With Facebook growing at a torrid rate, the private company has had to raise several rounds of capital as well as issue shares to its employees. As a result, the company has close to 500 shareholders. The problem? Once a company has more than 500 shareholders and $10 million in assets, an obscure Securities & Exchange Commission rule forces it to start filing as if it were a public company. So Facebook managed to get an exemption from the SEC.
Of course, it's unlikely that your company will face the same problem. Yet this example does raise an important question: How many shareholders should your small company have? There are no clear-cut answers, but entrepreneurs should keep the following general principles in mind.
Preference for Experience
First, if your company anticipates receiving venture capital, it is a good idea to try to minimize the number of your shareholders. For the most part, VCs want to keep things confidential, which can be tough when there are a lot of owners. Also, shareholder communications and tax reporting entail fewer hassles. Thus, fewer than 10 investors would be a goal to strive for.
Besides, VCs wants to see shareholders with experience—not friends, family, and others without experience investing in or running companies. Often, such investors do not understand the role of VCs and can cause problems when key decisions must be made, such as raising more money or selling the company. In other words, you should look for investors who will provide value—say, former entrepreneurs (especially those who have received venture capital) or corporate executives.
O.K., suppose your company does not plan to raise venture capital—this is a more common situation. In this case, it is still a good idea to be careful which investors you include.
It's important that you provide them with straight talk about early-stage investing. This means discussing the following:
• It's common for startups to fail.
• Even if a startup succeeds, the payoff may take five to 10 years, or longer.
• It will be almost impossible to sell shares of the company, except at a massive discount.
• There may be a need for more investment. In this case, the existing shareholders will have a smaller percentage of the company.
A company should not only provide a business plan—with realistic forecasts—but also engage in periodic disclosures to shareholders. One idea is to issue a quarterly update that covers new products and customers. There should also be disclosures of problems. For example, did the company lose a big customer? Is there a lawsuit? What's being done about such things? Investors will appreciate being kept in the loop and are probably more likely to reinvest in the company if you do so.
Differing Legal Limits
So what is a good number of shareholders when you know you won't be looking for venture capital? Fewer than 40 would probably be good. After all, there will be administrative costs. Moreover, you want to have the time to respond to shareholder questions. Something else—depending on your corporate structure, there may be legal limits. For instance, an S corporation can have only 75 shareholders.
You should also consider private placements,investments that are exempt from federal disclosure requirements. Bear in mind that depending on the type you select, you may be limited to only 35 nonaccredited investors, per federal securities regulations. (Nonaccredited means investors who are not considered wealthy or financially sophisticated.)
It's also advisable to have strong shareholder agreements. First, the management of the company should have the final decision on subsequent financings. This is absolutely critical. Unfortunately, there are examples where only one shareholder has prevented a financing—resulting in the failure of the venture.
Agreements in Advance
Next, a shareholder agreement should have clear guidelines for repurchasing shares. Essentially, this should be for any circumstance. Furthermore, there should be an agreed-upon valuation metric, such as by using a third-party appraiser.
Finally, make sure you hire a qualified attorney. The legal issues are likely to be complex. And if the agreements are not structured properly, a lawsuit can be devastating.
No doubt, finding the right number of shareholders is no easy feat. In the current environment, it is tough to turn shareholders away. If anything, you may have to go beyond the limits I've mentioned to keep your company going, which is fine. Ultimately, you want to make sure your company has enough capital to execute the business plan.
But, at the same time, you need to remain vigilant and look at the consequences of having too many shareholders. If you will be looking for venture capital, then keep the shareholder base small and focused on experienced players. But if you do not plan to go down this route, it's still important to keep things manageable and have investors who understand not only the rewards but also, more importantly, the risks of being investors.