Dec 6 2006 by Jason

What is a Typical Capital Structure Like?

(We got two questions that were similar)

Question 1: Is it normal to have the founders to have Class A shares, angel investors to have Class B shares, and a Class C pool for employee options. Liquidation preferences have classes B and C funding concurrently, with class A funding last?

Question 2: Is there any reason to issue a new class of company stock when creating an employee pool if the liquidation preference and voting terms are the same as an existing class?

Our Take: Neither of these structures is typical in a VC-backed company. Generally, founders and employees own common stock of the company and VCs (and sometimes angel investors) hold preferred stock. If the company has multiple rounds of financing, assume that each round will be a separate class of preferred stock.

In the first question scenario, the employee option pools would be paid ahead of founders. Regardless if the founders also own employee stock, we’ve never seen this structure.

The second question scenario makes us ask “why?” If the preferences and voting are the same, why go through the issue of creating a separate class? In some states, regardless of what the voting provisions of the company charter say, each separate class of stock gets voting rights for certain transactions.

Now, there is an exception – and it’s an important one. If there is only one class of stock and both employee options and investors hold the same class of equity, one can run very afoul of option pricing mechanics. The options will need to be priced at the valuation paid by investors, which is suboptimal for incentivizing employees. For this reason, we always make sure that investors purchase a separate class of stock apart form the class used for employee options.