editione2.1.1
Updated September 12, 2022In this section, we describe the basics of how stock and shares are used.
Those familiar with stock, stock corporations, public companies, and private companies can jump ahead to how those companies grant equity.
βDefinitionβ A company is a legal entity formed under corporate law for the purpose of conducting trade. In the United States, specific rules and regulations govern several kinds of business entities. Federal and state law have significant implications on liability and taxation for each kind of company. Notable types of companies include sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, and C corporations.
βDefinitionβ A corporation is a company that is legally recognized as an entity separate from its owners. The corporation itself, and not its owners, is obligated to repay debts and accountable under contracts and legal actions (that is, is a βlegal personβ). Most commonly, the term corporation is used to refer to a stock corporation (or joint-stock company), which is a corporation where ownership is managed using stock. Non-stock corporations that do not issue stock exist as well, the most common being nonprofit organizations. (A few less common for-profit non-stock corporations also exist.)
In practice, people often use the word company to mean corporation.
βDefinitionβ Incorporation is the legal process of forming (or incorporating) a new corporation, such as a business or nonprofit. Corporations can be created in any country. In the United States, incorporation is handled by state law, and involves filing articles of incorporation and a variety of other required information with the Secretary of State. (Note that the formation of companies that are not corporations, such as partnerships or LLCs, is not the same as incorporation.)
βDefinitionβ A C corporation (or C corp) is a type of stock corporation in the United States with certain federal tax treatment. It is the most prevalent kind of corporation.* Most large, well-known American companies are C corporations. C corporations differ from S corporations and other business entities in several ways, including how income is taxed and who may own stock. C corporations have no limit on the number of shareholders allowed to own part of the company. They also allow other corporations, as well as partnerships, trusts, and other businesses, to own stock.
C corps are overwhelmingly popular for early-stage private companies looking to sell part of their business in exchange for investment from individuals and organizations like venture capital firms (which are often partnerships), and for established public companies selling large numbers of stock to individuals and other companies on the public exchange.
In practice, for a few reasons, these companies are usually formed in Delaware, so legalities of all this are defined in Delaware law.** You can think of Delaware law as the primary βlanguageβ of U.S. corporate law. Incorporating a company in Delaware has evolved into a national standard for high-growth companies, regardless of where they are physically located.
βcautionβ This Guide focuses specifically on C corporations and does not cover how equity compensation works in LLCs, S corporations, partnerships, or sole proprietorships. Both equity and compensation are handled in significantly different ways in each of these kinds of businesses.
Loosely, one way to think about companies is that they are simply a set of contracts, negotiated over time between the people who own and operate the company, and which are enforced by the government, that aligns the interests of everyone involved in creating things customers are willing to pay for. Key to these contracts is a way to precisely track ownership of the company; issuing stock is how companies often choose to do this.
βDefinitionβ Stock is a legal invention that represents ownership in a company. Shares are portions of stock that allow a company to grant ownership to a variety of people or other companies in flexible ways. Each shareholder (or stockholder), as these owners are called, holds a specific number of shares. Founders, investors, employees, board members, contractors, advisors, and other companies, like law firms, can all be shareholders.
βDefinitionβ Stock ownership is often formalized on stock certificates, which are fancy pieces of paper that prove who owns the stock.
Sometimes you have stock but donβt have the physical certificate, as it may be held for you at a law office.
Some companies now manage their ownership through online services called ownership management platforms, such as Carta. If the company you work for uses an ownership management platform, you will be able to view your stock certificates and stock values online.
Younger companies may also choose to keep their stock uncertificated, which means your sole evidence of ownership is your contracts with the company, and your spot on the companyβs cap table, without having a separate certificate for it.
Later, we discuss several subtleties in how shares are counted.
βDefinitionβ Public companies are corporations in which any member of the public can own stock. People can buy and sell the stock for cash on public stock exchanges. The value of a companyβs shares is the value displayed in the stock market reports, so shareholders know how much their stock is worth.
βDefinitionβ Most smaller companies, including all startups, are private companies with owners who control how those companies operate. Unlike a public company, where anyone is able to buy and sell stock, owners of a private company control who is able to buy and sell stock. There may be few or no transactions, or they may not be publicly known.
βDefinitionβ A corporation has a board of directors, a group of people whose legal obligation is to oversee the company and ensure it serves the best interests of the shareholders. Public companies are legally obligated to have a board of directors, while private companies often elect to have one. The board typically consists of inside directors, such as the CEO, one or two founders, or executives employed by the company, and outside directors, who are not involved in the day-to-day workings of the company. These board members are elected individuals who have legal, corporate governance rights and duties when it comes to voting on key company decisions. A board member is said to have a board seat at the company.
Boards of directors range from 3 to 31 members, with an average size of 9; for private companies the typical board size is typically between 3 and 7 directors.* Boards are almost always an odd number in order to avoid tie votes. Itβs worth noting that the state of California requires public companies to have at least one woman on their boards.*
Key decisions of the board are made formally in board meetings or in writing (called written consent).* Equity grants have to be by the board of directors.*
βDefinitionβ A private company becomes a public company in a process called an initial public offering (IPO). Historically, only private companies with a strong track record of years of growth have considered themselves ready to take this significant step. The IPO has pros and cons that include exchanging a host of high regulatory costs for the benefits of significant capital. After a company βIPOsβ or βgoes public,β investors and the general public can buy stock, and existing shareholders can sell their stock far more easily than when the company was private.
Companies take years to IPO after being formed. The median time between a companyβs founding and its IPO has been increasing. According to a Harvard report, companies that went public in 2016 took 7.7 years to do so, compared to 3.1 years for companies that went public in 1996.*
βdangerβ With private companies, it can be very hard to know the value of equity. Because the value of private company stock is not determined by regular trades on public markets, shareholders can only make educated guesses about the likely future value, at a time when they will be able to sell stock.
After all, private company stock is simply a legal agreement that entitles you to something of highly uncertain value, and could well be worthless in the future, or highly valuable, depending on the fate of the company.
βconfusionβ Weβll discuss the notion of a company officially assigning a fair market value later, but even if a company gives you a value for your stock for tax and accounting purposes, it doesnβt mean you can expect to sell it for that value!
βDefinitionβ An acquisition is the purchase of more than 50% of the shares of one company (the acquired company) by another company (the purchaser). This is also called a sale of the acquired company. In an acquisition, the acquired company cedes control to the purchaser.
βDefinitionβ The ability to buy and sell stock is called liquidity. In startups and many private companies, it is often hard to sell stock until the company is sold or goes public, so there is little or no liquidity for shareholders until those events occur. Thus, sales and IPOs are called both exits and liquidity events. Sales, dissolutions, and bankruptcy are all called liquidations.
Often people wish they could sell stock in a private company, because they would prefer having the cash. This is only possible occasionally. We get into the details later, in our section on selling private stock.
βDefinitionβ A dividend is a distribution of a companyβs profit to shareholders, authorized by the board of directors. Established public companies and some private companies pay dividends, but this is rare among startups and companies focused on rapid growth, since they often wish to re-invest their profits into expanding the business, rather than paying that money back to shareholders. Amazon, for example, has never paid dividends.
If youβre considering working for a startup, what we cover next on how these early-stage companies raise money and grow is helpful in understanding what your equity may be worth.
If youβre only concerned with large and established companies, you can skip ahead to how equity is granted.