Cap Table & Share Class Design for California Startups: Common vs Preferred Stock, Protective Provisions & Equity Compensation

Why Cap Table Design Matters Under California Law

California isn’t Delaware. The California Corporations Code imposes default rules and mandatory protections that significantly affect how you structure equity, particularly around voting rights, distributions, and shareholder protections. Three statutory provisions create the California-specific landscape that founders must navigate:

First, California defaults to cumulative voting for directors under Corporations Code §708, unless you properly eliminate it through your articles of incorporation. Cumulative voting allows minority shareholders to concentrate their votes on specific board seats, potentially giving small investors disproportionate influence over board composition. Delaware doesn’t have this default, which is one reason many venture-backed startups incorporate there.

Second, California’s distribution limitations under §§500-501 impose a two-prong test that’s more restrictive than Delaware’s. You can only make distributions (including preferred stock dividends and redemptions) if you have sufficient retained earnings OR if your assets exceed 1.25 times your liabilities AND your current assets exceed current liabilities. This affects how you design preferred stock dividend rights and redemption features.

Third, California’s pseudo-foreign corporation statute—§2115—can import California’s shareholder protection rules onto Delaware corporations if more than 50% of your voting securities are held by California residents and more than 50% of your property, payroll, and sales are in California. This means you might get Delaware’s flexibility in name only while operating under California’s substantive rules.

Understanding these California-specific constraints shapes every decision you make about share class design, from how you split founder common stock to how you negotiate protective provisions with Series A investors.

Authorized Shares and Classes: The §§200-202 and §400-401 Framework

Before you issue a single share, your articles of incorporation must specify the number of authorized shares and the rights attached to each class under California Corporations Code §§200-202. This isn’t something you can “decide later”—the fundamental architecture of your cap table must be memorialized in your charter documents filed with the California Secretary of State.

Corporations Code §401 requires that your articles state the number of shares of each class the corporation is authorized to issue and specify the rights, preferences, privileges, and restrictions of each class or series. You can’t just create new classes or change the rights of existing classes without amending your articles and, critically, obtaining approval from the affected class under §903.

A typical early-stage California corporation might authorize 10,000,000 shares of common stock and 5,000,000 shares of preferred stock, with the preferred stock designated into separate series (Series Seed, Series A, Series B) as financing rounds occur. The common stock typically has standard voting rights (one vote per share) and participates pro rata in distributions after preferred stock liquidation preferences are satisfied.

The preferred stock authorization gives you flexibility to create multiple series with distinct rights under Corporations Code §409, which explicitly grants California corporations authority to issue convertible and exchangeable shares and to fix conversion ratios and other terms in the articles or through board resolutions pursuant to charter authority. This is the statutory hook that allows you to issue Series A Preferred with specific liquidation preferences, dividend rights, conversion features, and protective provisions without amending your articles for each new financing round—as long as your articles delegate that authority to the board.

Founders’ Common Stock: Par Value, Consideration, and Issuance Under §203

When you’re forming your startup, one of your first decisions is how to split equity among founders. Under California Corporations Code §203, your board of directors can issue shares for cash, property, services already performed, or contractual obligations to provide services or property in the future. Critically, the board’s determination of the value of non-cash consideration is conclusive in the absence of actual fraud.

This means you can issue founder shares for very low cash consideration (often $0.0001 to $0.001 par value per share, resulting in total cash consideration of $100 to $1,000 for a founder receiving 1,000,000 shares), for assignment of intellectual property to the corporation, for services already rendered, or for commitments to provide future services. The board resolution authorizing the issuance should document the consideration and, in the case of IP assignment or services, establish a reasonable valuation.

Most sophisticated founders understand that the absolute number of shares matters less than the percentage ownership. A founder with 4,000,000 shares out of 10,000,000 total issued and outstanding (40%) is in the same economic position as a founder with 400 shares out of 1,000 total (40%). The convention in venture-backed startups is to use larger share numbers (typically millions of shares for common stock) to provide granularity for option grants and to avoid fractional shares.

What many founders don’t fully appreciate is the importance of immediately subjecting founder shares to vesting restrictions and filing 83(b) elections. I’ll address that in the next section.

Founder Vesting and the Critical 83(b) Election

Founder equity without vesting is a recipe for disaster. If you and your co-founder each receive 50% of the company on day one with no vesting schedule, and your co-founder leaves after three months, they walk away with half the company while you continue building the business. Investors will never fund a company with this cap table structure.

