WHAT IS STOCK?
I was speaking to an entrepreneur in the energy tech industry the other day. He was struggling with understanding some matters that were negatively affecting his project. This was not his first rodeo. He had done a number of other business enterprises but was stuck on an issue.
The problem was that he didn't understand the fundamentals of corporate structures. It wasn't his fault really. No one properly explained to him the very fundamental things. Additionally, people overlook the basics because: the basics are easy to overlook, people think they're too good to spend time learning about the fundamentals, and people disregard it as being simple bullshit. Basically it's what I always talk about: people being complacent.
The basics DO matter. Have a solid foundational understanding of what you're doing. Sure, you can do advanced mathematics at some point down the line, but it all goes a lot more smoothly if you create a rock solid foundation of basic arithmetic.
So this is a basic article on what is stock. Read it. Understand it.
TABLE OF CONTENTS
I. Different types of companies
a. LLCs
b. C-Corps
c. Other
II. Types of C-Corp Stock
a. Common and Preferred Stock
III. Stock Ownership and Vesting
IV. Takeaways
ARTICLE
I. Different types of companies
A company can be created officially with the state as either an LLC or a C-Corp.
I already mentioned to form a C-Corp. But you may also hear of LLCs. The differences primarily concern: 1. how they define ownership of the company and 2. how they're taxed. Quick explanation as to the differences.
a. LLCs
(i) Ownership
LLCs do not have stock or shares.
LLC ownership is divided into units called member interests. These are flexible and can be defined in a variety of ways according to certain agreements. Some types of interests have special voting rights. Some don't. It all depends on how corporate law and corporate documents define the terms. This flexibility can oddly enough make LLCs more complicated than C-Corps.
You'll often see ownership in an LLC expressed in terms of percentage. So one person might be a 50% percent owner, another 25%, and another 25%.
(ii) Tax
LLCs are pass-through entities. This means that tax consequences of the company "pass through" the company to the individuals that own the business. Profits and losses of the business are reflected on the individual's tax return.
b. C-Corps
(i) Ownership
C-Corp ownership is divided into stock (or shares.)
How many shares of stock comprise a C-Corp? It all depends on however many the company wants to have. It details this information in the official charter it files with the state government. A company can have 10 shares representing 100% of the company or 500 shares representing 100% or 10,000,000 shares representing 100%--pretty much whatever it wants. It's customizable and it all depends on what the founders want to do when creating the company.
(ii) Tax
C-Corps have two layers of tax. Profits of the corporation as well as the dividend (distributions) made to the owners are taxed.
Note: you may have also heard of an S-Corp. An S-Corp is not a type of entity. It is a tax classification. Understand that. It's a subtle difference. People confuse that all of the time. An LLC or a C-Corp can decide to be taxed in different ways including as an S-Corp. In some situations, an S-Corp structure can help save on certain types of taxes.
c. Other types of Corporate/Business Entities in Texas and other areas
Generally speaking, there are also other types of company structures such as B-corps, L3Cs, series LLCs, etc. that don't get used much (i.e. less than 1% of the time.) If you don't know what these are, don't waste your time on them. Lots of states have a bit of an arms race to try to attract businesses to form in their state and thus allow for these kinds of specialized entities. Texas is one of those states that allow for some of these more unusual business entity types as Texas is favorable to businesses. If you need help, email me.
II. Types of C-Corp Stock
One C-Corp can have many different types of stock. This is possible if you think about what it means to own something. You might own some real estate. But what that really means is that you own a "bundle of rights." You have the right to sell the real estate. You have the right to allow visitors to come to the property. But do you have the right to stick dynamite all over it and blow it up? Or to pile trash 10,000 feet in the air on it? Maybe. Maybe not.
So owning a share of stock is like owning a bundle of rights. For example, you have the right to the property of the business if the business is terminated or liquidated.
a. Common and Preferred Stock
The company will also detail the different types of stock that the company has.
If you think of owning a share of stock as owning certain rights, then you can understand why there are different types of stock such as common stock and preferred stock. They are all ownership units of the company, but different types of stock have different rights (e.g., such as the capability of voting on certain matters of the company or receiving dividends.) State laws and the internal rules of the business determine what kinds of rights the shares have.
Common stock is the basic ownership unit of the company. They come with certain voting rights and are last to be paid if the company gets liquidated. If there is a liquidation, debt-holders (those who loaned money to the company), preferred shareholders, and others get paid before common share holders. Founders, employees, consultants receive common stock.
Preferred stock has priority over common stock in the event of liquidation (but they will not be paid before debt-holders.) They can also have better voting and veto rights. Investors receive preferred stock.
Preferred stock can generally convert into common stock at any time at a particular, defined ratio.
III. Stock Ownership and Vesting
The owners of the company-to-be will receive stock of the company. The initial owners are going to be the founders of the company.
I stress that it's important that stock is set to a vesting schedule. You're going to see this vesting concept discussed time and time again. This is because it's critical in the formation of a company and critical at other times.
Vesting is a system designed to give you ownership of something over time instead of outright. Vested stock means that it's yours outright. Unvested means the stock can be repurchased by the company from you if you choose to leave. The stock will vest over a few years time (called a vesting schedule) and you need to be working with the company for those few years in order to own all of your stock. The typical vesting schedule calls for all stock to be vested over the course of 4 years. After those 4 years, you can leave the company--do whatever--and still keep your stock. As a startup lawyer in Texas, I've seen lots of different kinds of vesting schedules but 4 years is normal.
Vesting is important. You do not want a situation where a founder quits, moves far away, and leaves with half of the company within a month of forming the company.
I've seen it happen.
There are acceleration clauses in agreements that allow for the vesting schedule to accelerate and have shares vested more quickly on the happening on certain events.
IV. Takeaways on 'What is Stock'
- LLCs do not have stock. They have member interests. C-Corps have stock.
- LLC member interests are more complex to understand than C-Corp stock. Form a C-Corp for your startup. It will be better for raising capital and for employee compensation purposes.
- Keep on eye on how terms are being defined
- Watch out who is getting which kind of stock. Preferred is better than common. Founders, employees, consultants of the company receive common stock. Investors receive preferred stock.
- A vesting schedule allows for slow outright ownership of stock. It's a good way to protect from partners that want to scram.