It’s not often that you hear entrepreneurs tell the truth about what it takes to get a startup rolling, especially about the nitty-gritty details of how to authorize shares of stock.

In this article, we’re taking away the mystery of share distribution.

If you’ve already decided to set up a C corporation and learned about initial valuation, the next step is to figure out how to split shares of the company fairly amongst stakeholders — and wrestle with the math behind those decisions.

Determining how many shares to offer your stakeholders

Allocating quantities of shares to founders can get tricky when you aren’t yet certain of the real value of your business.

There’s no right answer to the question of how many shares you should grant to each person because the quantity only changes their perception of ownership, not the actual value. A founder’s share percentage will stay the same regardless of share quantity.

Think about the math: 50,000 shares at $0.50 per share is the same as 500,000 shares at $0.05 per share. Both amount to $25,000.

Still, each recipient is likely to perceive those quantities differently. It’s human nature: 500,000 sounds more significant — even when we know it isn’t.

Because the number you settle on is based on the nominal value of your stock, it’s wise to set the share price at an appropriate range for your company’s stage of growth during the valuation process.

Also, keep in mind that in states like Delaware, franchise taxes are determined by the number of authorized shares, meaning that the number of shares you decide to start with will also carry tax implications. 

Stock ownership can be difficult to understand for those who have never owned stock before, so part of your job is to educate your team about what they’re receiving.

Enticing investors with preferred stock over common stock

Typically, about 80% of a startup’s shares will be considered common stock and split amongst founders. That leaves you with about 20% of your company’s total shares remaining — which may not feel like enough to split amongst potential investors.

How can you offer incentives to early-stage advisors and investors if you don’t have much equity left?

The answer: offer preferred stock.

The shares you’re distributing amongst founders will be common stock, your employees will probably hold restricted stock (i.e., options which can be converted into common stock), and investors can be incentivized with preferred stock.

When an investor owns preferred shares, they have first dibs on the money your company makes upon cashing out. After that, the remaining profits are split amongst those holding common stock.

The caveat associated with preferred stock

While this preferential treatment is attractive to potential investors who might otherwise be hesitant to fund a startup, it’s important to be aware that you could create a preferred overhang by offering this type of share. 

An overhang is what results when the amount your investors could claim in a cashout exceeds the amount the company is worth. In other words, they could scoop up all the earnings and leave your common stockholders with nothing.

Still, anyone who’s pouring millions into an early-stage company will want the assurance of owning preferred shares, and their backing is essential. 

The key is to educate yourself about the share authorization process and ensure that you take advice from people who understand the different kinds of stock and what they’ll mean for your business in the long run.

This article is based on an episode of the WTFAQ Podcast.