Previously in our Starting Your Business blog series we discussed governance of your business. In this blog, we will give you an introduction to issuing equity, starting with issuing equity to the business owners.
Issuing equity is a fundamental aspect of business ownership and growth, serving as a key tool for aligning interests, raising capital, and rewarding those who contribute to a company’s success.
When a company issues equity, it is granting an ownership stake in the business to the recipient. In a corporation, this stake is referred to as “shares” or “stock”. In a limited liability company (LLC) equity is represented by “membership interests” or “membership units”. In both business types, equity is issued to different individuals involved in the business for different purposes. For instance, a company might issue equity to investors as a means of raising capital, by offering them ownership in exchange for capital. Employees may receive equity as part of their compensation package, not only as a financial reward but also as a way for the company to acknowledge the employee’s contributions and incentivize their continued performance. Founders and owners receive equity to signify their ownership and acknowledge their efforts, vision, and willingness to take on the risks associated with starting and running the business.
This post will explore issuing equity to owners while subsequent posts in the series will explore issuing equity to different categories of individuals. It provides a detailed exploration of the process, necessary documentation, and key considerations for issuing equity within LLCs and Corporations.
Issuing Equity to Founders In an LLC
Unlike corporations, which issue stock or shares, LLCs allocate membership interests to their members (the LLC’s owners). These ownership interests represent each member’s share in the LLC’s profits, losses, and voting rights. Founders should take the following steps and considerations in issuing equity to the members:
1.Determine Ownership Percentages. An LLC must be wholly owned at all times–it cannot retain a treasury of undistributed ownership percentages to distribute at a later time in the way that a corporation can choose to issue some, but not all, of its stock. Thus, all of an LLC’s ownership percentage must be allocated upon the company’s creation (if the company has future goals of bringing on investors or additional members, then these parties will receive their membership interest by diluting current members when the time comes). If there is only one individual involved, this person will receive a 100% share of the Membership Interest. If there are multiple parties, then the parties should consider each founder’s contribution and be sure that it is fairly valued when deciding on allocation of the membership interest percentages.
2. Prepare the Operating Agreement. The Operating Agreement is an LLC’s governing document and outlines how the company will be run, including how profits and losses are distributed and how key decisions are made in the company. It also formalizes each founder’s ownership interest in the LLC. A well-drafted Operating Agreement should outline: 1) the capital contributions and membership interest of each member, 2) how profits and losses will be shared among members, 3) the rights each founder has when making important decisions and whether management and membership in the company will be handled jointly or separately, 4) how and when ownership interests can be transferred or sold, and 5) what will happen to a member’s membership interest in the event of their death, disability, and certain other occasions.
3. Issue Membership Units or Percentages. Many LLCs choose to assign membership units similar to shares in a corporation, which can make it easier to allocate ownership and track distributions. Alternatively, some LLCs simply allocate ownership as percentages. Whether using units or percentages, these must be carefully recorded in the LLC’s internal documents to reflect each founder’s ownership accurately.
4. Tax Considerations. Issuing new equity can trigger tax consequences, particularly if the equity is issued in exchange for services or at a value that differs from the fair market value. Consulting with a tax professional is advisable to navigate these complexities.
5. Business Considerations Beyond Documentation. Beyond the formalities of issuing equity, there are several business considerations that LLCs must address. One important consideration is the dilution of ownership that occurs when new equity is issued. Existing members may see their percentage of ownership decrease, which could also impact their influence within the LLC, especially if voting rights are tied to ownership percentage. This can be a sensitive issue, particularly in closely held businesses, and should be approached with careful planning and clear communication among all members.
Issuing Equity to Founders in a Corporation
The issuance of stock in a corporation is a critical component of a corporation’s ability to raise capital, compensate founders, and incentivize key employees. Issuing corporate stock has more formalities and complexities than issuing equity in an LLC. The process is governed by the corporation’s articles of incorporation, its bylaws, and the North Carolina Business Corporation Act (NCBCA). The steps and considerations involved in issuing shares to the founders of a corporation include:
1. Determining the Share Classes and Total Shares to be Authorized. When forming a corporation, the first step is determining the number of shares to authorize in the company’s Articles of Incorporation and what classes these shares will take. These authorized shares represent the total amount of equity the corporation can issue. A common approach is to authorize a large number of shares (for example, 1 million shares) to allow flexibility for future equity distributions to new investors or employees. However, founders should take care before blindly selecting a number, as certain states impose taxes the higher the amount of shares authorized.
2. Allocate Founder Shares. Once the total number of authorized shares is set, the next step is to allocate shares to the founders. This allocation should be based on the value each founder brings to the company. Typical factors influencing the share allocation include capital contributions, services, and intellectual property.
The founders should create a capitalization table or ledger that shows the ownership breakdown agreed upon for the corporation. It should list:
- The number of shares each founder holds,
- The total number of shares issued, and
- The percentage ownership represented by each founders’ shares.
A cap table provides a clear snapshot of ownership and helps prevent disputes later on as more investors and stakeholders enter the business. The company should update this as ownership changes are made within the company.
3. Vesting and Founder’s Rights. While founders may initially issue shares outright, it is often advisable to structure the shares with a vesting schedule to incentivize commitment. The corporation’s Bylaws and Stock Purchase Agreements should detail the vesting terms and what happens if a founder departs prematurely. Vesting protects the corporation by ensuring that founders earn their shares over time, aligning with the company’s long-term success. If a founder leaves early, unvested shares may be forfeited or bought back by the company at a nominal price.
4. Consider Tax Implications. When issuing equity, founders must consider the potential tax consequences and consult a tax professional before or soon after issuing stock.
5. Prepare a Shareholders’ Agreement. Founders should also consider preparing a Shareholders’ Agreement. This agreement governs the relationship between shareholders and addresses matters such as:
- Restrictions on the sale or transfer of shares.
- Other shareholders’ rights to purchase shares before they are sold to outsiders.
- Provisions for buying back shares if a founder leaves or passes away.
By defining these key terms, a Shareholders’ Agreement helps maintain control of the company and prevents unwanted outsiders from acquiring shares and management or voting rights in the company.
Conclusion
Issuing equity is a complex but essential process for businesses in North Carolina, whether structured as an LLC or a corporation. The procedures, documentation, and strategic considerations vary depending on the type of business entity, but the importance of careful planning and compliance with legal requirements remains constant. By following the appropriate steps and seeking professional guidance, businesses can successfully issue equity to owners, founders, and key stakeholders, paving the way for future growth and success.
Contact Skufca Law at (704) 376-3030 today to discuss the topic of issuing equity among owners and other questions related to starting a business. Next up in our Starting a Business series, we will discuss the process of issuing equity to employees.