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Authorized Shares: The Company's Capacity
What are Authorized Shares?
Authorized stock encompasses all the shares a company can legally issue, as determined by its legal framework. That is to say, there is legally documentation that specifies the total amount of shares the company is allowed to issue. Typically, companies begin with authorizing 10 million shares, though there is no rule that requires them to do so - it's simply a round number investors are comfortable with.
Importance in ESOPs
Understanding authorized shares is critical because legally, a company cannot issue more shares than it has authorized. This ensures that every time stock is issued, there must be sufficient authorized stock available, otherwise, the issuance is invalid. This is akin to owning a grocery store where you cannot sell more bananas than what you have in stock.
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Types of Stock Under Authorized Shares
The umbrella of authorized shares covers various categories, pivotal for understanding how stock is allocated and managed within a company, especially in the context of ESOPs. Here’s a breakdown of the different types of stock:
Outstanding Shares
Outstanding share are the shares that have actually been issued by a company. Outstanding shares are the total number of shares that are held by shareholders or reserved for equity compensation (eg. stock options). The number of outstanding shares can never been higher than the number of authorized shares.
Issued Stock
Issued stock refers to the portion of authorized shares that a company has distributed to stakeholders. These shares are fully paid for and owned by those stakeholders.
Reserved Stock Options ("The Pool")
Reserved stock options, often used for Employee Stock Option Pools (ESOPs), are a set number of shares that a company sets aside for specific use cases or for future financing rounds. This pool is typically created from the authorized shares and is a strategic reserve used to attract and retain talent or secure additional funding without the need to increase the authorized stock. Employers need to balance the size of this pool carefully to ensure it meets future needs without excessively diluting existing shareholders' equity.
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Example Calculation:
Consider a company, Fintechstic, with a current cap of 10,000,000 authorized shares. The board of Fintechstic decides to expand the company's operations and attract more investments by increasing the limit of authorized shares. They opt to increase the total number of authorized shares to 15,000,000. Following this increase, they aim to allocate an additional 10% of the new limit to the reserved stock option pool to enhance their ESOP scheme, aiming to attract top talent and maintain employee loyalty.
The calculation for the new addition to the reserve pool would be 10% of the new authorized shares limit, which is 1,500,000 shares (10% of 15,000,000). Prior to this adjustment, if the reserve pool was initially set at 1,000,000 shares, the new reserve pool total would now be 2,500,000 shares after adding the additional 1,500,000 shares. This strategic move not only increases the company's capacity to issue shares for future financing rounds but also significantly boosts the incentive offerings through ESOPs, making Fintechstic a more attractive employer in its industry.
Conclusion
Understanding the distinction between authorized shares, outstanding shares, and the share pool is essential for navigating the complexities of employee stock ownership plans. By effectively managing these elements, companies can leverage ESOPs to attract, retain, and motivate employees by aligning their interests with the growth and success of the business.
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