One of the most common questions we at Capbase get from founders is “How many shares should I set aside for investors?”
Most founders’ first thoughts after how to set up a new company is who gets what percentage. Also commonly considered is how to split equity between co-founders. When it comes to investors though, even if raising capital is high on your mind, you don’t set aside or allocate any equity for investors when starting a company.
This may seem a bit counterintuitive at first, but read on and we’ll explain why your investor shares are almost always created during a priced round fundraising event. A priced round is when a lead investor agrees to investment terms with a company, using a term sheet, and invests alongside other follow-on investors to purchase preferred shares directly from the company.
- When you incorporate your company, you don’t need to worry about shares for your investors. You’ll work that out with your investors when they decide to invest.
- When you set up your company, worry about how to split up equity with your co-founders
- When you set up your company, carefully consider the number of shares to put in your employee pool
- Don’t worry too much about preferred shares or multiple classes of shares when you’re getting started
Common stock vs preferred stock: What's the difference?
When investors put money into a private company, like a startup, it’s a high-risk investment and, as a result, they want certain protections. These protections are bundled together into a preferred class of stock.
These protections are most commonly voting rights, a co-sale and rights of first refusal (ROFR), a preference multiple, and opting to participate in a liquidation (preferred shares are non-participating “by default”), but can also include anti-dilution measures like a pro-rata right, or down round or “ratchet” protections.
Both common and preferred stock classes confer ownership in a company, with the percentage ownership of a single share being 1 divided by the total number of shares (common and preferred) that the company has issued. You may also hear the term “fully diluted ownership.” This includes the number of shares allocated in an option pool to determine ownership.
Can you have multiple classes of preferred stock?
The short answer is no: a startup would almost never have more than one class of preferred stock. That said, more mature startups will almost always have multiple series of preferred stock, all in the same class.
We’ve covered that common stock is in a different “class” than the preferred stock that we give to investors, but what about when you have different investors at different times? In this case, you wouldn’t have multiple classes of preferred stock, but multiple “series” of preferred stock. You’ve certainly heard of Series A, Series B, and so on—this is what those terms refer to. Each series of preferred stock corresponds to a separate offering of the stock—an occasion when a private sale from the company to investors occurs.
Each series of preferred stock can have special terms that apply to it—perhaps a separate preference multiple or a declaration of dividends—but it will inherit all of the other rights and terms of the preferred class. You might also hear about a Series A III or similar—this is a “shadow series.” In reality, there’s no difference between a shadow series and a regular series, except that, as a convention, all the shadow series are identical apart from their sale price.
Can you have multiple classes of common stock?
Some startups do have multiple classes of common stock, but it is fairly uncommon and probably isn’t a great choice for a new company just starting out. Often, multiple classes of common stock are used to restrict the voting rights of one class of common stock—for instance, in order to restrict the voting rights of the recipients of stock from a stock plan (employees and advisors.)
In theory, this can help a founder or group of founders retain control of the company slightly longer than they may otherwise be able to do. In reality, if the founders end up in a battle with investors in which employee votes count, and the founders cannot sway employee opinion in their favor, there are probably larger issues at play—founder control isn’t actually the key issue.
You may be familiar with Google’s “Class C” stock ($GOOG.A) which is similar to the regular publicly traded stock, but doesn’t have any voting rights. For retail investors, this isn’t much of an issue, but for large scale or “activist” investors, the voting rights matter enough that these securities trade at different levels (though not hugely different).
What about founder preferred stock or Series FF founder stock?
Founder preferred stock usually refers to one of two things—either preferred shares that are owned by founders that can later be converted into a different series of preferred stock, or supervoting stock.
Founder preferred stock that can convert into a different series can be useful for selling shares in a secondary offering to an investor. Usually, when a company raises money, all of the shares being purchased are new shares being issued directly by the company. This allows the company to increase its bank balance to lengthen its runway or to support other capital intensive activities.
