Here’s a riddle for you: XYZ Corporation’s Articles of Incorporation authorize it to issue up to 1,000,000 shares. Founder 1 owns 100,000 shares and Founder 2 owns 100,000 shares. No one else owns any shares. What percent of the company does each founder own? Many people would say 10% each. They would be wrong. Each founder owns 50% of the company.
This is a commonly misunderstood issue that confuses many business people. The confusion stems from not understanding the difference between the authorized number of shares and the number issued and outstanding.
The authorized number of shares (often referred to as authorized capital) is the number of shares the corporation is permitted to issue under its Articles of Incorporation. In the above example, the authorized capital is 1,000,000 shares.
The issued and outstanding shares is the number of shares that have actually been issued and are held by current shareholders. A shareholder’s ownership percentage is based on their percentage of the issued and outstanding shares. So in the above example, Founder 1 and Founder 2 each own 50% of the company:
The 800,000 shares that XYZ Corporation has not issued are called “authorized but unissued shares”. If the corporation eventually issues all 800,000 of those shares to employees or investors, then Founder 1 and Founder 2 will own only 10% each at that time. But that hasn’t happened yet. Ownership percentage is based on the number currently issued and outstanding.
Sometimes we want to know what percentage a person will own based on future issuance of shares. This is especially true when there is a stock option or other equity incentive plan. This determines the percentage a person owns “on a fully-diluted basis.” Let’s say XYZ Corporation has a stock option plan calling for the issuance of an additional 100,000 shares. To calculate the percentage Founder 1 and Founder 2 each own on a fully-diluted basis, you would treat all the options as if they had been granted and exercised. Therefore Founder 1 and Founder 2 each own one third of the company on a fully-diluted basis:
Investors use fully-diluted basis when deciding how much to pay for a certain percentage of the company. Let’s say Angel 1 thinks the company is worth $4,000,000, and she is willing to invest $1,000,000. That means the “post-money” valuation (the company’s value after she invests) is $5,000,000. Her $1,000,000 investment would equal 20% of the post-money valuation. Therefore she should own 20% of the company after she invests. Founder 1 and Founder 2 offer to issue her 50,000 shares (20% of the new total of 250,000):
Angel 1 would say no. She’s aware of the option plan because she did her due diligence. So she knows that once the corporation issues the 100,000 shares under the option plan, there will then be 350,000 shares outstanding. Her 50,000 would only represent 14.3% of that number. She wants to be sure that the number of shares she is issued represents 20% of the number that will be issued and outstanding after the options are granted (i.e. on a fully-diluted basis). She insists on receiving 75,000 shares, so that even if the company issues all 100,000 shares under the option plan, she will still own 20% of the Company on a fully-diluted basis (75,000 divided by 375,000 shares):
Angel 1 understands the company could issue an additional 625,000 shares in the future, which would dilute her (reduce her percentage). But that’s something investors anticipate and tolerate. They only make their fully-diluted calculations based on quantifiable future issuances such as stock options.
I hope this clears up any confusion you may have regarding the difference between authorized shares and issued and outstanding shares. Feel free to contact me if you have any questions.
This post is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.