Corporate Shares

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Percentage of Ownership Issues

The amount of contributed capital that was added with the last five shares was trivial. It might be a different situation if someone else were contributing even more capital per share or if some partnership with another company involved giving a percentage ownership of the company but acquiring some competitive advantage or strategic partnership in the process. In those cases, the investor's percentage ownership in the company would have also been diluted, but in a positive way. Founders and investors alike all wind up with a smaller slice of a bigger pie. But, as it stands, the investor would have the right to be miffed. The general rule is that when dilution occurs, the overall value of the company should be increasing at least enough to offset the effects of dilution.

It becomes clear that if a corporation is formed before investor capital will be raised, planning ahead is important to be sure the original founders will be positioned with an adequate slice of the overall equity without needing to try to make inappropriate equity 'adjustments' later.

Avoid Legal Pitfalls

As we've witnessed with the Enron collapse, corporate insiders are always closer to the corporate checkbook and the internal decision-making process than investors. Consequently, the government works to protect the rights of investors. Once you have investors, you're subject to all security laws. You really want an attorney experienced in securities law to help with the structuring of the deal. That can help prevent misunderstandings and legal problems down the road.

Exchanging Property for Stock

The same issue can occur with exchanges of property for stock. I think it's always best when physical assets are transferred to a company in exchange for stock that two conditions be met.

• The assets are really necessary to the corporation.
• The assets are transferred at their fair market value.

Following these guidelines helps prevent the above sort of a problem where some investors feel their ownership was diluted unfairly.

Internet Legal Resources Guide has a simple Assignment of Assets form that can be used to document an exchange of non-cash assets for stock.

Given this article's example of transferring shares on the cheap side and the dilution of investor equity, and given the imprecision in valuing non-cash assets, it's easy to understand why the transfer of non-cash assets to a corporation when there are multiple founders or investors can be problematic.

When there are multiple parties involved in forming a corporation, it's important for all parties to discuss and agree upon how the initial equity is being divided and what cash and other non-cash assets are being contributed to the company in exchange for the equity. Intellectual capital, such as a trademark or a patent, may also be exchanged for stock. And stock can be an incentive to lure talented people to your company.

If you're the only founder and investor, there shouldn't be a problem with an exchange of assets for stock. For example, when many sole proprietors decide they want to form corporations, business assets are transferred to the corporation in exchange for corporate stock. You might want to discuss the transfer of assets for corporate stock with a tax attorney to be sure you are maximizing your total future tax savings. Usually, the transfer of assets in exchange for stock is a non-taxable event.

The Internal Revenue Service has more information about the conditions when the transfer of assets in exchange for stock might be taxable.

Please note I'm neither an attorney nor an accountant and am not rendering legal or accounting advice. I'm just presenting my own personal understanding of how equity distribution works within a small corporation. I highly recommend consulting an attorney experienced in corporate law to help you plan your corporation's distribution of equity, especially if you seek investors or are teaming up with other entrepreneurs.

Corporate Resources

Below are some links that might help you learn more about corporations, stock, and equity:

• Business Structure (from thinkinglike.com)
• The Essential Corporate Handbook
• Findlaw.com's Business Structure section
• Maintaining control when you issue stock
• Paying The Founding Piper
• Setting up a C-Corporation

For more about issued and outstanding versus authorized shares, go to this Dividing the [Equity] Pie article and this MIT article.

Peter Hupalo

Author of Thinking Like an Entrepreneur

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