How many shares should I have? How many shares am I allowed? How many shares do I give to my sister-in-law who helped with my business plan? What about shares for my roommate, who says it was her idea? What will the investors think?
Questions like these, about shares and sharing, come up a lot as you develop a plan for starting a business. I'd like to help you answer these by sharing some general background, context and examples about some fundamental concepts that belong in a startup business plan.
What Are Shares and Why Do I Care?
" Shares" are shares in ownership, and we buy and sell shares on the stock market. The simplest one-person business has no need for shares because nobody's sharing anything. However, as soon as there's a second person involved, then sharing becomes a possibility. Corporations are normally owned by shareholders, and each shareholder has some number of shares.
The Simple Math of Shares
The math of share ownership is very simple. Divide the total value or worth of the company by the number of shares, and that's the value of each share. The illustration below demonstrates. Notice that C15 is the product of dividing C14 by C13. For instance, if there are 1,000 shares of a company and you know that the company is worth $50,000, then each share is worth $50.
You can also calculate the worth of the company--we call that "valuation"--by multiplying the number of shares times the price of a share. So if you decide to issue 100 new shares of that $50,000 company and sell those 100 shares to Aunt Mabel for $5 each, then you just changed the value of the whole company. Consider the calculation below: You can see that valuation is the product of shares times price per share (C13 x C15 in this illustration).
This simple math can affect your business plans unexpectedly. Analysts in general and tax authorities in particular have little or no sense of humor about stock transactions. You may have decided to sell to Aunt Mabel for $5 a share just because you like her, but in doing so, you've changed the formal value of the company. There are fine points attorneys and CPAs might add--and I'm neither--but for a lot of legal purposes, something is worth what it was last bought and sold for, so this company is now worth $5 per share. Did you undervalue it? That's tough. Maybe you should have given 100 of your shares to Aunt Mabel as a gift instead of selling them to her.
How Many Shares Should You Have?
Nobody cares very much how many shares there are in a startup, at least not as an isolated number. This same example company with its 1,000 shares could have just as easily had 10 shares at $5,000 each or 100,000 shares at $0.50 each. What matters is price times total number of shares--that's what a company is worth.
And much more important than the number of shares is how much of the company any given owner owns. After she gets those 100 shares in the example above, Aunt Mabel owns about 9 percent (100 / 1100 = .090909).
How Does This Relate to Your Business Plan?
Most business plans, particularly startup plans, need to deal with shares. The first key point is to define who owns what among the founders of the business. A startup business plan involving more than one owner should define stock ownership. Whether that's 100 shares or 10 million, you need to decide who owns how many, and why.
Dividing shares isn't specifically about the financials or the numbers inside financial tables because the financial projections in a normal business plan will include a single number for the total dollars invested called "paid-in capital." You should show that number in the starting balance of the company, as part of the capital.
Percentages do matter a lot, of course, because ownership matters a lot. It's critical for your planning, and it belongs in the text of your plan. But the example below illustrates where paid-in capital shows in the starting balance. In the chart, it's not broken down into shares or who owns what--you can include that in the related text if you're developing a plan for outsiders who want or need to know this.
So what's fair when it comes to who gets how much? I get a lot of questions about fairness regarding stocks, as if there were some formulas recorded somewhere. "It's her idea," you might ask, "but my money, and he's the only one working there every day. What's a fair division of ownership?" I can't tell you. There are no standard formulas. I can, however, tell you this: The information should be in your business plan. Never, ever, get going in business without defining shares and ownership.
Stocks, Valuation, and Investors
If you're going to seek outside investors as part of your business plan, you have to understand the underlying math. Investors want to know how much money you want for how much ownership. You can't duck the fact that asking, say, $2.5 million for 60 percent ownership in the company means that you believe your company is worth more than $4 million. Consider this last illustration, which should be part of every plan seeking investment:
The numbers in the investment offering are extremely important and should be the logical extension of the rest of your plan. The investment amount of $2.5 million in this example should be based on what the plan shows as necessary to get the business going--money that will be well spent on the business.
The investment amount of 60 percent is what the plan suggests is a fair share of ownership to be given to investors who invest the suggested amount. The valuation in the next cell is simple math: Divide the amount of investment by the share offered, and you get the implied valuation. The number of founders' shares is an arbitrary number that's set formally when the company's founded, based on the ownership share your company determines to be fair.
The number of new shares to be given to the investors is simple math: If they're to have 60 percent of the company after investing and founders have 1 million shares, then issuing 1.5 million shares for the new investors makes the math work. The investors end up with 1.5 million of 2.5 million total shares outstanding, which is exactly 60 percent.
We can't leave this subject without a reminder that selling stocks is most often against the law. The Securities and Exchange Commission tightly regulates stock sales to protect investors against fraud. Companies spend enormous resources trying to "go public," meaning that it becomes legal to sell stock to lots of people. If you're thinking about it, see an attorney before you even get close.
The author is an Entrepreneur contributor. The opinions expressed are those of the writer.