James T. Carroll
When negotiating stock or other forms of equity in their companies, executives too often deal in terms of percentages: an offer letter with a new employee may promise her “options for 2% of the company” or a commercial agreement might entitle a vendor to “5% of the company’s common stock.” While the executives may find percentages a convenient shorthand for understanding the size of the “slice of the pie” being negotiated, when they deliver those terms to the company’s counsel, groans and (polite) admonishments are likely to follow.
Why the negative reaction? Although percentages can be a useful measurement of someone’s share of a company’s economic value or their voting control at a particular moment, they are a poor metric for defining their amount of ownership of a company over time if the company plans to issue additional equity in the future. The problem with negotiating in terms of percentages when agreeing to ownership interests is that the parties often fail to clearly state (1) when the percentage is measured and (2) whether the parties intend for the percentage to remain fixed over time. If these two key components are not clearly understood, then the company could find itself stuck with an employee or other person claiming a fixed percentage ownership in the company for an indefinite period. To avoid this situation, always discuss company ownership in terms of shares of stock or other units of equity.
The casual misuse of percentages in negotiating equity terms often stems from a misunderstanding of (or inattention towards) the concepts of equity value and dilution. The value of a share of stock is primarily a function of (a) the total value of the company and (b) the total number of shares of stock that are “outstanding” (i.e., held by stockholders). The greater the value of the company, and the fewer the total number of outstanding shares, the greater the value of an individual share of stock. For example, a share of stock in a fledgling startup worth $100,000 with 100,000 outstanding shares is worth only $1.00, but a share of stock in that same company one year later, valued at $1 million with 200,000 outstanding shares, would be worth $5.00. Note, though, that the ownership percentage represented by that one share of stock would have decreased over the same period, from 0.0001% to 0.00005%. To maintain the same ownership percentage (0.0001%), the owner of that share would have had to purchase (or be granted by the company) his pro rata portion of the additional 100,000 shares issued in the interim (in this example, one more share of stock) and the total value of the two shares would be $10.00.
So, the decrease in ownership percentage that occurs when a company issues stock to raise capital or compensate employees, often called “percentage dilution,” is not necessarily a bad thing, so long as the proceeds or services exchanges for the stock provide adequate value to the company. When, for instance, a company sells new shares at a price equal to the value of the company divided by the total number of outstanding shares, an existing stockholder’s percentage ownership will decrease, but the value of his stock will stay the same, as each share of his stock will share proportionately in the value of the money coming into the company. If, however, the company sells shares for less than the current per-share value of the company’s stock, the existing stockholders will experience “economic dilution”—the value of each of their shares will be proportionately decreased by the shortfall in the value of the shares being sold.
If, due to the terms of his agreement with the company, an existing stockholder has arguable right to maintain a certain ownership percentage of a company, then to maintain that percentage the company must issue additional shares (or transfer shares from other existing stockholders) to that stockholder whenever the company sells stock to new investors. While the stock issued to the new investors may be sold for adequate value (the cash invested in the company), no value would be received by the Company (or the other stockholders) for the stock issued or transferred to the existing stockholder with the fixed-percentage-ownership right, which instantly causes economic dilution of all of the other stockholders, including the new investors if the additional shares of stock are issued by the company.
Obviously, such a situation is a windfall for the stockholder with the fixed-percentage ownership right, an economic loss to the other stockholders of the company, and a significant disincentive for new investors. Companies with stockholders with fixed or undefined percentage ownership agreements are usually unfundable until they find a way to settle those stockholders’ claims, which can come at significant expense. So, when coming to terms on stock and other equity, whether for compensation, investment or commercial arrangements, always deal in numbers of shares of stock or other equity units, and avoid the problem with percentages.
About the Author
James T. Carroll is a counsel in the Emerging Companies & Venture Capital practice at law firm Perkins Coie LLP. He focuses his practice on the representation of start-up and high-growth technology companies in matters of corporate finance and securities, venture capital, mergers and acquisitions and corporate governance.