What happens to the “unallocated” shares in my Shareholders Agreement?

(This was first published on Linkedin Pulse on 24 Jun 2015).

This question has come up a lot lately. Let’s take a look at an example that may outline some of the decision points involved.

You’ve recently signed a Shareholders agreement that has an allocation for ESOP of 15% of the Company, as part of a $500K capital raise.

To keep things simple, let’s say 60% of the company belongs to the founders, and the remaining 25% to seed / angel investors.  To keep this example straightforward, we’ll assume founders own their shares outright (ie: there’s no cliffs or vesting at this stage).

So your cap table will look something like this:

Founders                            60%                      6,000 shares

Seed / Angel Investors       25%                      2,500 shares

ESOP pool                          15%                      1,500 shares

The shares for founders and for seed & angel investors will have been issued as part of your capital raise, and the shares would have been registered with ASIC (“Australian Securities & Investment Commission”) or similar agency in your country.

How about the ESOP shares. There’s 1,500 of them. Until you have a person to allocate them to, they’re not registered with the securities agency.

So at the moment, you have a Shareholders Agreement referring to 10,000 shares and the securities register (in this case with “ASIC”) has 8,500 issued shares.

Does that mean the 1,500 shares don’t “exist”. Technically, they don’t at this moment in time.

However, what you do have is a legally binding expectation set with the owners of the Company (in this case founders and investors) that 15% of the Company can be allocated to employees at a future date, without having to get specific shareholder approval each time. Normally the allocation process will be decided by the Board, however the exact approval process would be included in your Shareholder Agreement.

Let’s say you set up an Employee Stock Option Plan (ESOP) and 12 months later, you’ve done the following:

  • 10% of the company has been allocated to stock options for specific employees
  • 30% of the options issued have been vested and can be exercised by the employees, should they so choose. It is unlikely they would choose to do so before an exit, or having access to cash to pay for the options.

At this stage, you have 1,000 "shares" issued as options. Options are only registered as shares once they are "exercised".  However, as per the legal records of your Company, these "shares" now exist, under the terms of the options agreement. 

Your cap table would now look like this:

 Founders                                        60%                      6,000 shares

Seed / Angel Investors                    25%                      2,500 shares

ESOP

               Unvested options             7%                           700 shares

               Vested options                  3%                           300 shares

               Unallocated ESOP            5%                           500 shares

Within your company records, you would have the following documents:

  • Members register, showing 8,500 shares issued to founders and investors
  • This members register would be reflected by the securities agency with 8,500 shares on issue
  • An options register, showing the 1,000 options allocated to employees
  • The options register would also show which of the 300 options were now vested

Let’s say a further 6 months pass and you have an offer to buy the company.

As part of the ESOP plan, in this scenario all unvested options vest, which means the employee can choose to exercise the options, which they do as part of the sale. Your cap table would now look like this, immediately prior to the sale:

Founders                                         60%                      6,000 shares

Seed / Angel Investors                    25%                      2,500 shares

ESOP

               Allocated shares               10%                      1,000 shares

               Unallocated ESOP            5%                           500 shares

Within your company records, you would have the following documents:

Members register, showing 9,500 shares issued to founders, investors & employees

  • This members register would be reflected by the securities agency with 9,500 shares on issue
  • An options register, showing the 1,000 options allocated to employees, now fully vested and exercised.

At this point, you still have 500 shares, or 5% of the company, unallocated.

What happens to these will depend on the terms of the sale, it may be the buyer wants to roll this over into options available within their own ESOP as a way of retaining staff once the company’s been sold.

Let’s say that’s not the case, in this example. The 500 shares don’t exist and won’t be part of the final settlement on sale of the Company.  

Hence the ownership structure of the Company, in terms of splitting up the proceeds, would be as follows:

Founders                                         63.1%                   6,000 shares

Seed / Angel Investors                    26.3%                   2,500 shares

ESOP

               Allocated shares               10.6%                   1,000 shares

This is a simplified example, as you can see there are many variations. Every time I know I’ve been involved in any transaction, a significant amount of time is necessary to ensure the existing and then the future share structure of the Company is accurate and well understood by everyone involved.