What it Means When Founders ‘Demand’ 51% Ownership

Among the many responsibilities when starting a company, a founder needs to define how many shares will exist; this is part of the incorporation process. Soon thereafter, the founder needs to create a vision for how s/he sees those shares allocated among various stakeholders. These typically include the founder him/herself, future investors, as well as employees, directors, and consultants. How the founder sees that pie divided tells us a lot about the personality and leadership qualities of the founder.

Terminology

Authorized Shares: When shares are created as part of the incorporation process, they are termed authorized. Once authorized, they commence their life in the company’s treasury. Authorizing additional shares usually requires a majority vote of existing shareholders; after all, such an action has the potential to seriously dilute the ownership of every shareholder. Why would a shareholder vote for such a move? Because creating additional shares (e.g., to attract investors or incentivize other contributors) means current shareholders could end up with a smaller piece of a much larger pie instead of being stuck with a large piece of a smaller pie.

Earmarked Shares: Treasury shares can be reserved (i.e., earmarked) for specific purposes such as for incentives for employees, directors, and consultants (either in an option pool or incentive stock plan) or investors. This responsibility usually rests with the board of directors.

Issued Shares. When treasury shares are granted or sold to individuals (or entities), they are termed issued, allocated, or allotted. The recommendation to grant shares as incentives to employees, directors, or consultants is typically made by officers of the company and approved by the Board of Directors.

Chronology

Moment of Incorporation: If the founder is working with an attorney to incorporate, customized articles of incorporation are likely created, and they will define how many shares are authorized, how many of those authorized shares are to be purchased (at some nominal price) by the founders, and what corporate processes manage the authorization, earmarking, and allocation of shares. If the founder is inexperienced and is just filing for incorporation with the State, the company will receive boilerplate articles of incorporation which will just define how many shares are authorized.

Soon Afterwards: Part of the founder’s leadership responsibility is creating a vision for future equity distribution, i.e., who is going to own what percentage of the company in the foreseeable future. This is the subject of this blog.

Ongoing. As the company progresses, it is the task of officers and directors to lead the company toward that vision, or to make changes to that vision to best meet the needs of shareholders.

Equity Distribution Alternatives

Founder Wants Majority Ownership. In my 28 years of advising and mentoring aspiring entrepreneurs, I’d estimate around 10% have “demanded” at least 51% ownership of the company. It is not a coincidence that in every case these entrepreneurs have been sole founders. After all, why would any individual want such an ownership stake? The only reasons I can think of are:

• I am not a team player. I don’t care what others think; I’m the only one that matters.
• I am extremely paranoid: Others will fire me for no reason at all
• I’m so incompetent, others will fire me as soon as they learn how incompetent I am.
• If everybody else thinks I’m doing the wrong thing for the company, screw them!
• I don’t care about loyalty. Everybody has screwed me in the past anyways.
• I am my company. We are one. See my earlier blog, You Are Not Your Company.

Founder Wants Minority Ownership. These are the other 90% of entrepreneurs I have worked with. The logic is:

• If I provide other stakeholders with significant ownership, they will work as hard for the company as I plan to.
• Being a founder doesn’t give me the unalienable right to manage the company.
• My responsibility as a leader is to make decisions that are in the best interests of all stakeholders, not just in my own personal best interests. I can easily lose sight of that if I have a majority of the shares.
• If a majority of shareholders (i.e., owners of the company) think that I (as an officer) am not making the best business decisions, they should fire me. Note: I’ll still be a shareholder.
• Checks and balances improve a company. When one person controls a majority of shares, s/he can fire all directors, officers, and employees. No checks and balances exist.

Example 1

In the mid-1990’s, I was on the board of directors of a software startup in Boulder, Colorado. To reduce cash burn, we compensated the lead developer with stock options in lieu of cash. Although we had planned to be in business for a long time, a publicly-traded company made an offer to acquire us at two years old with terms we could not refuse. All of us did extremely well financially, but the lead developer walked away with the largest individual share of the acquisition price. Fortunately, (1) that individual understood the value of the options we had offered him, (2) all of us recognized that dilution to our ownership caused by that individual’s stock options was far less significant than the value his loyalty and hard work brought to the company.

Example 2

In the three startups with which I have been associated since the one described above, I have planned equity ownership using the ?-?-? rule, i.e., ? to founders (regardless of how many of us exist), ? as incentives to employees, directors, and consultants, and ? earmarked for future investors.

In actuality, after starting with 1,000,000 shares and allocating 333,333 to founders, we earmarked around 100,000 shares for an initial option pool with plans to earmark additional tranches (up to a total of 333,333) to the option pool as shares in the initial pool became exhausted through grants to individuals. And then the remaining 333,334 shares were available for investment rounds Series A, B, C, and so on. Although these were the plans in all three cases, I must admit that we did not end up with perfect ?-?-? distributions. For example, in one case, things went south and our Series C was a significant down round, resulting in major dilution to both founders and optionholders. In another case, we solicited no investments so ended up with a 50-50 split between founders and optionholders. However, the point is we planned according to the ?-?-? rule and that helped to create corporate cultures of trust, democratic governance, mutual respect, and very low employee turnover.

Summary

The above advice is industry-specific. All my startups have been in high tech, where employee loyalty is critical. My son is in the restaurant and food distribution industries. In these cases, salaries are fairly low and employee turnover is incredibly high. Stock incentives would not be particularly effective at retaining employees. Perhaps 10% might be more appropriate to reserve for employees, directors, and consultants for high-turnover industries.

ABOUT THE AUTHOR

Al Davis was trained as a computer scientist (PhD, Computer Science, University of Illinois at Urbana-Champaign), but much of his career has been devoted to business leadership. He spent roughly half his career in industry and half in academe. As an entrepreneur, he has been a founder and/or executive in 5 startups (1 IPO, 1 public acquisition, 2 failures, and one TBD), a limited partner, non-managing GP and member of the investment advisory board for a small VC fund, an angel investor since 1983, and a mentor for many dozens for aspiring entrepreneurs. He is currently president of Offtoa, Inc.

He has held academic positions at the University of Colorado, George Mason University, University of Tennessee, Atma Jaya University in Yogyakarta, Indonesia, University of Jos in Nigeria, Universidad Politécnica de Madrid in Spain, University of Technology, Sydney in Australia, and the University of the Western Cape in South Africa.

He has published 100+ articles in journals, conferences and trade press, as well as 9 books, was editor-in-chief of IEEE Software from 1994 to 1998, and has lectured 2,000+ times in 28 countries. He has been a fellow of the IEEE since 1994 and a life fellow since 2015. Find out more about Al at www.a-davis.com.