Some clarification on confusing equity-related terminology
Founders often ask us about the meaning of certain equity-related terminology. We thought it would be useful to explain some commonly used (but frequently misunderstood and misused) terms.
These are the shares authorized in a corporation’s articles/certificate of incorporation or charter. The number of authorized shares represents the outer limit of shares that can be issued by the corporation; there may be many unauthorized shares at any given time that remain unissued (see below explanation on fully diluted).
Ten million is a typical number for authorized shares. Stockholder approval is required to change the number of authorized shares. All shares, regardless of class (e.g., common or preferred), count towards the number of authorized shares.
Founders should think carefully before granting themselves too small or too large of a portion of authorized shares; doing so may result in additional corporate actions, paperwork, fees (to attorneys and the Secretary of State), and franchise taxes that could be avoided. Unlike with corporations, there is no equivalent concept to “authorized shares” for limited liability companies (LLCs). An LLC is not required to publicly file the maximum number of units that it can issue, though an LLC’s operating agreement – which is not a public document – could impose such a limit.
Fully diluted shares
These are the shares that have been issued or approved for issuance by the corporation’s board of directors, including all shares available for issuance in the incentive equity pool and shares subject to outstanding, unexercised options, warrants, or similar rights. “Fully diluted” is a term that can be applied to any type of equity, including LLC units.
Issued and outstanding shares
These are the shares that have been issued by the corporation’s board of directors and remain in the hands of stockholders.
To better understand the difference between “issued and outstanding” and “fully diluted,” let’s use an example: the shares subject to purchase (but not yet exercised / purchased) under an option granted to an employee would not constitute “issued and outstanding” shares because this employee does not own the shares yet. However, the shares underlying the option would count towards the number of “fully diluted” shares.
To see if you now understand these concepts, check out the example at the beginning of this post.
Categorised as: Lawyering