Many founders ask me if it’s a good idea to set up a separate class of shares for themselves with higher voting rights. The answer is, it depends. It’s usually okay at the beginning of a startup’s life, but founders should be prepared to address investors’ concerns as the startup evolves.
Lead institutional investors almost always require changes to the voting structure, or at the very least provisions to their liquidation preferences, in order to avoid any future impasses.
There’s nothing special about founder shares. They are just common shares issued by the startup to the founders. At the onset of a startup, the typical price-per-share will be $0.0001 or similar. This makes it possible for founders to purchase their shares outright for a very small amount.
For example, let’s say a startup has 2 founders and they split their ownership 50%-50%.
Founder 1: 2.5M
Founder 2: 2.5M
At $0.0001, both these founders can purchase all their shares outright for $250.
The biggest benefit to founders is that they can now show the $250 as ordinary income in their tax filing for the year, and benefit from the lower capital gain taxes when they eventually sell some or all of their shares after the required holding period or during a liquidity event.
Typically, every outstanding share in a startup corresponds to one vote and shareholders can vote their outstanding ownership interest on key corporate actions. For example, if the board decides to increase the option pool, or bring on an executive, or get acquired, shareholders could call for a vote to decide the outcome on such matters. In most cases, a simple majority will win (although there are variants of voting structures where some pre-defined threshold may be required to claim a majority).
At the onset of a startup, the majority of the shares are owned by the founders and all decisions automatically get operationalized amongst founders. This is a good thing since founders get to move quickly in the direction they think is best for the startup.
Startups create multiple classes of Common & Preferred shares, each with specific rights and privileges.
A common scenario I observe amongst TWO12 customers is the creation of 2 classes of Common shares. One class with 10x voting rights issued to the CEO or all the founders, and another class with 1x voting rights issued to employees, advisors, and other participants. When there are multiple classes, they are designated with different markers.
As an example:
Common Class A – 1x voting rights
Common Class B – 10x voting rights
If founders anticipate bringing on several unknown investors and common shareholders who may potentially attempt to influence the startup’s direction, then it’s a good idea to set up a separate class of shares for founders with higher voting rights.
A good example would be founders planning to raise capital on a Reg CF that will result in a large number of unknown investors entering the startup’s cap table. Another example would be for founders expecting to conduct secondaries to allow existing shareholders to sell their vested shares to potentially unknown participants.
Giving control away too soon can cause unwanted friction amongst shareholders that could impede founders’ ability to make key business decisions. Even if a founder is the largest individual shareholder, a majority vote by the remaining shareholders can still override the founder – including deciding to fire the founder.
TWO12’s cap table platform tracks different share classes and provides founders with the necessary insights to preserve control and equity. We provide founders with dashboard that can be used to plan your capital raise and understand how voting rights evolve across capital raises.