Structuring the Capitalization of a Startup

Introduction

When it comes to starting a new business, capital structure should be one of the primary considerations for founders and investors. Ensuring that capitalization is structured correctly is essential for establishing a business’s long-term success. Structured capitalization can help protect the founders and investors while also making good use of the capital resources. In this blog post, we will explore some of the important considerations in structuring the capitalization of a startup and the potential benefits it offers.

Key Takeaways

• Establishing a structure for capitalization can help protect founders and investors
• Optimal capitalization can make good use of the capital resources available
• Learn how structured capitalization leads to a business’s long-term success

Sources of Capital

The lifeblood of any startup is the capital that is invested into it. Capital is key in helping a business acquire resources and launch projects. For startups, there is a wide array of sources of capital available to them. When structuring the capitalization of a startup, it is important to comprehend all these sources. Most startups rely on a mix of debt, equity and cash reserves.

Debt

Debt can be used to fund initial investment into a business when equity is absent. This can be done through borrowing, such as bank loans and lines of credit. Debt is commonly the first option taken by startups as it is the swiftest and no shareholders are required. Although it is rapid and efficient, debt must be taken great caution and comes with a fixed cost.

Equity

Equity is when investors exchange money for an ownership stake in the company. It is a great way for a business to garner cash for its operations without asking for any loan repayments. The downside is it dilutes the majority shareholders’ stake in the company and decision-making power.

Cash Reserves

Another way to fund a startup is through cash reserves - money that is set aside for running costs, emergencies or unforeseen expenses. Using cash reserves can be a great idea as it eliminates the dilution of any majority stakeholder as well as there being no interest payments. Having cash reserves helps in creating financial stability.

• Debt - Used to fund initial investment when equity is absent, such as bank loans.
• Equity - When investors exchange money for an ownership stake in exchange for cash.
• Cash Reserves - Set aside for running costs and unexpected expenses. No interest payments. Creates financial stability.

Types of Equity Securities

Raising capital for a startup is a complex process with various methods and considerations. One way to structure the capitalization of a startup is through the issuance of equity securities. Equity securities are an equitable interest in the company and provide certain rights to their owners. The two primary types of equity securities are Common Stock and Preferred Stock.

Common Stock

Common stockholders are owners of the company with limited voting and liquidation righs. Common stockholders often have the right to vote for the election of the Board of Directors, to approve certain major corporate decisions and to receive dividends on the company’s profits. Common stock also provides equity appreciation when the company is successful.

Preferred Stock

Preferred stockholders have certain rights and privileges not enjoyed by common stockholders. Preferred stockholders have the right to receive dividends before common stockholders, and in some cases, the right to receive preferential payments in the event of a liquidation of the company. Additionally, preferred stock typically has convertible and callable features, providing the ability for the holder to convert it into common stock at a predetermined rate or for the company to call the stock away from the holder.

• Preferential Dividend Rights
• Conversion Rights
• Call Rights

Structuring the Capitalization of a Startup: Vesting Schedules

When it comes to providing ownership of a startup, vesting schedules are a common way to do so. Understanding the basics of vesting schedules, and how they work, is essential to setting up a successful business that allows different members to own a stake in it. The following will look into how vesting schedules are established and how they are used.

Establishing Ownership

With a vesting schedule, the ownership of a startup is established by dividing the total amount of shares up among members or founders of a company. This is done in order for everyone to have an equal stake in the company. Typically, the amount of shares and value of taxes, which vary depending on the type of vesting, is spread out over a designated period of time, with the founder or member having the right to receive the shares once the designated period of time passes. This is done to incentivize founders and members to stay with the startup and put in their effort in making it successful.

Vesting and Retirement

The vesting schedule also assists in retirement planning of a founder or a member of the company. Once the vesting period is over, the founder or the member will have the full ownership of the percentage of the shares that were vested. This structure allows for the founder or the member to receive their stock over time (i.e. monthly, quarterly, and any other frequency). Furthermore, it also allows for the founder or member to accelerate the vesting of a particular stock if the company has a clawback or repurchase agreement in place. This allows for the company to reduce the total number of shares should the situation arise.

In addition, the vesting schedule can also be structured such that it will accelerate the vesting of stock should a founder die or become disabled. This further enhances the retirement planning of the founders and members, providing them with assurance beyond their death.

5. Buy-sell Agreements

As a business owner it is important to ensure that you have the appropriate buy-sell agreements in place in order to protect the company, its employees and its shareholders. A buy-sell agreement provides a written agreement between the parties that specify what will happen when one of the parties wants to sell off their interests in the business. These agreements can help to ensure that in the event of a sale, the owners are protected and the business is transferred to the new owner(s) in an orderly and efficient manner.

A. Understanding Basic Terms

A buy-sell agreement is a legally binding agreement between the owners of a business that dictates the circumstances in which an owner can transfer or sell his/her ownership interest in the business. The agreement may also govern the manner in which the business is to be transferred or sold, the timing of the transfer, the price at which the business could be transferred, and any restrictions that the parties may have on the transfer.

B. Types of Buy-Sell Agreements

There are a few different types buy-sell agreements that can be used including:

• Cross-purchase agreements – this is when the business owners are purchasing their own shares or interest in the business.
• Entity-purchase agreements – this is when the company purchases the shares or interest in the business.
• Wait-and-see agreements – this is when the agreement dictates that regardless of who purchases the interests, they cannot do so until the existing owners have had an opportunity to purchase it first.

It is important to remember that the buy-sell agreement should be reviewed periodically to ensure that it reflects the needs and objectives of the business owners.

Distribution Mechanisms

When structuring the capitalization of a startup, part of the process involves establishing ways of distributing profits to investors. Distributing profits allows businesses to attract more capital while rewarding existing shareholders, so it is important to have a good understanding of common mechanisms used.

Dividend Policy

A dividend policy defines how and when a startup pays out its profits or the amount of profits kept by the company for reinvestment or future expenses. The policy is typically specified in the company's charter documents and typically granted to holders of common stock. When dividends are disclosed, shareholders can decide whether the company pays out appropriate cash flows or if their goals are better achieved through capital gains.

Stock Splits and Reverse Splits

Stock splits and reverse splits affect the amount of outstanding shares, but do not affect the value of ownership. They often occur after a significant jump in price or during a move to a larger exchange. Splits can help improve liquidity by reducing the minimum number of shares available to purchase, while reverse splits help maintain a higher price for the company. A typical split is two or three for one, which means that for each existing share a shareholder owns, two or three new shares are given in return.

For startups, these techniques can help to maintain the perceived value of the company and ensure that the capitalization structure is kept in balance. However, it is worth noting that stock splits and reverse splits are not always necessary.

Conclusion

Investing in a startup can be a risky endeavor. However, there is a great opportunity for success when investments are carefully structured and capitalized. The considerations of the form of entity, managerial responsibilities, and levels of investment can help founders and investors reach the most beneficial and successful outcome for their investments.

Recap of Considerations

Structuring the capitalization of a startup must consider the direct and indirect investments, the form of entity, the managerial responsibilities and the levels of investment for both founders and investors.

Benefits of Structured Capitalization

• Structured capitalization can ensure that investments are best and most effectively allocated.
• The entity form and managerial roles can protect investors from legal and financial liabilities.
• Capitalization structures can articulate the goals of founders and investors and align them in the business venture.
• Structured capitalization can also lead to increased financial opportunity and greater economic growth.

Investors and founders should carefully consider the structure of capitalization and its implications prior to forming the startup. By taking the time to structure the investments, both investors and founders can benefit from a more successful, monetary and administrative outcome.