Four mistakes founders make with share capital

Being a founder means that everyone assumes you’re an expert in lots of things. The nuts and bolts of how your cap table works is one of those things that’s just assumed. But share capital, particularly in an English company with nearly 200 years of legal backstory, is complicated!

Here are four mistakes that we’ve seen cropping up quite regularly, and some practical tips on why they matter and how to avoid them.

“I’m taking a new investment round, but I’ve promised Khalid he won’t get diluted by it”

The problem here is what “dilution” means when we’re talking about shares.

If Khalid has 1,000 shares out of 5,000 when he invests, that’s 20%. If you then issue 1,000 new shares, he now has 1,000 shares out of 6,000, which is 16.66%. His percentage ownership has been “diluted” – he hasn’t sold any shares, but he owns a smaller percentage of the company.

As the total number of shares is going up, everyone’s ownership percentage is going to drop as we’re dividing by a bigger number – it’s not possible to choose which shareholders get diluted, and making a promise to an investor or other stakeholder that they won’t be diluted by a particular load of shares (or, worse, that they won’t ever be diluted!) is going to cause all sorts of problems.

There are ways to deal with it if you absolutely have to, but they all really boil down to giving Khalid more shares so that he stays at the same ownership percentage. Issuing him more shares might give him tax problems, and definitely will dilute everyone else even more; founders sometimes end up having to give up some of their own shares to dig themselves out of a promise like this.

It’s a bad situation to be in, and easily avoidable – shareholders shouldn’t be asking to be “undilutable”, and you shouldn’t be offering it!

As you grow you may find investors who ask for “anti-dilution protection”, so that they get some extra shares if you do a round at a lower price than the one they’re paying. Those protections are not what we’re talking about here as they don’t try to keep investors at the same percentage as they started – certainly something to think carefully about, but nowhere near as problematic as a promise of being immune from dilution.

“Sarah’s coming on as CXO once she can quit her current job. I’ve promised her 10% when she joins”

It’s totally normal that discussions about equity start with percentages – whether it’s investors, advisors, big hires or option pools, all of the “knowhow” out there talks about percentages. But there are some grey areas that can give you similar problems to the Khalid example, particularly if you’re talking today about shares that might not be issued for months, or if you have a few cap table changes in a short period.

If you’re talking about percentages, there’s an implication that the person you’re talking to will get that percentage of your capital at the point when you issue them shares. So, if your cap table might change between then and now, it’s important that you make sure you’re clear whether you’re factoring in those changes or not.

You’re telling Sarah 10% today, but you might bring on other key hires with equity, or even take in some investment, before Sarah joins – 10% of the company on the other side of those events could be a much larger number of shares (and therefore more dilution for everyone else) than it is today. And what if you talked about percentages with the hire/investor as well? Does their percentage factor Sarah in, or is she diluting them?

You can’t avoid talking about percentages, but you can try to be clear – when you’re talking to Sarah you can specify a number of shares and say that’s 10% of today’s cap table, or if you’re talking to investors you can talk about your valuation (pre-money, ideally). Either way, the key is as early as possible to move the conversation beyond a percentage and into a fixed amount.

“Oh, Jeff? He was an early employee and had some shares but he left before he hit his vesting cliff so I took him off the cap table.”

The good news is that no-one’s going to argue about the result here. Jeff knew his equity was on a vesting schedule with a “cliff” provision, so that if he left before that point in time he’d lose all of his shares. He left, he shouldn’t have any shares. Simple!

The bad news is that those shares, once they were issued to Jeff, were his personal property. It’s not possible to just snap our fingers and make them vanish – a company can cancel shares, but it’s a pretty serious process and might not be available to a startup in high-growth cash-burn mode.

Jeff can transfer his shares, either to the company or to some or all of the other shareholders. Most vesting arrangements are set up to give Jeff an obligation to do that. But in order to make those shares move there will need to be one “stock transfer form” per person who is receiving shares – and unless your arrangement with Jeff says otherwise, he will need to sign each one.

It’s important to deal with this properly at the time he leaves because, when investors or buyers come and look at your paperwork, if they can’t see any paper trail showing Jeff giving up his shares it’s going to cause a problem. You don’t want to have to track Jeff down and ask him to sign paperwork to fix things with an investor or buyer watching you, that could really slow things down at a crucial time.

“We held the board meeting to issue the shares, but Amrita didn’t come up with the money in the end – it’s alright though, I hadn’t sent the form to Companies House so they weren’t issued”

This one may not be a problem, depending on what exactly happened at the board meeting. If the board resolved to issue the shares “conditional on” or “subject to” receipt of the money from Amrita, if the money never arrives there are no shares issued and the whole thing goes away. If that’s the case it’s worth having another quick board meeting for the board to agree that they’ve waited long enough for the money, and the offer to Amrita is off the table.

Unfortunately, the board often just resolves at that first meeting to allot and issue the shares to Amrita. If that’s the case then Amrita has a right to those shares even if she never pays for them – the company can ask for the money, and even potentially sue her for it, but that doesn’t make her right to the shares go away unless she agrees to give it up.

Just like in the Jeff example, when a later investor or buyer comes to look at this it is going to cause problems if it hasn’t been dealt with properly.

The most important thing to remember is that the right to have shares is created by the board meeting – not when the form goes to Companies House, not when the cap table spreadsheet is updated, not when the money arrives, not when the share certificate is signed… all of those things have to happen within certain time limits after the shares have been issued; but if they happen late or not at all, that doesn’t mean the shares haven’t been issued.

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Four mistakes founders make with share capital

“I’m taking a new investment round, but I’ve promised Khalid he won’t get diluted by it”

“Sarah’s coming on as CXO once she can quit her current job. I’ve promised her 10% when she joins”

“Oh, Jeff? He was an early employee and had some shares but he left before he hit his vesting cliff so I took him off the cap table.”

“We held the board meeting to issue the shares, but Amrita didn’t come up with the money in the end – it’s alright though, I hadn’t sent the form to Companies House so they weren’t issued”

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