Finance 101

How many shares should you issue? How do you price them? It all depends on what you're up to

"Back in 1993, I incorporated my company, mainly in the interest of liability protection," says Tim McCorry, chief executive of the McCorry Group, a $2-million manufacturer of sports fitness products in Berwyn, Pa. Back then, McCorry says, "I knew I wanted to get out of the starting gate clean, grow my business, and one day bring in investors. But I didn't know about such things as how many shares of stock the company should have or how much they should be worth. I looked to my attorney for guidance on that point."

McCorry is not alone. Of course, it's a snap to tell how much one share of a public corporation is worth. Just pick up a newspaper or log on to one of the proliferating market-watch Web sites. Stock-price swings are easy to track and quantify. With private companies, though, stock pricing is a complicated and usually costly proposition -- one that is tied to today's realities, future prospects, and, above all, the owner's motivation for coming up with a price. Still, despite the complexities, it is an important issue for entrepreneurs, especially those who, like McCorry, intend to one day raise growth capital from outside investors.

To demystify matters, let's start at the one point in time when a private company's stock situation is straightforward: incorporation. Generally, in an incorporation an owner, with a lawyer's assistance, chooses a corporate structure and files the necessary paperwork with the secretary of state's office. If the filing occurs before start-up, the company has no book value, except whatever initial investment has been made in it. That means that you and your attorney can set an initial stock price without supplying any additional information (for example, about ongoing operations or current assets).

At this early phase, the company's attorney typically makes a recommendation about whether the stock should have what's known as a "par" (or stated) value or no-par value. "This decision has no impact on the way you'll run your business in the future," emphasizes Richard Yanofsky, a partner in the Boston office of law firm Holland & Knight. But that doesn't mean the decision is insignificant, because it might have tax or accounting consequences, depending on the state in which you incorporate. "If I were incorporating a business in Massachusetts," Yanofsky says, "I'd probably choose a no-par value for a company's stock, since it's easier to account for. But in Delaware, you'd calculate some kind of par value, based on the initial capitalization, because that could lead to certain tax savings."

The more important issue, at this early stage, is how many shares will be authorized (that is, registered with the secretary of state) and how many will be issued (actually transferred to the entrepreneur and any minority owners). Those two numbers are not necessarily the same -- in fact, they often are different. Here again, lawyers usually take the lead after talking with entrepreneurs about their future plans. (See "Taking Stock of Your Priorities," below.)

The possible permutations are endless. "Let's say your company authorizes 1,000 shares in total and there are two equal owners, you and your partner," explains Michael Trabert, a certified public accountant and certified valuation analyst with CBIZ-SMR Business Services, a financial-consulting firm in Mayfield Village, Ohio. "Of those authorized shares, you might decide to issue a total of 600, divided equally between you and your partner. You might never issue the remaining 400 shares, or you might decide to issue some portion or all of them if your company decided to bring in outside investors or a third partner." You or your partner might even decide to sell (or gift) some of your 300 shares, rather than tapping into that unissued pool; it's up to you to decide. (See "Deciding Which Shares to Share," below.)

In many states, incorporation fees are generally tied to the number of shares authorized. So Yanofsky, for one, generally chooses to authorize the highest possible number for the lowest filing fee, which is generally more than 100,000 shares for around $200 or $300. "That gives the owner plenty of room to maneuver at a later stage if he begins to bring in investors or award stock to key employees," he says.

Regardless of the number of shares that are authorized, a lawyer will typically recommend issuing only 100 or 1,000 shares to a single owner. "There's no point in complicating matters," Yanofsky explains. "What you mainly want is a nice round number for the entrepreneur, which makes it simple to calculate smaller percentages if shares are going to be issued to somebody else at some point in the future."

