Schedule a Consultation: 858.483.9200
San Diego Startups: Structuring Corporate Stock to Satisfy Investors and Owners (Part III)
If you are in the process of starting a new San Diego business, consider issuing different classes of stock — voting vs. economic — as a vehicle for enticing investors without losing control of your new business. In other words, there are ways to use the corporate stock structure to satisfy the needs of investors and owners. We discussed this with respect to Facebook in an earlier article.
We also raised some of these concerns in an article discussing whether an investor can “take over” your business. In general, the answer is “no” — an investor cannot “take over” your new business unless there is an agreement. In this article, we discuss using corporate structure to help satisfy the divergent needs/desires of owners vs. investors for startups.
What is to be understood is that an owner of a business has a different set of concerns from an investor. Yes, an owner wants to make money, but an owner also wants to run and control the business. This is about career, livelihood, status, and personal/family growth. Owners do not want their control diluted by investors or others who may not have the same stake in the success of the enterprise. By contrast, an investor is often only interested in the rate of return on his, her or its investment; any desire for control is related to the need to recoup the investment. In general, an investor is in the business of making money from investing, not in the business of operating a business. This is about divisions of labor and differences in experience and expertise.
San Diego Corporate Law: Common Stock vs. Preferred Stock Classes
As discussed in the earlier articles, often an investor seeks the return on investment through contract. Contracts are well and good, of course, but any breach of the investment contract requires litigation. Litigation is expensive and time-consuming and there is no guarantee that the investment is fully recouped even if the litigation is successful.
Just as often, the corporation can be structured to provide the investor with a more secure means of recouping the investment through voting and non-voting classes of stock. In a simple example, assume the corporation established two classes of stock, “common” and “preferred.” Common stock can be defined as voting shares that are entitled to lump sum payments (“dividends”) that are declared by the board of directors. By contrast, preferred stock can be structured with no voting rights, but given the right to annual set lump sum payments (dividends) regardless of whether the business has profits that year.
With two classes of stock, the owner can maintain control over the common shares while giving a majority of preferred stock to the investors. Structured in this manner, the owners keep control of the corporation.
San Diego Corporate Law: Process For Establishing Classes of Stock
Often, preferred shares are created later in the life-cycle of the corporation. But, multiple classes of stock may be authorized at the point of formation in the original articles of incorporation filed with the California Secretary of State. If only one class — common stock, for example — is issued at the beginning, later, the board of directors can resolve to issue — with the approval of the shareholders — a second class of stock. As can be seen, it is relatively easy to create more than one class of stock serving different goals.
The main reasons for creating multiple classes of stock at the formation stage is ease, lack of disagreement, and absence of any concern for fiduciary duties. At later stages, the board of directors and the shareholders have to weigh any issues with respect to self-dealing, corporate opportunities, and other fiduciary duties, particularly if there is a set of minority shareholders opposed to creating the new class of shares. The board and majority shareholders must provide sufficient justification for the new class/structure. Those duties do not prevent creation and issuance of the new class; rather more time and thoughtful consideration is needed to avoid litigation.
San Diego Corporate Law: Useful for Issuing Stock to Family and Employees
Note that having two classes of stock is useful not only for investors, but also for issuing stock to family, employees, and others. This is another reason to consider multiple classes of stock when the corporation is formed. Issuing shares to family members can be a mechanism for estate planning. Issuing shares to employees can be a mechanism for incentivizing and/or rewarding hard work and loyalty. At the same time, the owners may be reluctant to give family members and employees part control of the company. Thus, issuing preferred shares accomplished the “reward” aspect without sacrificing control.
Contact San Diego Corporate Law Today
If you would like more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email. Mr. Leonard has been named a “Rising Star” four years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal. Mr. Leonard’s law practice is focused on business, transactional, and corporate matters, and he proudly serves business owners in San Diego and the surrounding communities. Like us on Facebook too.
You Might Also Like:
Time to Incorporate and Start Your San Diego Businesses
FAQs About Forming a California Corporation
California Startups Must Disclose Financial Information to Shareholders
