Authorized vs. Outstanding Shares

Monday, January 19, 2009 at 11:42AM

This next question deals with the issue of terminology when it comes to shareholder ownership. There are probably a number of questions that can be addressed here, and I won’t try to hit everything in a single post. This deals with Authorized vs. Outstanding shares, but there are also terms such as full-diluted shares, qualified stock options, non-qualified stock options, warrants, and who knows what else. Most knowledge about these things I’ve accumulated simply by dealing with them, and it’s an area of business where it can seem overwhelming to someone who has not done it before. Don’t worry, it’s not. As you learn the terms, everything will make sense. That said, on with the question.

In January 2007, I started an Corporation. When filing the Articles of Incorporation, the number of (common class) shares authorized were 10,000. I issued to myself (purchased) 1,000 shares at $1 per share.

The question is, if I now wish to give a new partner 5% shareholding in my company, how many shares must I issue? I assume it is roughly 52.63 (or 53) shares, so that would mean:

Total Shares will be 1,053 shares (100%)

I will retain 1,000 shares (approx. 95%)

My new partner will get 53 shares (approx. 5%)

Is that correct? (The number of Authorized Shares — 10,000 — when the company was formed is what is confusing to me, but I’m assuming that does not play a role in my above question of wanting to give someone 5% shareholding in my Corp.)

Thank you in advance for your time!

Yes, you are correct in you calculation. The outstanding shares in this case, will be 1,053 — and that is the only number that matters at this stage of the game. If someone were to come along and buy the company, for example, the number of outstanding shares is what would be used to calculate who gets what.

The authorized shares you refer to is really an unimportant number for most small businesses and early stage startups. The authorized shares are simply the number of shares that the shareholders have authorized the board of directors to hand out through the course of business, and it’s a number that exists to protect shareholders from a board of directors that suddenly decides to give itself 10 billion shares and dilute everyone else to near 0% ownership.

In a public company, this number matters, for the above reason. If the company were to approach having an outstanding number of shares equal to the authorized shares, then the shareholders would need to vote on expanding the number of authorized shares before the board could hand out any more.

For most small companies, the shareholders, the board, and the management are close to or exactly one in the same. If you need more shares, your lawyers would have you sign a simple document that authorizes the increase and that’s about it.

However, I will provide a bit of unasked-for advice to deal with your particular scenario. I would advice against handing out 5% of the company to a new employee. Instead, consider using stock options which vest over time. This way, if things dont’ work out, a dud employee won’t walk off with 5% of the company. The other way to deal with this is with a restricted stock grant, as I’ve described in my posts dealing with founder’s shares .

Also, be aware that handing out stock (or issuing stock options below market value) will trigger tax consequences. If you give stock away, and the IRS determines that your company is really worth $1000 a share, then your new employee has to tread the value of the stock they received as income, and pay income tax accordingly. Stock options, used properly, can avoid this problem. There are pluses and minuses (tax wise) to using options, but it’s important that you don’t end up shafting your employee by increasing their income taxes inadvertently.

I’m happy to answer follow-up questions about options if you have them. However, suffice it to say that you should probably talk to a knowledgeable attorney about how best to provide ownership to your new employee, in order to protect both of you from business and tax risks.