What is equity? And who gets it? All venture and seed investors would buy equity shares for ownership and secure their investments with preferred stocks purchase while making investments. Thus it is important for entrepreneurs to understand what it means to their company.
Equity broadly means ownership interest. Stock is one of the expressions of equity for businesses. However, one can hold equity in any asset. It is good to know what the classifications of equity shares are and who gets what in case one decides to start a business, raise funds, or in case of insolvency.
A very simple example of how it works:
In common practice, startups organise their stock into two main classes – common and preferred stock. The third option is in the form of options and warrants like employee stock ownership plans (ESOPs) etc.
Common shares and preferred shares – Common shares can be defined as the basic ownership of the company while preferred shares are mostly issued to investors who come in at a later stage.
Common shares can be classified into
Founder shares, given to the firm’s originators. They are issued shortly after the formation of the company. The holders are entitled to the profit remaining after the tax payments. These shareholders are likely to receive dividend after all classes of stock, and mostly would hold special voting rights.
Other common shares: Parties other than the founders can acquire common shares through one of the following ways:
The holders of the common shares are in various agreements with the company regarding voting rights, transfer rights, dividend payments etc. In case of a solvency, the common shareholders are the last in hierarchy to receive payments, if any is left after paying to all other liabilities, bond holders, and equity holders. However, they are entitled to higher ownership and voting rights.
Authorised but unissued shares: The company stocks many shares that it is authorised to issue but has not issued yet and have been kept aside for contingencies or future purposes, like stock split. Another reason why a company has to maintain a stock reserve is for a case wherein the stock option holders or the employees who were given option at time of hiring might exercise their options.
These shares cannot be used to cast vote or are entitled to receive dividends. These should not be confused with treasury stocks, which can be bought back by the management.
Vesting of shares is a method generally used to incentivise the employees and build teams, and the attached terms protect the company from ownership dilution in case people quit or are fired. Unvested shares are issued with the condition/option that the company will buy them back at the original purchase price, when the stockholder's relationship with the company ends. As decided during time of issue, the company’s option to repurchase lapses over the agreed timeline and the shares become vested.
Voting/non-voting shares – Equity shareholders hold the right to vote for the board of directors and other strategic matters. During the time of issue, the voting rights are determined and some shares might have restrictions, i.e., have a fractional vote instead of a complete vote, or their vote is proxied to another shareholder who can vote on behalf of the original shareholder. Such shares may be typically issued to heirs or divorced spouses, trustees, or a former board member.
Founders Fund (FF) common stock – FF stocks are a different class of shares issued in addition to the common shares, mostly to founders and principals of the company. These shares are issued with the clause that whenever the company receives any round of investments, the shares will be converted into preferred shares and sold to the investor. This clause is with the intention to get the founders some cash out.
Preferred shares, as the name suggests, are shares that have a higher preference than common shares in terms of payment of dividends and return of equity share capital at the time of winding up. However, they do not hold any voting rights. These are special instruments that have properties of both debt and equity. They are listed separately and trade at a different price than the common stock. Preferred shares are classified into:
Convertible and non-convertible stocks, issued on pre-set terms, wherein the shareholders have the right to convert shares into common stock whether at par or at another value set when the preferred stock was issued. Practically, if a company’s common shares are selling at a higher rate than the preferred share, the company will insist on a conversion of preferred share to common share to eliminate the permanent dividend payment obligation.
Callable and non-callable, wherein the company holds the rights to redeem or call back the preferred shares after a pre-specified period. The investor will try to keep the period to the longest to receive the fixed dividend payments. A company will make an offer to redeem if conversion to common stock looks attractive.
Term or perpetual life – Preferred shares sometimes behave like bond, where after maturity the shares are redeemed at a pre-determined price. These are called term shares, while some preferred shares are like common stock, and can be held as long as the company is running. Investors should be wary of the interest rate and time of maturity while purchasing these shares.
Cumulative and non-cumulative – The dividend payment terms of the preferred shares are decided at the time of issue of shares. Preferred shares have higher preference for dividend shares. However, if the company under-performs in a particular quarter and is unable to pay dividends, then in case of cumulative shares, the company is obligated to pay the arrears in the cumulative quarter. Thus the dividend amount will pile up and the company is obligated to pay the lump sum amount when possible. In case of non-cumulative shares, the inability of company to pay dividends a particular quarter leads to lapse of dividend payment in that particular quarter to the shareholders.
Voting and non-voting – Mostly, preferred shareholders do not have the right to vote in board matters. However, some shares might hold the right to vote in matters related to dividend payments.
Participating and non-participating – Common stock holder divide the remaining dividends among themselves post the payments to preferred shares. The participating shares holders hold the right to receiving the part of this distribution and getting the excess dividend over its normal dividend payment.
Stock option is the special privilege given to the buyer to buy or sell the stock at a pre-determined future date at the agreed-upon price. Types of stock options are -
ESOPs are a popular way of ensuring employee loyalty, and can be given to employees, board members, advisors, contractors etc. They have an extensive restriction in terms of buying and holding the stocks and are linked with a vesting period (four years or more), post which the holders have a right to buy at a discounted price.
Employee Stock Purchase Plan (ESPP) allows employees to purchase company shares at a pre-determined date and price (mostly a discounted rate). Stock options are perceived to be an effective employee retention and incentive tool.
Stock Appreciation Right (SAR)/Phantom Equity Plan (PEP) – Sometimes, because of cost, regulatory requirements, corporate considerations, or other issues companies may adopt SAR/PEP to incentivise the employees. Here the employees are allotted notional shares i.e., no real purchase of shares occurs. On completion of vesting conditions, the appreciation in the price of underlying shares is estimated and payment is made to employees. However, no cash purchase of shares has been made. These plans generally result in cash outflow for the company.
Restricted Stock Award (RSA) – Under this, the employee receives an award of stock subject to certain underlying conditions. If the underlying conditions are not met, the shares are forfeited. The employee is considered to be the owner of the shares from the date of issue and generally has an entitlement to receive dividends and voting rights.
Restricted Stock Unit (RSU) – Similar to RSA, in this option too the date of award is in the future, if specified conditions may relate to performance or tenure of employment. Until shares are actually delivered, the employee is not a shareholder and does not have voting rights or rights to receive dividends. It is important to note that RSU is not an immediate transfer of shares subject to forfeiture, but a promise to give shares in the future. RSUs are generally entitled to quasi-dividends.
Right equity mix for a startup
With such a large array of options, it might get overwhelming for a company to decide on the right mix of equity during initial stages of funding. Common stock leads to sharing of ownership while preferred shares bring with it fixed obligations. There is no rule as to the right proportion and it largely depends on the consensus of both parties. Ideally, businesses refrain from issuing preferred stocks until there is a need for a huge amount of capital. For smaller rounds it's always advisable to stick to common shares, as with an inconsistent cash-flow in business, dividend payments might become a burden.
At the initial stages, the amount of funds that the company requires are less, mostly between the range of Rs 50 lakh and Rs one crore, as funds are required mostly for product development and creating bit of traction. Thus, it's wiser for startups to stick to pure equity to avoid the fixed obligation of payments of quarterly dividend.
“At the initial stage, not more than 10-15 percent of the equity should be lost,” explained Apoorv Ranjan Sharna, Co-Founder & President, Venture Catalysts. “If lot of equity is lost at this stage, co-founder dilution will be too high, which might lead to dissatisfaction in case of number of co-founders being more in number (two or more),” he added. Startups also have an option of opting for convertible instruments at this stage of funding. However, this option is executed mostly when the investor and the startup are not at consensus regarding valuations.