October 2007
The equity plan reserve is a crucial component of a venture-backed company's capital structure. While the size of the reserve is often calculated as a percentage of the pre-investment capitalization, it is always determined with the post-investment capital structure in mind. In the typical transaction, the shares in the equity plan are considered part of the pre-money capitalization, as a result of
which the existing shareholders, including the founders, bear all of the dilution resulting from the plan. As such, this percentage is a heavily negotiated term.
A complication arises when a venture capital investment is structured to close in multiple tranches. The parties may want to
adjust the size of the equity plan reserve depending on whether one or all of the tranches close. If the reserve is set as a percentage of the initial closing — assuming all shares are sold — the reserve will be larger than what was agreed upon in the event that only a portion of the shares are actually sold, which will result in a windfall for the investors. Alternatively, if the reserve is set at a percentage — assuming that only the initial closing has occurred — the company will need to amend both the charter (the equity plan reserve number is often set forth in the antidilution provisions of the charter) and the equity incentive plan in order to increase the reserve upon the occurrence of additional closings. Stockholder approval would be required for both such amendments.
Investors and companies may avoid these complications by
following these steps:
By providing for an automatic adjustment to the equity plan reserve, companies and investors will ensure the correct size of the
reserve and avoid seeking stockholder approval of amendments to the charter and the plan at each additional closing.
Investor Rights Agreement
The Company hereby covenants that it will take such action as may be necessary following the consummation of each Closing, to increase the number of shares of the Company’s Common Stock reserved for issuance under its 2007 Equity Incentive Plan to that whole number of shares which is closest to 15% of the Company’s Common Stock, measured on a fully-diluted, as converted basis.
Charter Provision
“Additional Shares of Common Stock” means all shares of Common Stock issued by the Corporation after the date hereof, other than shares of Common Stock issued or issuable:
. . .(d) pursuant to an employee stock benefit, option, purchase or similar plan approved by a majority of the Board of Directors up to a maximum of xx,000,000 shares (as adjusted to reflect any stock split, stock dividend, combination, recapitalization or adjustment, and including currently outstanding options; and as further adjusted in accordance with the provisions of Section X of the Investor Rights Agreement, dated as of __________);
For more information on this topic, please contact the author, Daniele Ouellette Levy.
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