Too many founders make the mistake of confusing authorized shares with fully diluted shares.
The net result is that founders end up giving too much of their company away at the onset.
What are authorized shares?
Authorized shares are the total shares the startup specifies in its 'Article of Incorporation' as what it plans to issue to its common and preferred shareholders. Beyond this, authorized shares have no significance.
A typical number for total authorized share count is 10M.
What are fully diluted shares?
Fully diluted shares on the other hand are the total of the option pool created, and the number of common, preferred, and warrants the startup has issued to its shareholders.
Fully diluted share count will always be less than the total authorized shares.
How is price-per-share arrived at?
The simplest equation to arrive at the PPS is:
|PPS = Pre-Money Valuation / Fully-Diluted Shares|
Examples of impact to dilution
Scenario 1: Incorrect PPS determination
Let's say the startup has the following share structure:
Authorized shares: 10M
Issued common shares: 4M
Issued preferred shares: 1M
Options Pool: 500K
In this scenario, the fully diluted share count is 6M.
Price-per-share (PPS) is a function of the fully diluted share count (and not the authorized share count).
If the founder wanted to raise capital at $1/share, the pre-money valuation would be $6M ($6M / 6M fully-diluted shares = $1).
By mistaking the total authorized to be fully-diluted share count, the founder is inadvertently setting a PPS of $0.60 ($6M / 10M shares).
So, a $100K investment will give the investors 166K shares ($100K / $0.60) instead of 100K shares ($100K / $1).
Scenario 2: Incorrect issued shares to employees
Another scenario is using a percentage math to give out shares to employees.
So, if you wanted to issue 1% of your equity to your employee, incorrectly using authorized shares would give out 100K shares instead of 60K shares.
100K shares would actually be 1.67% (100K / 6M) and not the intended 1%.
Steps to avoid these problems
It's simple. Just recognize that all share calculations should be based on the fully-diluted shares.
Usually, these mistakes happen early on while founders are trying to quickly issue shares for the investments they are bringing in or to incentivize their employees. Such mistakes have compounding negative effects until they are discovered and corrected
We have developed the TWO12 platform with built-in sanity checks to prevent such costly mistakes from happening. Let us help you preserve your equity.