Understanding shares in startups
July 28, 2021
We all love a fluffy and sugary cake. And shares are like cake 🎂
Except, you can turn that cake into cash. So, if you like cake and money, keep reading 🎂💰
Cakes come in different kinds, flavours, and may taste different in your favourite corner restaurant. Despite their differences, all cakes have a few things in common — like their ingredients: flour, butter/vegetable oil, and water.
Shares come in all kinds of shapes and sizes — they also work differently across the continent of Africa and in different countries. Shares get complicated, but in this article, we’re going over things they all have in common in the technology financing world. Above all, shares are held by a stakeholder. A stakeholder is someone that owns a financial stake in the company that issued the shares.
Shares have two major ingredients in common:
Dilution — shares are quantifiable — they increase and decrease based on specific calculations.
Rights — all owners of shares will usually be able to participate in the company — through voting and attending important meetings.
Dilution and share mechanics
Shares are numbers. They have specific formulas and calculations that we use. These calculations can get intense pretty quickly — and that’s probably why you should ditch that random excel sheet cap table. It’s crucial to maintain accurate and precise calculations that are captured in a cap table.
This is because those calculations determine dilution. We’ve all heard that term, “Jeff Bezos got diluted”. What this basically means is that as your startup grows and issues shares, existing stakeholders are diluted: their percentage ownership in the company decreases as time goes on.
Now, in Raise fashion, let’s understand dilution through a real story.
So, you start by incorporating a Nigerian company. On your Corporate Affairs Commission document (CAC), you’ll have created a few thousand shares to the founders. As the company grows, you’ll generate more and more shares — of different kinds, shapes and sizes. The more shares you issue, the bigger the cake pie becomes, and the more shares are added to the company.
Those new shares will usually be created to sell to new investors or employee stock options. That’s great news for the company! More shares created is a sign that you’re growing. But, the original shares issued on your CAC won’t change. If a founder was issued 100 shares on the CAC, and the total amount of shares of the company was 1,000, the founder owns 10% of the company (100 divided by 1,000 is 10%).
One day you’ll add on shares to bring the total amount of shares to 10,000 — but on the CAC, the founders’ shares are still at 100 shares. The cake pie got bigger, but the founder’s cake slice stayed the same. They went from owning 10% to 1% (100 divided by 10,000 is 1%). The founder’s ownership percentage got diluted from 10% to 1%.
It’s important always to understand share calculations and mechanics (there are some simple ones to know, we promise). If you don’t, you’re at risk of being diluted without knowing it.
We’re repeating that sentence to be clear: if you don’t understand share calculations and mechanics — you could be slowly losing ownership of your startup without even knowing it.
Rights and classes
Shares are divided into classes. There are two common types of shares: (1) common; and (2) preferred. Those classes can also be divided into series (e.g. Series A, B and C preferred shares).
Common shares are the base layer of a cake. They form the foundation on which we add ingredients like rights, preferential calculations and convertibles. They’re what you’ll issue when you first incorporate the company — and are usually held by founders. These are the most important kinds of shares for the company, as they’ll determine the share price and value of the company. They come with some basic rights like voting and participating in meetings. Think of common shares as your company’s foundational share class.
Preferred shares are like the ingredients for a cake. These are share classes that give special (or preferred) rights to investors. These are much more complicated types of shares that come with a lot of complex mechanics, rights and voting powers. It’s always important to consult legal professionals whenever you’re creating or selling preferred shares.
The rights that stakeholders get in a company are determined by the type and amount of shares they hold. You may have guessed it already, but preferred shareholders (held by professional investors and venture capital firms) will hold substantial rights like voting and board seats. This means that when you’re selling preferred shares — you are not only diluting existing stakeholders — but you could be in control of the sale of the company.
As usual, there’s a lot to unpack here, and we’ll break down those aspects in future posts.
Until next time! #keepbuilding
DISCLOSURE: This communication is on behalf of Raise Impact Technologies Inc. (“Raise”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Raise does not assume any liability for reliance on the information provided herein.