The standard approach is to issue founders restricted stock subject to a vesting schedule—typically four years with a one-year cliff. Under this structure, if a founder leaves before the one-year anniversary, they forfeit all unvested shares (100% in this case). If they leave after one year, 25% of their shares have vested and they keep those, but they forfeit the remaining 75%. After the cliff, shares typically vest monthly or quarterly over the remaining three years.

From a federal tax perspective, this creates a restricted stock award (RSA) governed by Internal Revenue Code §83. Here’s the crucial issue: under §83, you recognize ordinary income when the property (your founder shares) becomes transferable or is no longer subject to a substantial risk of forfeiture. Without any action, you’d recognize taxable income as your shares vest each month, based on the fair market value at each vesting date. If the company has appreciated significantly, you could face enormous tax bills on paper gains with no liquidity to pay them.

The solution is the 83(b) election. Under IRC §83(b) and Treasury Regulation §1.83-2, you can elect to recognize all income in the year you receive the restricted stock rather than waiting for vesting. If you make this election within 30 days of receiving your founder shares, you pay tax on the difference between what you paid for the shares and their fair market value at issuance. For true founder shares issued at formation when the company has minimal value, this often results in zero or minimal taxable income at issuance, and all future appreciation is taxed as capital gains when you eventually sell (assuming you hold the shares for more than one year after exercise and two years after grant).

The 83(b) election is filed with the IRS using Form 15620 (or following the format in Revenue Procedure 2012-29) and must be postmarked within 30 days of the stock transfer date. This deadline is absolute and unforgiving—there are no extensions and no do-overs. If you miss the 30-day window, you’re locked into recognizing ordinary income as shares vest, potentially creating tax obligations of hundreds of thousands of dollars or more as your startup grows in value.

For California founders, there’s an additional consideration: California doesn’t have a separate 83(b) election for state tax purposes, but it generally conforms to federal tax treatment. The practical effect is that filing the federal 83(b) election also addresses your California state tax obligation on the restricted stock.

Every founder receiving restricted stock should file an 83(b) election unless they have a very specific reason not to (such as paying significant cash for high-value stock where the immediate tax hit would be substantial and they’re uncertain about the company’s future). For typical founders receiving shares for nominal consideration at formation, the 83(b) election is essentially mandatory.

Creating Preferred Stock Under California Corporations Code §409

When institutional investors invest in your startup, they don’t buy common stock. They purchase preferred stock with specific economic rights and protective provisions designed to protect their investment and provide preferential treatment in various exit scenarios. California Corporations Code §409 provides the statutory authority to create these customized securities.

Section 409 explicitly authorizes California corporations to issue “partly paid, assessable, convertible, and exchangeable shares and rights” including options and warrants, and empowers the board to fix conversion ratios and other terms either directly in the articles of incorporation or through board resolutions pursuant to authority granted in the articles. This statutory flexibility is functionally equivalent to Delaware General Corporation Law §151, which provides the foundation for Delaware’s preferred stock ecosystem.

A typical Series A Preferred Stock term sheet will include the following economic and governance rights, all of which must ultimately be reflected in either your amended articles of incorporation (creating the Series A as a designated series of preferred stock) or in contractual agreements among the parties:

Liquidation Preference: Series A investors typically receive a 1x non-participating liquidation preference, meaning they get their investment back before common stockholders receive anything in a liquidation event (sale of the company, dissolution, etc.). Some term sheets include participation rights where preferred stockholders get their preference AND THEN convert to common to participate in remaining proceeds, which is economically much more favorable to investors but has fallen out of favor in balanced financings.

Dividend Rights: Preferred stock often includes dividend rights, though these are frequently non-cumulative and payable only if, as, and when declared by the board. Cumulative dividends, where unpaid dividends accrue and compound over time, create significant future obligations that can complicate later financings and must comply with California’s distribution limitations under §§500-501. In practice, dividends are rarely paid by early-stage companies because doing so depletes cash that should be used for growth.

Conversion Rights: Preferred stockholders typically have the right to convert their preferred shares to common shares at any time on a 1:1 ratio (subject to anti-dilution adjustments). Conversion is generally automatic upon either an IPO meeting certain criteria or approval by a specified percentage of preferred stockholders. The conversion ratio is the key mechanism for anti-dilution protection.

