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I've been researching for over a year now as an aspiring entrepreneur, but I am still fuzzy on how equity gets distributed at every stage of company growth.

Is a set amount of "shares" created upon inception of the company? Or is it just a mutually agreed understanding that each founder "owns" a portion of the company and will get shares accordingly in the future? When shares are created, is there some standard number that most companies start with (e.g. 1,000,000 shares?)

Let's use an example of a small company with 3 founders. For ease of explanation, each founder agrees to split equity equally 33%-33%-33% upon creation of the company. So what happens next at the seed stage when a family member gives the founders 25k? How is it redistributed for a round of VC investment? How are founders compensated for releasing their own equity to make room for investors?

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One of the things you will have to establish early on is what you want to do about dilution. This refers to what happens when the pie gets bigger - that is, you each own 1/3 of the pie, but suddenly each of you owns a smaller percentage of a larger pie.

Say, for example, that you each own 33% of the company. You have determined, prior to the investor putting in $25,000, that you feel the company is worth about $100,000, and the investor agrees. Thus, he will put in $25,000, and get 25% of the company. However, without dilution, this would mean that you and your co-owners will need to give up percentages totaling 25% of the company.

Let's try this in real numbers:

You create 30,000 shares of stock, and each own 10,000. In order for the investor to own 25% of the shares, either you would each need to give up 25% of your shares (leaving you with 7,500 shares each, and the investor with the same), or you would need to create 10,000 more shares to give to the investor. This would dilute your shares, so that the same number (10,000) went from 33% of the total to 25%.

I hope this makes sense and is helpful. :)

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Yes this clarifies a lot of what was escaping me. Thank you for your insight on dilution. ~Joe – Joe Oct 23 '09 at 5:09
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It's quite simple. This is an example in CA, but probably not very different in other states. When I incorporated my company, the articles of incorporation said that the total number of shares that the company is authorized to issue is 5M.

We then divided 1.5M shares between the founders. Note that you can't just give the founders stock, it needs to be in exchange for something, including work. So in your case, you can give each founder 500,000 shares in exchange for doing X amount of work.

Now let's say an investor comes in and invests, 25k. You don't make the founders give any stock back. You just allocate more stock. It's up to you and the investor to decide how much to allocate, just remember to make it clear if you're talking about a % pre or post investment. In other words, giving the investor 150k shares in the above case is 10% pre (out of 1.5M) but 9.09% post (out of 1.65M).

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All this really depends on how you set things up.

Each state will be slightly different, but generally speaking, comanies established as C-corps will have issue a certain number (1,000.... 100,000, no set number) to the investors. Partnerships and LLC are done through a percent of interest/ownership (such as in a partnership or LLC). It will most certainly be easy for you to set things up as the latter; LLC are by far the easist when getting started.

In regards to the investment, if you handle it as a loan, it's pretty straight forward: the company is obligated to pay back $25K over 5 years with 8% interest, with each founder personally guaranteeing the loan.

If your investor expects interest in the company (I would... especially if I'm the only one putting in 25K), then the existing owners will need to agree on what percentage they will each give up. Unless it's a close friend, it will cost you a lot. VC funding will cost you even more.

This is something you should really get a lawyer involved with, especially if you are considering high-percentage equity splits (33%-33%-34%). If you end up being successful, not having an understanding of what's required and expeced ("corporate bylaws") then it can get very, very messy.

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