's completion, the startup has the right to re-purchase the stock, keeping it within the company.
Investors may demand that restricted stock be issued to founders or key employees, encouraging them to stay with the company, further contributing to the startup's growth and success. Since many investors contribute to the company based on the founders' background, ability, or passion, they want to secure these key individuals. Restricted stock is one way to do that.
What are Startup Stock Options?
Another form of startup ownership or equity is a stock option. Unlike other ownership options, stock options are not actual shares of stock. They represent the right to purchase startup stock at a fixed price. Because the stock price is fixed, if the value of the startup increases, the stock option holder stands to make money on the difference.
Two types of stock options exist--incentive stock options ("ISOs”) and non-qualified stock options (“NSOs”). The primary difference in these stock options is the taxability, with ISOs qualifying for special tax treatment.
Like common stock or restricted stock, stock option grants are also ideal for early, loyal employees or strategic advisors. Stock options are typically not granted to investors, as they are not as attractive as preferred stock.
Pros and Cons of Common Stock in Startups
As a startup, it’s essential to objectively establish your business's value, which directly impacts your common stock price. By establishing these figures early in your business venture, you can show the value of your business to potential investors as well as to your early employees and advisors.
As a young company, it’s often difficult to establish a startup valuation as no concrete data exists about annual sales, profits, expenses, and taxes. Furthermore, with startups, the valuation numbers can change based on varying forecasts, estimates, supply and demand, economic and industry-specific factors, and other unknowns, often making valuation and common stock pricing a moving target.
However, by staying on top of your startup’s valuation, even as you face changes and unknowns, you can better plan for your startup’s financial need, growth, and the path forward through any developments year in and year out.
Learn more with us
- Dual-class stock structure for startups: all you should know
- How to calculate the price of preferred stock for a startup
- What is sweat equity and how does it work?
- What is a SAFE agreement in VC funding?
- How to calculate stock profit?
- Learn more about fundraising and venture capital
Access more guides in our Knowledge Base for Startups.
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At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most—your business. If you're looking for help establishing equity rounds for your startup, we can get your documentation ready, overall shepherding this process to ensure it's done right, get in touch with us.
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