Anti-Dilution Protection: If the company later issues shares at a lower valuation than the Series A price (a “down round”), the Series A conversion ratio adjusts to give investors more common shares upon conversion, protecting them from dilution. The two common formulas are “full ratchet” (extremely investor-friendly, rarely used) and “weighted average” (more balanced, and the market standard). Weighted average anti-dilution comes in broad-based and narrow-based variants, with broad-based being more founder-friendly because it factors in the entire capitalization including options.

Redemption Rights: Some preferred stock includes the right for investors to force the company to buy back their shares after a certain period (typically 5+ years) at the original purchase price plus accrued dividends. California Corporations Code §402 governs redeemable shares and imposes restrictions on redemption, including that redemption must comply with the distribution tests under §§500-501. Redemption rights are less common in pure venture deals but appear more frequently in growth equity or private equity investments.

These economic terms are typically spelled out in the certificate of designation (or certificate of determination) filed as an amendment to your articles of incorporation when you close the financing. But economic rights are only half the story—protective provisions are equally critical.

Protective Provisions: Class Voting Under §903 and Contractual Veto Rights

Preferred stockholders don’t just want economic preferences—they want veto rights over major corporate actions that could harm their investment. These protections come from two sources: statutory class voting rights under California Corporations Code §903, and contractual protective provisions negotiated in the financing documents.

Section 903 provides statutory protection by requiring approval from each class of stock that would be adversely affected by certain charter amendments. Specifically, §903 requires a separate class vote (in addition to the overall shareholder vote) for any amendment that would: (1) increase or decrease the authorized shares of that class, (2) change the par value of shares of that class, (3) alter or change the powers, preferences, or special rights of shares of that class in a way that affects them adversely, or (4) effect an exchange, reclassification, or cancellation of shares of that class.

This means you cannot, for example, amend your articles to eliminate the Series A liquidation preference, or to create a new class of super-preferred stock that ranks senior to Series A in liquidation, without obtaining approval from the holders of Series A Preferred voting as a separate class. Section 903 creates a statutory baseline of class protection that exists regardless of what your investor agreements say.

But investors don’t rely solely on §903. The typical venture financing includes extensive contractual protective provisions (sometimes called “investor consent rights” or “major investor rights”) that require approval from a specified percentage of preferred stockholders (often a majority, sometimes a supermajority, occasionally specific major investors individually) before the company can take certain actions.

Common protective provisions include requirements for preferred stockholder approval to: authorize or issue senior or pari passu securities; amend the charter or bylaws; change the size of the board; pay or declare dividends; purchase or redeem shares (other than repurchases from terminated employees); liquidate, dissolve, or effect a merger or sale of assets; incur debt above specified thresholds; make acquisitions or investments; change the business; create subsidiaries; enter related-party transactions; or increase the option pool beyond the initially approved size.

These contractual provisions go well beyond the statutory protections of §903 and effectively give investors veto power over nearly all significant corporate actions. California Corporations Code §204 explicitly authorizes the articles of incorporation to contain “any provision for the management of the business and for the conduct of the affairs of the corporation” not in conflict with law, including supermajority vote requirements and other governance restrictions. Many protective provisions are memorialized in the charter, while others appear in the investors’ rights agreement or voting agreement executed alongside the stock purchase agreement at closing.

From a founder’s perspective, protective provisions are a necessary part of institutional venture financing, but they should be reasonable in scope and consistent with market terms for your stage and geography. You should resist provisions that give investors line-item veto rights over ordinary operational decisions, and you should ensure that protective provisions include reasonable thresholds (such as debt limitations that allow for normal working capital lines) and sunset provisions that eliminate certain vetoes upon an IPO or other liquidity event.

Voting Rights and Board Composition: California’s Cumulative Voting Default Under §708

Board control is often more important than economic terms for early-stage companies. Investors understand this, which is why term sheets always specify board composition and board election mechanics. But California law creates a default voting structure that founders and investors must affirmatively address: cumulative voting under Corporations Code §708.

Cumulative voting allows shareholders to multiply the number of shares they own by the number of directors being elected and cast all those votes for a single director or distribute them among multiple candidates as they choose. For example, if you own 1,000 shares and there are five directors being elected, you have 5,000 votes that you can concentrate on one candidate or spread across multiple candidates.

