In the previous article, I discussed ball-parking the percentage of equity to issue to an investor as part of a start-up. As a logical continuation, this article will discuss the number of shares to issue to an investor.
A common analogy is that building a company is a lot like baking a pie, in that the greater the value of a company, the bigger the pie to be shared by investors. Issuing stock is akin to slicing the pie, in that, each share represents a piece of the pie. Regardless of the number of times you slice the pie, the total size does not change. However, you want to ensure that the pieces are sufficiently large so investors are not being issued crumbs, but sufficiently small so that the pieces can be exchanged and new investors can be accommodated.
Before I continue, I would like to clarify two things. First, many people tend to use the terms “authorized”, “issued” and “outstanding” shares interchangeably. Casually, they have similar meanings, but legally, there is an important distinction. Authorized shares represent the maximum number of shares of a particular class that many be issued by a corporation, according the Articles of Incorporation. Normally, no maximum is set, however, if there is a maximum and the corporation wishes to exceed this, the number can be increased by the Board of Directors. Issued shares represent the number of authorized shares that have been given to shareholders. So, if a corporation has 25 million authorized shares, and 10 million are owned by shareholders, the corporation is considered to have 10 million issued shares and 15 million unissued shares. Finally, outstanding shares are those shares owned by all shareholders with the exception of the corporation, which are called treasury shares. So, if a corporation owns 1 million of the 10 million issued shares, 9 million are considered to be outstanding. In summary:
Authorized = Issued + Unissued
Issued = Outstanding + Treasury
Second, if a corporation does run into issues with the number of shares, this can be amended. Stock reverses and splits can be executed to ensure that the price per share falls within a reasonable range. The downside of a reverse or split is that it requires shareholder consent and some legal maneuvering, which takes time and money. So, an intelligent share budget at the beginning of a venture can be of help as the business progresses.
In deciding on the number of shares to issue to an investor, I tend to rely on the “Rule of 20″. This is a term I coined from my experience (albeit limited) of trading public securities. Shares trading in the $20 range are affordable to retail investors purchasing in lots of 100. At the same time, the bid-ask spread is not so great as to cause a wild percentage change. For example, bidding $0.25 below a $20.00 share represents a 1.25% discount, whereas bidding the same amount below a $2.00 share represents 12.5% discount. So, I feel $20 per share represents a “sweet spot”, which might explain why many IPOs seem to fall in this range (although, I cannot seem to find any empirical data to support my claim).
The “Rule of 20″ is applied by taking the estimated exit value of the company and dividing it by 20 to arrive at the number of shares issued and outstanding at the time of exit. So, if a venture expects to exit with a $50 million valuation, there should be 2.5 million shares belonging to founders and investors. (In the case of an IPO, these numbers would be pre-money.)
By applying the methodology discussed in the previous article, you can easily determine the number of shares to be issued at each stage of investment. In that example, the founders retained 54.64% of the company at exit. Given that the exit value was $30 million, the “Rule of 20″ states that 1.5 million shares would be issued and outstanding at exit, of which 819,600 would belong to the founders. Therefore, at inception, the founders would have issued themselves 819,600 shares for nominal consideration. The angels retained 17.93% at exit, equating to 268,950 shares with a price per share of $3.72, implying a pre-money seed valuation for the founders of just north of $3 million. The same math and process can be applied to the interests of the other investors.
The “Rule of 20″ is valuable in that it helps to maintain a reasonable price range. Issuing shares to new investors at a nominal (i.e. fractions of a penny) or astronomic (i.e. greater than $10,000) price per share is certainly allowable, but, I feel it is best to follow the guidance of the public markets.