Sometimes, usually at a slightly later stage (Series B or later), founders can get access to liquidity by selling a portion of their stock to investors. This allows founders who have been deferring paying the credit cards they ran up to bootstrap the business to have a little bit of a pay day as their company is beginning to take off.
The concept behind the Series FF stock is that it allows investors to give this liquidity to founders while keeping the holdings from their investment as a single block of preferred stock—rather than being split up between preferred and common. While this is nice to have, it’s not usually something that will make a tremendous difference in any long-term outcomes for the founder or the investor.
Supervoting founder shares are another matter altogether. These shares allow the founders to cast some greater number of votes per share (10 is a common multiple) so it’s much easier for founders to maintain a greater level of control for longer. Investors have a primary goal of protecting their investment, while founders may wish to protect their own interests, which may not always be aligned with those of the investors.
Example: a company is going to the market to raise a Series D. The company will be speaking to a lot of investors, but will probably have options to exit for an acquisition as well. You could have a situation arise where the current investors want the founders to continue to raise money and grow, but the founders want to join forces with a larger company, or simply want to be able to take a slight step back from the hectic pace of founder life and be someone else’s employee for a little while.
This situation is reversed when the investors think that the company has grown as much as it can on its own, and they want to take a safe exit at a solid ROI while the founders want to go for broke and try to completely dominate their space, or expand into adjacent markets.
The potential for this kind of a conflict makes investors nervous—especially about investing in companies with supervoting founder stock. Some high profile founders may have luck in keeping provisions such as these in their companies past their first fundraising round, but it’s rare this happens. First time founders usually choose to keep a simpler corporate structure when they start, with a single class of stock.
Why you don’t set aside preferred shares for investors
When you set up a new company, it’s uncommon to contemplate authorizing any preferred stock or selling it to founders.
It would never be sold to founders because the shares to be sold to investors will be sold by the company so that the company can raise money, and not by the founders directly. It would also be rare to authorize any preferred stock at the time of incorporation because the terms of a priced round can vary so widely. No two preferred classes are exactly alike.
Many priced rounds will be based on the NVCA Model Legal Documents, but the specifics for a particular round vary from company to company, and from raise to raise. Each time that you raise money from a group of investors, it takes the form of Series Preferred funding.
What is series preferred funding?
With Series Preferred funding, a company will issue new shares of a preferred class of stock and sell them to investors. This is also known as dilutive fundraising, because raising new capital in this way dilutes the ownership of a single share. (Non-dilutive fundraising includes factoring monthly revenues, bank loans, and various forms of venture debt.)
Example: You have a company with ten shares, each worth $1, and you want to raise an additional dollar for the company. You could just sell one more share for one more dollar. The total value of the company is now $11 instead of $10, but each share is now only worth 9.09% of the company. Prior to the fundraise, one share was 10% of the company.
Series preferred funding usually becomes relevant to a company when it raises its first significant “chunk” of capital. This could be a Series Seed or a Series A, and happens when the company has some traction. Before this time, most companies will raise money from angel investors using either a SAFE or a convertible note.
The shares sold to preferred investors will be new shares of a new preferred series that will have its own rights, and will have a price set in the company’s “charter” or its articles of incorporation. Each preferred series may consist of multiple shadow series. Each preferred series will also have a place in the company’s preference stack.
What is a shadow series?
A shadow series is a series of preferred stock that is identical to another series in all but issue price. Shadow series are most commonly seen in the conversion of instruments like SAFEs or convertible notes.
A company that raises three SAFEs at three different caps and and discounts, and then raises a Series Seed round, will end up having four series of preferred stock after that initial round — Series Seed-1, Series Seed-2, Series Seed-3, and Series Seed-4. It is up to the person drafting the documents to determine which series is which, but usually the newly raised capital (at the highest price per share) is Series Seed-1; the various SAFEs convert at lower prices per share, with Series Seed-4 being the lowest price per share.
What is a preference stack?