The practical effect of cumulative voting is that minority shareholders can secure board representation even if they don’t have majority voting power. A shareholder with just over 16.67% of the votes can guarantee one seat on a five-person board by concentrating all votes on a single candidate, regardless of how the majority shareholders vote.

California defaults to cumulative voting for all corporations with more than one shareholder unless the articles of incorporation provide otherwise. This is fundamentally different from Delaware, where cumulative voting exists only if the charter affirmatively provides for it (DGCL §214).

For venture-backed startups, cumulative voting typically must be eliminated because investors want explicit control over board composition through designated board seats rather than mathematical voting thresholds. The standard venture-backed board structure is something like: two founder-designated seats, two investor-designated seats, and one independent seat mutually agreed upon by founders and investors. This structure doesn’t work if minority common stockholders can use cumulative voting to elect their own representative to the board.

You eliminate cumulative voting by including an explicit provision in your articles of incorporation stating that directors shall be elected by a plurality of the votes cast and that shareholders do not have cumulative voting rights. This should be done at formation if you anticipate institutional financing, or as part of your Series A charter amendment if you haven’t already addressed it. Under California law, eliminating cumulative voting requires approval by the outstanding shares (not just a majority of votes cast), so you need to address this before your cap table becomes too dispersed to obtain unanimous or near-unanimous consent.

Equity Incentive Plans: Options, RSAs, and Compliance with California and Federal Law

Your cap table isn’t complete without an equity incentive plan that allows you to grant stock options and restricted stock to employees, directors, and consultants. The option pool is typically sized at 10-20% of the fully-diluted capitalization and is almost always shown as “pre-money” in venture financings, meaning founders bear the dilution from the option pool rather than splitting it with investors.

Designing an equity incentive plan requires compliance with both California securities law and federal tax law. The key statutes are California Corporations Code §25102(o) (state securities exemption), SEC Rule 701 (federal securities exemption), Internal Revenue Code §§421-422 (incentive stock options), and IRC §409A (deferred compensation and option pricing).

California Securities Exemption – §25102(o): California’s securities qualification requirements would normally require you to obtain a permit from the Department of Financial Protection and Innovation before offering equity to employees. Section 25102(o) provides an exemption from qualification for offers and sales of securities under a written compensatory benefit plan to employees, directors, and consultants, subject to specific requirements set forth in Title 10 California Code of Regulations §260.140.41.

The requirements include: a written stock option or equity plan approved by the board (and, for California corporations, by the shareholders within 12 months before or after board adoption); securities offered under the plan must be non-transferable except by will or intestate succession; employees who exercise options must be provided with specified financial information about the company; and there are limitations on the amount of securities that can be offered to consultants and on total offering amounts.

Compliance with §25102(o) is critical for California companies and for out-of-state companies offering securities to California residents. The exemption applies to both stock options and restricted stock awards. If you fail to comply with §25102(o) and don’t have another exemption available, you could face rescission rights (where employees can demand their money back) and regulatory penalties.

Federal Securities Exemption – Rule 701: Rule 701 under the Securities Act of 1933 provides an exemption from federal registration for compensatory stock options and equity issued by non-reporting companies under written compensatory benefit plans. The rule has a 12-month rolling issuance cap: the greater of $1 million, 15% of the issuer’s total assets, or 15% of the outstanding securities of the same class.

If aggregate sales under all Rule 701 plans in a 12-month period exceed $10 million, the company must provide enhanced disclosure to recipients, including GAAP financial statements and risk factor disclosure similar to what you’d see in a registration statement. For most early-stage startups, you won’t approach the $10 million threshold, but fast-growing companies need to monitor their Rule 701 usage carefully.

Stock Options vs. Restricted Stock: You have two primary vehicles for equity compensation: stock options and restricted stock (or restricted stock units). The tax treatment and practical considerations differ significantly.

Stock options give employees the right to purchase shares at a specified exercise price (the “strike price”) which must equal or exceed the fair market value of the underlying common stock at the date of grant to avoid IRC §409A penalties. Options come in two flavors: incentive stock options (ISOs) which receive favorable tax treatment under §§421-422 if holding period and other requirements are met, and non-qualified stock options (NSOs) which are taxed as ordinary income on the spread between exercise price and fair market value at exercise.

