How Startup Equity Works: Common and Preferred Share Classes

The first for-profit corporation was authorized by her royal majesty, Queen Elizabeth I, in 1600. While a lot has changed since the Dutch East India Company was incorporated, the fundamentals of how corporations work remain the same. Ownership in a stock corporation is represented through shares of stock. Shareholders are the people who own the shares, and are thus part of the corporation.

Even though holders of company stock may have an ownership stake in the corporation, the shareholders do not control the corporation directly, even though shareholder approval may be required for certain decisions made by the corporation’s directors. Shareholders, instead of exercising direct control over the corporation, have control over who is on the board of directors. In turn, the board of directors controls the corporation through the corporation’s officers.

When reading about venture-backed startups, you may frequently hear the terms “preferred shares” or “series A” or “series preferred shares”. What do these terms mean and how do they relate to board control in a startup corporation? Why do startups typically issue multiple classes of shares?

Startups commonly issue both common and preferred stock. Preferred stock differs from common stock in that preferred stock has additional rights and privileges that common stock does not, particularly with regard to liquidation and dividend preferences, at a minimum. Startup common stock will be issued to founders, employees and consultants, whereas preferred stock is typically only issued to investors.

When a startup incorporates, the corporation typically authorizes a certain number of common shares in the articles of incorporation that are filed with state officials to register the new corporate entity. Most startups authorize at least 10 million shares when they first incorporate. Then, when a startup raises a large round of capital, an amended charter will be filed with state officials to authorize a new class of preferred stock that will be reserved for the investors participating in that financing round.

With each subsequent financing round, the startup will typically authorize a new series of shares, for issuance from the preferred share pool. A financing is usually referred to by the series of stock that was created in that round of financing for the startup. This is where the terms “Series A” and “Series B” come from — the Series A preferred shares are the first preferred shares issued to investors in the startup, and the Series B the second, the Series C the third, and so on. While it is not common for common stock to be divided into series, preferred stock is almost always divided into one or more series with each financing round.

A corporation typically cannot issue stock unless the board has approved the share issuance and there are enough shares available for the issuance. If the stock being issued is a specific class of shares, then there must be enough shares of that class available for issuance. Finally, if the stock being issued belongs to a specific series of preferred stock, then there must be enough shares of that series available for issuance.

To determine how many shares are available for issuance, start by determining the number of authorized shares listed in the company’s certificate of incorporation. A corporation cannot issue shares that have not been authorized. If the company’s stock is divided into classes and/or series, the certificate of incorporation will state the number of authorized shares for each class or series, as well as the total number of authorized shares across all classes of stock. Many startups choose to authorize 10 million shares of common stock when they are first incorporating.

If a startup wants to issue shares but there are not enough authorized shares available for issuance, then the corporation must file an amended certificate of incorporation with the Delaware Secretary of State to increase the number of authorized shares. If a startup needs to authorize additional shares to issue to employees and service providers, the amended charter would increase the number of authorized common shares. If a startup wants to issue additional shares of preferred stock to investors, the amended charter would adjust the number of authorized preferred shares in that class and/or series of stock.

A corporation with a simple capital structure may have only one class of stock authorized in the certificate of incorporation, which would normally be common stock. Venture-backed startups, on the other hand, will typically issue many series of preferred stock to investors as they scale up and raise additional capital for growth.

Keep in mind, as a founder, your board of directors will need to approve all share grants and stock option awards to employees before these equity grants can be awarded to employees as part of their compensation package. When you issue equity to advisors, consultants and employees on Capbase, our software sends out all the required board approvals and shareholder consents for signature.

• The number of shares authorized in a corporation is typically set out in the company’s certificate of incorporation
• Shareholders do not directly control the operations of a corporation; instead, they have control over who is on the board of directors
• Startups typically issue common shares to founders, employees, advisors and consultants; they issue preferred shares to investors as part of venture financing rounds
• The preferred class of stock in a startup is typically subdivided into series, each representing a different round of financing, like Series A, Series B, and so on.
• When corporations need to authorize new shares, an amended certificate of incorporation must be filed with the Delaware Secretary of State