When founders put money into their own companies, I believe there are two ways they should do it. First, pay for your founders stock with cash. Founders stock is common stock. This is your “sweat equity,” so the amount of cash you pay for the stock at inception of the business and before there is any value should be quite low. For example, you might have the company issue 2,000,000 shares at $0.001 per share for $2,000 total. This should be the first money in, and the new company needs a few thousand dollars just to pay incorporation expenses and get going.
Additional funding is your investment in the company, and you need a different security for that. The equity security for investment is preferred stock—that is what angels and VCs will normally want to purchase. If you are the only investor for now, you probably don’t want to set a value on the shares of the company, so think about putting the money in as a convertible note. Convertible note transactions do not set a valuation on your stock, and later, when you raise funds, your note will convert into equity and so you will get equity for your investment.
When founders don’t set up a different security for their investment, the risk is that the additional funds they put in become capital contributions that merely increase the tax basis in their founders stock. It becomes part of the founders’ sweat equity—they don’t get additional shares for their investment. This can happen when the company subsequently brings in money from outside angel or venture capital investors. If the founders haven’t documented their investments, the new investors may consider it “water under the bridge.”
Keep the sweat equity and the money equity separate by issuing different securities.
Image credit: CC by Harald Deischinger