ISOs have significant limitations: they can only be granted to employees (not consultants or directors), the aggregate fair market value of stock underlying ISOs that first become exercisable in any calendar year cannot exceed $100,000, and they must be granted pursuant to a written plan approved by shareholders within 12 months. Despite these limitations, ISOs are the default choice for employee equity because they allow employees to potentially pay zero tax at exercise and convert all gains into long-term capital gains if they hold the stock for at least two years from grant and one year from exercise.

Restricted stock awards (RSAs) transfer actual shares subject to vesting, rather than the right to purchase shares in the future. RSAs are taxed under IRC §83 (as discussed in the founder vesting section), with an 83(b) election allowing recipients to recognize income at grant rather than vesting. For very early employees joining when stock is worth pennies, RSAs with 83(b) elections can be extremely tax-efficient, similar to founder grants. However, as the company’s 409A valuation increases, RSAs become less attractive because the recipient must pay tax on the full value at grant (if they make an 83(b) election) or at vesting (if they don’t), and they must pay this tax in cash even though they haven’t sold shares to generate liquidity.

409A Valuations: IRC §409A provides that stock options granted with an exercise price below fair market value are treated as deferred compensation subject to harsh penalty taxes. To avoid 409A issues, startups obtain independent 409A valuations establishing the fair market value of their common stock. The IRS provides a safe harbor for valuations performed by qualified independent appraisers using reasonable methodologies.

As a practical matter, every institutional financing triggers a new 409A valuation because the preferred stock price provides strong evidence of the company’s overall value, which must be allocated between preferred and common. A contemporaneous 409A valuation from a reputable provider creates a presumption of reasonableness that protects the company and option recipients from IRS challenge. Valuations should be refreshed at least annually and whenever there’s a material event (financing, significant revenue milestone, product launch, etc.) that could affect value.

Delaware Incorporation for California Startups: When §2115 Imports California Law

Most venture-backed startups incorporate in Delaware rather than California, even if they’re headquartered in California and all their operations and employees are in California. The reasons are well-known: Delaware corporate law is more flexible and predictable, Delaware courts have extensive expertise in business disputes, Delaware allows for broad indemnification and exculpation of directors, and the entire venture capital ecosystem defaults to Delaware formation.

Delaware General Corporation Law provides advantages in share class design that mirror California’s flexibility but without some of California’s mandatory shareholder protections. DGCL §151 grants broad authority to create classes and series of stock with customized preferences, rights, and restrictions. DGCL §102(a)(4) requires the certificate of incorporation to state authorized shares and may specify different classes with particular designations, preferences, and rights. DGCL §242 governs charter amendments and requires class votes when amendments would increase or decrease authorized shares of a class or alter the powers, preferences, or rights of a class—similar to California’s §903 but interpreted and applied by Delaware courts with an extensive body of precedent.

Critically, Delaware does not default to cumulative voting (DGCL §214 makes cumulative voting optional, available only if provided in the charter), and Delaware’s distribution rules under DGCL §170 are more flexible than California’s two-prong test.

But California founders who incorporate in Delaware need to understand California Corporations Code §2115, the “pseudo-foreign corporation” statute that can import California law onto your Delaware corporation. Section 2115 applies when: (1) more than 50% of the voting securities of a foreign corporation are held by persons with California addresses as shown on the corporation’s books, and (2) more than 50% of the corporation’s property, payroll, and sales are in California based on a weighted formula.

When §2115 applies, California imports numerous provisions of the Corporations Code onto the foreign corporation, including: §§300-305 (director duties, removal, and vacancies), §§500-505 (distribution limitations), §§708-710 (cumulative voting and shareholder meetings), §§1201-1202 (reorganization procedures and dissenters’ rights), and several others.

The practical effect is that your Delaware C-corp may be subject to California’s cumulative voting default, California’s restrictive distribution tests, and California’s procedural requirements for corporate actions, even though none of these are required under Delaware law. Courts have upheld §2115 against constitutional challenges, though the statute remains controversial and California’s application of it to Delaware corporations raises choice-of-law questions that remain partially unresolved.

For California founders, this means you need to think carefully about whether Delaware incorporation actually delivers the benefits you’re seeking. If your cap table will be California-heavy (founders, employees, and angels all in California) and your operations will be primarily California-based, §2115 may apply and you’ll get the worst of both worlds: Delaware formation costs and franchise taxes plus California substantive law.

