Does this new owner also get his shares diluted? For example, let's say we agreed to give him 40% for sweat equity (vested of course). He doesn't actually get 40% right because his shares would also be diluted?
Also, does it matter whether a portion of the company is given away because of a financial investment or sweat equity? Does either one dilute the shareholders more or hold any more significant ramifications?
The answer for the most part depends on how the company is structured. . If you promise someone 40% that would normally mean that only 60% is available to others. If one person or group of persons holds 60% of the authorized shares (or membership units for an LLC) then the new person will hold 40% and no more.
Having said that, if you had 100,000 authorized shares and the new person received 20,000 shares while other owners held 50,000 shares, with 50,000 unissued, the new owner would have 40% of the company so long as no more shares were issued. Ownership is determined by issued and outstanding shares or membership units.
When dilution occurs because of someone investing capital, the value of the remaining shares or units typically stays the same or increases. Here, of course, with no capital investment, dilution of value is a very real, indeed probable, result.
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Whether you sell or gift the shares is irrelevant to dilution.
Of course the shares of the remaining shareholders are diluted unless they have "preemptive rights" which entitles them to purchase additional shares to maintain their percentage.
Make sure you have a CPA for your venture.
The above is general legal and business analysis. It is not "legal advice" but analysis, and different lawyers may analyse this matter differently, especially if there are additional facts not reflected in the question. I am not your attorney until retained by a written retainer agreement signed by both of us. I am only licensed in California. See also avvo.com terms and conditions item 9, incorporated as if it was reprinted here.
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I agree with my colleagues and will add the following:
If you have a proper operating agreement and update it appropriately when additional equity is issued, then the answer to your question should be obvious once the capitalization table exhibit (reflecting either units or percentage interests) is updated.
If your LLC does not have a proper OA and cap table, then you should retain a business lawyer to help you.
This information does not constitute legal advice and does not establish an attorney-client relationship.
When an LLC gives new shares to a new owner and all shares are the same, the old owners' shares are usually diluted. If the LLC owners give a new owner 40% of the LLC,, the 40% owner's interest is not diluted because he or she gets 40%. Everyone else's interests are diluted because, instead of dividing up 100% they are dividing up 60% of the shares. Whether given away or sold, issuance of new shares usually dilutes the old owners' interests. How the new owners gain their shares, by sweat equity or investment, does impact capital accounts. and may impact other things, such as attitudes toward the business.
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The interesting aspect of my colleagues advise holds in the fact that the value of the shares can increase or at least stay the same if the transaction is performed prudently. To elaborate; although it may be the case that a certain percentage of ownership may be reduced by the introduction of additional capital or through the issuance of additional shares, interestingly, if additional value added to the companies overall worth increases beyond the portion of dilution then the net result will be a monetary increase to all share holders, despite the fact they have experienced a percentage decrease in ownership. This aspect involves very sophisticated executive management decisions in the way the transaction is negotiated and structured. Remember that a sound business model must not only create value, but also CAPTURE VALUE.
Pragmatically this means that any issuance of additional shares or authorization of outside funds contributed by members not in proportion with ownership, or the addition of an entirely new member must be carefully utilized so as to increase the over value of the company to compensate for the decrease in ownership.
Often times in circumstances as you have suggested, (sweat equity) the value increase is not realized. Mainly this is a result of writing a membership agreement that has no teeth, so to speak. Or if the agreement does have some teeth they are made dull by the fact that the court system is needed to apply force or exercise rights. Also, the result of applying force in such a manner disrupts the company in a way that can devastate the harmony, depletes resources and causes a dramatic decrease in the value of the company.
While on the outset of the transaction all members have good intention to serve the best interest of the company as well as, serve the best interest of other members, human nature is a powerful barrier which prevents such accomplishment from fruition. Inevitably, many human characteristics are not conducive to prudent business management. The power of human nature is often under estimated. This is the problem. The solution is obeying a very precise process of creating very precise and thorough membership agreements in which give the company the ability to address future inadequacies in performance with minimal use of the court system.
There are many methods in which this can be accomplished. Although this may at first inspection appear tedious, the long term benefits of undertaking such a process are so magnificent that such a concern should appear negligible and frivolous when compared to the benefit of doing so. I hope this has given you and your company additional insight. Best Regards, Codi M. Dada, Attorney at Law & Business Consultant. email@example.com