This questions comes up frequently, and is a simple misunderstanding that is easy to clear up.  It primarily pertains to corporations, but can apply to LLCs as well depending on how they are set up.

Rule #1: Your percentage ownership in a company is not based on the number of shares that are authorized.  It is based on the number of shares that are issued.  Corporations always issue ownership in terms of “shares” and the Articles of Incorporation set a maximum on the number of shares the company can “issue” and we call this the number of “authorized” shares.  The company can issue fewer than this number.  But it can’t issue more.  Your percentage ownership of the company is based on the number of issued shares, not the number of authorized shares.  For example, a company may be authorized to issue 100,000 shares.  But right now, there is one shareholder who only holds 20,000 shares.  Even though more shares could be issued, so far this one owner holds all of the issued shares, and she owns 100% of the company.  If you are then issued 20,000 shares you own 50% of the company.  Why?  Because you have the same number of shares as the original shareholder.  The fact that there are more shares authorized doesn’t mean anything until those “available” shares are actually issued to someone.  For now, you hold 50% of the company because each of you owns 20,000 shares.  Your percentage is calculated by dividing the number of shares you hold (20,000) by the total number of shares everyone holds, including you (40,000 total).

Rule #2: Watch out for “dilution”.  In the example above, it’s true that you own 50% of the company right now.  So if that’s the case, then why bother setting a specific number of “authorized” shares if that number doesn’t actually affect the percentage of the company that I own?  The reason is that there may be more shareholders coming in the future.  If the company eventually issues the full 100,000 it has authority to issue, your same 20,000 shares you’ve always held are now only 20% of the company.  This is because your 20,000 didn’t change, but the number of total issued shares (including yours) has risen to 100,000 total.  So the number of authorized shares is very important.  It tells you how much your ownership can be “diluted” if the company issues that maximum number of shares.  When buying your 20,000 shares, if staying at 50% is important to you, you need to enter into an agreement with the other shareholder that the company will not issue more shares.

Rule #3: Five-percent isn’t as simple as it looks.  Consider business owner “Steve” who runs a software company, and he’s always been the only shareholder.  Steve holds 1,000 shares in his company.  He has a great employee, Alex, and wants to give him 5% of the company.  Simple, right?  5% of 1,000 is 50 shares.  But this is not correct.  Steve wants to keep his whole 1,000 shares.  If he issued 50 shares to Alex, and reduced his own shares to 950 then the percentage would be right, and Alex would have 5% of the company.  But this would technically be a sale of shares by Steve to Alex.  And Steve doesn’t want to report a sale of stock on his tax return.  He just wants the company to issue new, never-before-issued-shares to Alex.  This is a better tax result for Steve.

Why is this more complicated?  Can’t we just issue 50 shares from the company instead of “selling” them out of Steve’s shares?  No.  The number 50 doesn’t work anymore.  If Alex received 50 shares, we would calculate his percentage by dividing 50 into the total number of issued shares including the 50 he just received.  So Alex’s percentage would actually be 4.8% (50 divided by 1,050 equals .0476).  This is too far from 5% to allow for rounding.  To get Alex the 5% he has been promised, you would need to issue him 52.6 shares.  52.6 divided by 1,052.6 equals .0499 which can be properly rounded to 5%.

That’s all for today.  Have an excellent day.

Launch Strong.  Build Strong.  Exit Strong.

JDV

Notice: Details such as the amount of the transaction, the location of the property, dates and other information have been modified for confidentiality.

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