Many startups address this by incorporating in Delaware but planning to “out-grow” §2115 over time as they hire employees in other states, bring in out-of-state investors, and expand their customer base nationally or internationally. Others simply accept that §2115 will apply but rely on Delaware formation for its signaling value to investors and for access to Delaware courts if disputes arise.

If you’re incorporating in Delaware while operating in California, you should: (1) ensure your charter properly eliminates cumulative voting under Delaware law, even though §2115 might re-import it; (2) draft your protective provisions and economic terms to comply with both Delaware law and California law where §2115 might apply; (3) document your board resolutions and stockholder consents in a way that satisfies both Delaware and California requirements; (4) consider whether your distribution, redemption, and dividend terms comply with California’s §§500-501 tests in addition to Delaware’s more flexible standard; and (5) monitor your §2115 status as your cap table and operations evolve.

Practical Cap Table Scenarios: From Formation Through Series A

Theory only gets you so far. Let’s walk through concrete examples showing how cap table design plays out at different startup stages.

Formation – Two Founders: You and your co-founder are forming a California corporation to build a SaaS platform. You authorize 10,000,000 shares of common stock, par value $0.0001. You issue 4,000,000 shares to yourself and 4,000,000 shares to your co-founder, each paying $400 cash (4,000,000 shares × $0.0001 par value). Both grants are subject to four-year vesting with a one-year cliff. You both file 83(b) elections within 30 days.

At this point your cap table shows: Founder A with 4,000,000 shares (50%), Founder B with 4,000,000 shares (50%), and 2,000,000 shares unissued and available for future option grants. Your articles provide that directors are elected by plurality vote and shareholders do not have cumulative voting rights. You’ve set up a clean cap table structure that will be attractive to institutional investors.

Pre-Seed Round – Creating the Option Pool: Six months later, you’re ready to raise a small pre-seed round from angels and you need to create a formal option pool. You adopt a 2024 Equity Incentive Plan reserving 1,200,000 shares for future grants (making the pool 15% of the fully-diluted cap table: 1,200,000 ÷ 8,000,000 = 15%). The plan is approved by your board and by your shareholders (just you and your co-founder at this point) to comply with California requirements and to allow for ISO grants.

You then issue 1,000,000 shares of common stock to five angel investors for $250,000 total ($0.25 per share). Your post-closing cap table shows: Founder A 4,000,000 shares (40%), Founder B 4,000,000 shares (40%), Angels 1,000,000 shares (10%), Option Pool 1,000,000 shares reserved (10%). Note that the option pool counts in the denominator for calculating percentages even though options haven’t been granted yet.

Series A – Introducing Preferred Stock: Eighteen months after formation, you’ve built a working product, acquired initial customers, and you’re ready to raise $2 million in Series A financing at a $8 million pre-money valuation. The term sheet requires that the option pool be increased to 20% of the fully-diluted post-closing cap table.

Here’s how the math works: The pre-money valuation is $8 million. But the investors will require that the option pool expansion happen “pre-money,” meaning founders dilute themselves to create the additional pool before investors come in. If the current pool is 1,000,000 shares and you need to get to 20% post-closing, you need to do the math backwards to figure out the required pool size.

Post-closing capitalization will be: Common stock currently outstanding (9,000,000 shares) + Pool increase (X shares) + Series A shares issued (Y shares) = Fully diluted. You need Pool / Fully-diluted = 20%. Working through the algebra and using the $2M investment at the $8M pre-money valuation, you ultimately increase the pool to approximately 2,500,000 shares (from 1,000,000), and issue 2,500,000 shares of Series A Preferred at $0.80 per share.

Your post-Series A cap table shows: Founders 8,000,000 common (approximately 57% on a fully-diluted basis), Angels 1,000,000 common (approximately 7%), Series A investors 2,500,000 preferred (approximately 18%), Option Pool 2,500,000 shares reserved (approximately 18%). The founders have been diluted from 80% to 57%, but they’ve brought in $2 million in growth capital at a meaningful valuation.

The Series A Preferred has a 1x non-participating liquidation preference, meaning if the company sells for $10 million, the Series A investors get their $2 million back first, and the remaining $8 million is distributed pro rata to all shareholders based on their common-equivalent ownership. If the company sells for less than $2 million, the Series A investors take the entire proceeds and common shareholders get nothing. If the company goes public or sells for a very high price, the Series A investors will convert to common to participate in the upside rather than taking just their 1x preference.

