This is fifth in a series on launching, growing and ultimately selling a technology company with a corporate finance focus. Topics include cap structures, equity plans, financing, corporate partnering, board matters and how to achieve a successful exit.

Deciding where to incorporate and what the initial structure should look like is the easy part of setting up your company. The first real test comes with who gets the founders’ shares and how many. There is a lot of confusion around this issue and mistakes can create:

• tax problems for the founders
• structuring problems that can interfere with financing efforts
• in some extreme cases, control issues that blow up the company

What are founders’ shares?

Founders’ shares are the initial shares issued when the company is first formed (and only at that time) to the principals who created the company and are committing to build it. The term does not refer to a class of shares – the class will the same common shares issued to other shareholders. Instead, it refers to the category of the holder of those shares, why they hold them and the price at which they were issued. Who holds the founders’ shares sends a very important message. Investors see these shareholders as the people who are principally accountable for the company’s success. The ones who will commit to make the company successful or die trying.

Founders’ shares are issued at a very nominal price. I typically advise companies to issue a number of founders’ shares in the millions (plus or minus 5,000,000 in total), at a price as low as $0.0001 per share and typically not more than $0.01 per share. They are issued at a nominal price because the company typically has no measurable value when it is first formed — no material assets but hopefully a great idea. Because you are obliged to issue shares at their fair market value, you can only issue nominally priced shares at a time when the company has little measurable value. So you have only one chance to do this right.

Paid for in cash – not credit or barter!

It is very important that these founders’ shares be issued for actual cash and not for services rendered, services to be provided over time or in exchange for your business idea or any other asset. If a company issues shares in exchange for services or assets, those are taxable events to the individual. CRA will want to equate the share value to income that you should be paying tax on. And as we all know, the tax man always extracts his pound of flesh!

“The way to look at founders’ shares is this: Before any real value has been built in the company, you, the founder, get the right to buy a block of shares for cash at a very low price reflective of the fact that the company has just been formed. You are being given this right because of your commitment to join the company, bust your butt and serve as a founder.”

Receiving shares for assets

If you have real assets you wish to put into the company, hard or otherwise, that should be a separate transaction with shares issued for value (ie. at a real price). In fact, you should make sure this is a separate transaction so you are receiving shares for those assets as well as the sweat equity you are getting for being a founder. If you don’t, you are leaving equity on the table. And if you do, then make sure to get tax advice on the vend-in transaction.

Founders and sweat equity

While founders’ shares are not issued in lieu of future services, it is expected that the founders will work their ass off for below market wages — or in some cases without any wages at all — for some period of time.  That is why it’s called sweat equity. In fact, it is not uncommon in start-ups to see the junior staff being paid at or near market and the senior people – at least those who are founders – being paid well below market or sometimes not at all.

If you don’t do this right you may end up building a great company and not be rewarded for the sweat equity you put into it. In the next few blogs, I will deal with who should get founders shares, how vesting works and best practices, and how to avoid structural mistakes.

Next up, how to split up the pie.

David practiced corporate finance law for 20 years representing numerous BC-based technology companies before retiring to co-found a venture capital fund where he was a partner and portfolio manager for ten years. He now provides corporate finance/M&A advice to a portfolio of early stage companies with a view to growing them to the point they are ready to exit, and then leading that process.