Although it's essential to keep your corporate structure clean and state registration documents accurate and up-to-date, there's no point in making yourself crazy by attempting to design an initial stock structure that will accommodate every possible capital change that could occur as your company grows. Some people (mainly friends, family members, small angel investors, or key employees) will probably accept already authorized but unissued shares if they decide to make an investment; but venture capitalists and other professional investors likely will insist on a new capitalization scheme that will provide them with extra privileges and protections. At that point you'll need to amend your corporate documents, which will include a new description of your stock plan. Again, the fee will be based in part on the number of shares authorized.

Until you reach that point, however, it pays to keep things simple for as long as possible. For Tim McCorry, who ran his company for seven years before recently starting to negotiate a multimillion-dollar infusion of capital, that meant initially authorizing and issuing a grand total of 100 shares, all of which went to him. Their par value was based on his initial investment of $30,000. "When our new investment round is completed, the company will be recapitalized with many more shares authorized and a smaller portion of them being issued to me -- but they'll be much more valuable," McCorry says.

Ah yes, increasing value. "Entrepreneurs need to remember that once they pass the initial incorporation stage, stock price is a range concept. There's no single right number that everyone can point their fingers at," notes Tony Morabito, a certified public accountant and accredited senior appraiser at Bonadio & Co., an accounting firm in Pittsford, N.Y. "The reality for private companies is this: at any point in time, there's a high number and there's a low number, and somewhere within that price range is the number that's going to get chosen as a company's stock price, based on why their owners need to know it."

For simplicity's sake, we can lump owners' motivations into two broad categories: government driven (when an owner, say, plans to file an estate- or gift-tax return or set up an employee stock ownership plan) and market driven (when an owner sells stock to outside investors, for instance, or gives it away to a key employee). In cases in which a tax liability will be triggered, it makes sense to price stock as low as possible. (See "When You Want a Low Share Price," below.) When an owner is selling part or all of a company, on the other hand, obtaining the highest possible price is desirable.

To figure out the right price, you'll often need an appraiser, who considers the motivation behind the appraisal before coming up with the magic number. "But there are times when it's the market, not any valuation method, that decides," says Trabert. "You might own 1,000 shares of your company's stock, which an independent appraiser values as being worth $300 apiece. But if a potential strategic partner could recognize all kinds of synergies and is willing to pay $600 per share, then that's what your stock is worth."

Not surprisingly, there are some fledgling efforts to use the Internet to add some structure to, and create demand in, the highly fragmented marketplace for private-company stock. But given how new and untested those efforts are, they're not yet effective. Currently, the main way to get a sense of your stock's fair-market value is -- as it's always been -- by negotiating a deal.

In what might seem to be a perversity of the private markets, it wouldn't help you to manage any better if you knew that your company's shares were worth, say, $120 apiece in 1997 (when you gave a minority stake away to a child's trust fund), $300 in 1998 (when you brought in an angel investor), and $220 in 1999 (when you gave a piece of the company to your chief financial officer). Unlike prices on the New York Stock Exchange on different days -- or even in different years -- private-company share prices just aren't comparable, because they reflect valuations for different purposes. But that's not cause for despair. There's no reason why private companies can't use their stock prices as a performance measure, if they're willing to spend some time and money up front on developing the proper valuation tools. "An entrepreneur could retain an appraiser to develop a stock-price formula that would measure key performance indicators for his or her business and yet be simple enough for company staffers to plug in current results on a yearly basis," says Morabito. "Those numbers would then be comparable from year to year and would be another useful way of evaluating how your company is doing."

Two downsides: The initial cost will probably be in the range of $10,000 to $15,000. And you still will need to hire appraisers to price your stock according to different methods if some type of tax issue arises. True, it's a hassle -- but a small one compared with those you'd face complying with public-stock requirements.

The bottom line when it comes to valuing your company's stock? Stock price is one number that can be understood only within its larger context. So concentrate on the big picture rather than on small swings in value, if you're going to make sense of your company's price.

Jill Andresky Fraser is Inc. 's finance editor.