“Preference stack” refers to the preferential payment that stockholders get in the event of a liquidity event for the company (an exit via public offering, private sale, merger, or bankruptcy). It’s called a “stack” because the stockholders at the top of the stack get paid first, and ones at the bottom (the common stockholders) get paid last. In most cases, the most recent money put into the company will occupy the highest position in the stack, but this is discussed at each round of fundraising.
Taking a different approach—one used by startups almost as frequently—various preferred series of stock will be in pari passu; they all occupy an equal place in the stack, and they’re treated as a single class when it comes to liquidation calculations.
How does investor equity impact founder equity?
Companies sell equity to investors in order to increase the financial health, and the company’s capabilities. These shares are sold directly by the company, with money going to the company. Founders do not sell their shares to investors during fundraising (except in special cases discussed above). When companies increase the total number of shares, it decreases the ownership of each individual share. This means that in most cases existing shareholders are diluted (unless they buy more shares to maintain their percentage).
What is dilution?
Dilution is the effect of raising capital by issuing new shares in a company. When you increase the total number of shares in a company, you decrease the percentage of the company that each share represents. If you have 10 shares in a company, each share is worth 10%. When you issue an additional share and have 11 shares, each of those shares is now worth 9.09% of the company.
When a founder or existing shareholder is diluted in a fundraising round, though their share of the company may decrease, the value of their holding in the company does not decrease. Since the new investors are adding capital to the company, they are increasing the overall value of the company by that same amount. In effect, existing shareholders have a smaller piece of the pie, but the whole pie is bigger—leaving each shareholder with the same amount of “pie” that they had prior to the investment.
Can founders avoid dilution? What about anti-dilution?
When raising money from investors via a series preferred fundraising, founders cannot avoid dilution. Anti-dilution measures exist for preferred holders in the form of “ratchet” provisions, but any anti-dilution for common holders usually expires when money is raised.
Any anti-dilution measures in place for any shareholder of a company can make it more difficult for a company to raise money, lead to worse outcomes for founders, and in some cases, make fundraising functionally impossible.
How much dilution should I expect?
Rule of thumb: Expect a dilution of 10-20% per round. So, if you and your founding team hold 100% at incorporation, and you raise an angel round, a seed round, a Series A, a Series B, and a Series C before exiting, you would expect to hold between 32% and 59% of the company at exit.
How many shares do investors hold at Series A?
The number of shares that investors hold varies from company to company, but the percentage is fairly consistent. At Series A, the company typically will have raised an Angel Round and a Series Seed (though this can vary — some companies use the terms Series Seed and Series A interchangeably.) Assuming the company has done only an Angel Round and a Series A, then you could count on investors owning 20% to 35%. If the company has also raised a Series Seed (three rounds total), then investors may own as much as 48% — but this would be fairly rare, and more often they’d be in the 30-40% range.
What percentage of the company do investors own at exit?
This one is very difficult to answer, because companies exit at such different places. You could have a situation in which a company has only raised a few angel checks, then gets “acqui-hired,” with investors owning almost nothing. At the other end of the spectrum, you have companies such as SpaceX, which has raised more than 60 rounds of funding. If you take your company all the way to an IPO, you and your co-founders should expect to hold about 20% of the company after going public.
Raising money for a company can be a complex process, but it doesn’t have to be. While we’ve given you a lot to think about in this article, the good news is that you don’t need to agonize over these things when you’re setting up a new company. If you incorporate your startup with Capbase, it becomes even easier—with automatic cap table management and updates as you send SAFEs and Convertible notes to angel investors, raise series preferred financing, hire employees, build your board of advisors, and issue stock or stock options to contractors.
Written by Stefan Nagey
Serial entrepreneur, engineering & business leader who co-founded and led his last startup to a $14M Series A financing and a successful exit. Years of experience leading teams & building scaleable, secure software systems.
Most founders have little clue about how cap tables work when they start their first startup. Keeping accurate records of your cap table is essential for startup founders if they plan on raising capital from VCs or selling the company.