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If you keep in mind a few crucial points before issuing stock, you will help preserve flexibility to allow your company to grow.
Be thoughtful. Understand what the articles, bylaws, and agreements with other investors require before you issue stock. Run the numbers; the company should determine that dilution to existing shareholders resulting from a new stock issuance is acceptable. Bring in lawyers, accountants, and tax advisors to understand how issuing stock might affect the company.
Shareholders have rights. Shareholders are entitled to certain rights, such as voting and notice rights. A company requires the consent of shareholders before it takes certain major actions. A company with many small shareholders may not be able to move as quickly as one that has fewer shareholders or certain capitalization mechanisms.
Negotiate with your investors early. If not properly thought out, you may inadvertently give your new equity owners control that might impede your ability to grow the business. For this reason, it is very important that the company and the investors negotiate any terms before the stock is issued. In addition, the investors should consult their own lawyers, accountants, and tax advisors. This negotiation process is often accomplished through a term sheet that describes the number of shares, the purchase price, and any additional rights and obligations (if any) that the investors may receive.
Be aware of valuation and tax considerations. Accepting services or cash in exchange for equity can drive up your company’s valuation and make it very difficult to issue reasonably priced shares in connection with significant investment or stock option plans. In addition, issuing equity in exchange for services will cause the new shareholder to accrue an income tax liability based on the fair market value of shares, which may in turn make your shareholder very unhappy when the time comes to pay the IRS.
Pay attention to the securities laws. Federal and state securities laws apply. An improper issuance may create expensive problems if you run afoul of these laws.
Keep these points in mind as you plan your company’s capitalization, and do not be reluctant to ask legal and tax advisors for help.
This article is provided for general education purposes. Please check with a legal or tax advisor for legal or tax advice.
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