equity, founderIf a startup has three founders, A, B, and C, with each 1000 shares (so each own 33%), could A and B decide to create a million new shares and selling them for pennies to another company that they own? C would then be left with only +/- 0.001% of the original company, and through their other company, A and B would own 99.99% together instead of 66%.
This might seem a bit farfetched, but still, is it legal? If yes, how can C protect himself?
What you describe is not far fetched and can occur fairly commonly.
In the example, since share price would depend on the value of the company, creating the new shares without changing the value of the company would dilute the value of the existing shares including the ones owned by A and B. Ownership stake would not change until the new shares are sold. When the new stock is offered for sale, C has the option to buy it just as A and B or the second company owned by A and B. If C is unable to buy more and doesn’t want to reduce the stake C can vote to block the sale in the board but would get outvoted by A and B.
Share authorization, issue and sale is governed usually by the articles of incorporation, corporate bylaws and shareholder agreements. In case of founders you can have a founders agreement as well.
A simple way to protect that would be to add a clause into the bylaws stating that new share authorizations, issue and sale must be unanimously voted by board of directors. You can also restrict sale of shares to companies owned by shareholders where the ownership stake in these companies is more than a particular percent. More commonly, there would be whats called an anti dilution provision which lets investors protect their equity. There are many types of this provision some giving them right to buy new stock at particular prices or in particular quantities. Founders can also create preferred stock with specific restrictions on sale to non founders and different voting rights to maintain control.
If there is a founders agreement, you can state that shares would not be sold without discussion or without first offering to the founders. Many investors these days would insist on a vesting schedule for founders to prevent the founders from exiting the company early before the investments have been recovered.
The exact legality of what you describe may depend on the state the corporation is registered in as there maybe government laws on anti dilution and preemptive rights for existing shareholders that all corporations have to abide by. A good lawyer from the state or the SBDC maybe able to give you exact information.
You can look at the articles of big corporations like Google or Facebook to see how they prevent this and on anti dilution clauses.
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