A few months ago, a client was looking to expand their company by bringing in more partners. However, his partners were unwilling to give up equity. This is fine, however in order to grow while maintain one’s shareholding amount within the company, the shareholders needed to put more money into the company. Either by hiring more workers/consultants or purchasing more assets. They did not want to expand through labor or capital expenditures. So they had to bring in new equity partners that were willing to invest money or sweat equity into the company. But, as mentioned earlier, they didn’t want to give up equity. The founder ended up leaving the company and starting anew. Sad but a necessary step when working with partners that could not agree on how to move forward.
In reality, founders almost always have their equity positions reduced over time. Pretty much every founding CEO you can think of will have a lower % than what they started with. I will explain why.
Hypothetical Scenario
Typically, when Company A is formed there are a specified number of shares. Let’s say 100 shares (in reality it’s more like 1 million or more, but for simplicity). Founder 1 has 40%, Founder 2 has 35% and Founder 3 has 25%. So that means Founder 1 has 40 shares, Founder 2 has 35, and Founder 3 has 25 shares (assuming all shares are out and none are held as treasury stock). The founders decide to grow the company by seeking $50,000 (for hiring a consultant). They can take a loan and keep their respective positions or bring in someone that can invest or do the $50,000 worth of work.
Equity Reduction
So in the hypothetical above for Company A, the board of directors (the three founders in this case) can decide to either 1) issue more shares say 9 more to the new shareholder or 2) give some of their own shares (to keep it at 100 shares). Either way Founder 1-3 will have a reduction in their equity positions.
- In option 1 (109 outstanding shares): Founder 1 will have 36.69% (40/109), Founder 2 will have 32.11% (35/109), Founder 3 will have 22.93%, and New Guy will have 8.25% (9/109).
- In option 2: Say each founder gives up 3 shares; Founders 1-3 will have 37% (37/100), 32%, 22% respectively, and New Guy will have 9%.
Equity Maintenance
Let’s say the Founders do not want to give up any position. They would have to divvy up the $50,000 proportionally so that their respective positions aren’t diluted. However, in the hypothetical they do not have an extra $50k to invest into the company. If outside money is not brought in through a loan, then the only way they can maintain their positions while giving up equity is to have a combined ownership of anything less than 100%. This is because mathematically it is impossible to give more if there is nothing else to give. So, let’s adjust the hypothetical to say Founder 1 has 39%, Founder 2 has 34%, and Founder 3 has 24% (a 1% reduction for all) for a combined total of 97% and 1,000,000 shares. That means there are 30k shares available (without having to issue new stock) for New Guy to claim. If new shares are issued, then New Guy can be given any number of shares as long as Founders 1-3 have 97% of the total amount of shares.
Company Growth
As the company continues to grow it will have to issue new shares (unless it takes on debt, which companies frequently do both). At some point, the Founders will not be able to or unwilling to keep pumping money into the company to maintain their position. Hopefully, at this point they won’t have to because the dividends that they may receive will be enough to satisfy their return on investment (ROI) needs.
This is why founding members rarely have the same percentage as the company grows.
For those that like pictures, check out this great infographic from FundersandFounders.com
Leave a Reply