Companies organized as corporations grant stock to shareholders of the company. The reason for a stock grant generally involves raising capital or preserving capital. The first reason for a stock grant is to form the company. The company will grant stock to the founders of the company in exchange for services to the company or capital contributed.
The company may continue this trend by a stock grant to later employees. The company wishes to preserve capital by compensating the employee with company stock. The double benefit of this approach is that it incentivizes the employee. The employee now has a vested interest in the success of the company. The value of her stock will rise or the company will declare greater dividends if the company performs well. In theory, this should incentive the employee to perform her job better and to encourage other employees to perform at a higher level.
The company may grant stock at various times throughout its growth or lifecycle to raise additional capital. That is, the company will provide stock to outside investors in exchange for their investment of capital. At some point, the company may wish to undergo a public offering or IPO. During an IPO, the company sells a specific quantity of shares to major investors. The shares are then listed and sold openly on public exchanges. This IPO is known as an initial public offering.
Types of Stock or Stock Equivalents
There are numerous forms of equity or stock and shares that a company might issue. These include common stock, preferred stock, stock options, restricted stock units, and stock appreciation rights. For purposes of this article, we explain the characteristics of the two types of company stock and shares.
- Common Stock – The basic or common form of ownership of a corporation is common stock. If a company issues a single class of shares, it is generally common shares. Common stock provides rights as defined by state law or the companies governing documents. Generally, common stock or common shares allows a shareholder a single vote per share for matters submitted to shareholders for approval.
- Preferred Stock – Preferred stock and preferred shares, as the name implies, gives preferential treatment or status to the preferred shareholder above the common shareholder. Preferred shareholders receive rights specified in the companies governing documents or the preferred stock grant. Common rights of preferred shareholders include: dividend rights, liquidation preference, conversion rights, redemption rights, preemption rights, information rights, voting rights, registration rights, etc.
The Process for Granting Stock
A company must undertake several steps in order to grant stock. The primary steps are as follows:
- Board Approval – The board of directors must approve any issuance or stock grant. The bylaws will generally lay out the number or percentage of shareholders who must approve a stock grant. In some case, the bylaws may allow existing shareholders the right to vote on the issuance of stock, but this is only in very closely-held companies.
- Authorization – A company must authorize stock before it can issue shares. The company authorizes stock through the articles of incorporation. When the company was originally incorporated, it was required to state the number of authorized shares and the par value of those shares. If the company wishes to issue shares that are not currently authorized, it must amend the articles of incorporation to authorize the type and number of additional shares to be issued.
- Stock Purchase/Grant Agreement – As previously discussed, the company will either issue stock to raise money or to compensate employees. Stock issued to raise money is done through a stock purchase agreement. The investor agrees to provide value to the company in exchange for the stock. If shares are issued to employees, this is done through a stock grant. The stock grant agreement is generally an additional agreement accompanying an employment agreement.
- Securities Compliance – If stock is being offered for sale to outside investors (not current employees or owners of the company), federal and state securities laws apply. The company is obligated to either register the shares, the issuance, or perfect an exemption from registration. The board must approve any registration or exemption.
- 409A Valuation – A company granting stock to an employee is providing compensation to the employee. As such, the company must know the fair market value of the stock at the time of grant. This is known as a “409A valuation” as a reference to the relative tax provision. The 409A valuation must take place annual and if there is any major financing event.
- Capitalization Table – The capitalization table (or “cap table”) is the table containing the percentage of company ownership held by shareholders. It will account for all of the classes of equity and shareholders. It will indicate the number and percentage of shares held. The capitalization table is generally part of the company’s bylaws as an attached schedule.
Characteristics of Common Stock Granted to Investors
The first investors to receive common shares are the founders of the company. The number of shares issued to each founder reflects the intended ownership percentage. Later investors rarely receive common shares. Instead, they receive preferred shares with specified rights. One common right (or sometimes obligation) of preferred shareholders is the ability or duty to convert their preferred shares into common shares. The rights or obligations of the preferred shareholder are spelled out in the company governance documents or the stock purchase agreement.
Characteristics of Common Stock Granted to Employees
The stock grant to employees is generally subject to various restrictions. Restricted stock generally cannot be sold for a specified period of time after receipt. Also, these common shares are generally subject to a vesting schedule. This means that the shareholder is the record owner at the time of receipt; however, she does not acquire actual ownership of the stock until a specified time in the future. Generally, the company will make a certain percentage of the issued stock vest in the shareholder at the 12-month mark. Afterward, the shares vest evenly over time. Most vesting schedules last for 3-4 years. The reason for restricting the shares and providing for a vesting period is to incentivize loyalty to the company. If the shareholder leaves before the shares are vested, she generally forfeits her ownership rights. Most shareholders negotiate accelerated vesting rights in the event the company is sold or she is fired without cause.
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