Transfer Restrictions, Founder Lock-Ups, and Secondary Sales

Your cap table design should address not just who gets shares and what rights attach to them, but also when and how shareholders can transfer shares. Transfer restrictions serve several purposes: they prevent common stock from being widely distributed to unknown parties, they give the company and existing investors a chance to purchase shares before they’re sold to outsiders, and they keep the cap table clean and manageable.

California Corporations Code §418 requires that transfer restrictions be conspicuously noted on stock certificates (or in written statements for uncertificated shares) to be enforceable against transferees without actual knowledge. Delaware has similar requirements under DGCL §202. The typical transfer restrictions in venture-backed companies include rights of first refusal (ROFR), co-sale rights, and sometimes drag-along rights.

Under a ROFR, if a shareholder wants to sell shares, they must first offer them to the company and/or to existing investors at the same price and terms being offered to the third-party purchaser. This gives the company control over who gets to be a shareholder and prevents competitors or other undesirable parties from acquiring equity.

Co-sale rights (or “tag-along rights”) allow investors to participate pro rata in any founder sale to a third party. If a founder wants to sell 10% of their holdings to an outside buyer, investors with co-sale rights can reduce the founder’s sale proportionally and sell their own shares in the same transaction at the same price. This prevents founders from getting liquidity while investors remain illiquid and ensures all shareholders benefit from liquidity opportunities.

Drag-along rights require minority shareholders to sell their shares on the same terms as the majority if the majority approves a sale of the company. This prevents holdout situations where a small shareholder can block an acquisition that the founders and investors support. Drag-along provisions must be carefully drafted to comply with California securities laws and to ensure that the process for triggering the drag is clear and not susceptible to abuse.

Founders are typically subject to additional lock-up restrictions that prevent them from selling shares for a specified period (often until an IPO or until the investors achieve a specified return on investment). These founder lock-ups recognize that founders shouldn’t be looking for early exits while investors are locked in for the long term.

Many founders ask about secondary sales—selling some founder shares to generate personal liquidity before an exit. Whether this is possible depends entirely on your agreements with investors and on the ROFR and co-sale provisions in your charter and stockholder agreements. Some investors will permit small founder secondary sales in later-stage rounds (typically capped at 10-20% of the founder’s holdings) as a way to reduce founder financial stress and keep them focused on building the company rather than worrying about personal finances. Other investors refuse to permit any founder liquidity before an exit, viewing it as misalignment of incentives.

Mistakes Founders Make in Cap Table Design

Over 13 years and 1,750+ completed projects, I’ve seen founders make the same cap table mistakes repeatedly. Here are the most common ones and how to avoid them.

Mistake 1: No Founder Vesting. Issuing founder shares without vesting creates massive problems when a co-founder leaves early. Investors will require you to fix this before they invest, which means the remaining founders must retroactively agree to subject their shares to vesting, potentially triggering new tax obligations. Implement founder vesting from day one and make it mutual—all founders vest on the same schedule.

Mistake 2: Missing the 83(b) Deadline. Failing to file the 83(b) election within 30 days of receiving restricted stock is a permanent mistake with potentially catastrophic tax consequences. You cannot get extensions or fix it later. Every lawyer and accountant will tell you to file the 83(b), but founders still miss this deadline with alarming frequency, usually because they’re moving fast and don’t prioritize administrative tasks. Create a system where the 83(b) election is prepared and filed the same day you issue restricted stock.

Mistake 3: Oral Equity Promises. Promising equity to early employees or advisors without documenting it properly leads to disputes and potential securities violations. Every equity grant—whether options or restricted stock—must be documented in writing, approved by the board, and issued in compliance with your equity plan and applicable securities laws. “I’ll give you 1% when we raise money” is not sufficient. Get a board resolution, issue the grant documentation, and comply with §25102(o) requirements.

Mistake 4: Overvaluing Sweat Equity. When founders contribute services or intellectual property as consideration for shares under §203, the board must make a reasonable valuation. Wildly inflating the value of contributed IP or services can create tax issues (if the IRS challenges the valuation) and can undermine the board’s credibility with future investors. Document the IP being assigned, get a board resolution approving the valuation, and be conservative rather than aggressive.

Mistake 5: Ignoring §2115 Implications for Delaware Corps. Incorporating in Delaware but operating primarily in California without understanding how §2115 might import California law creates unexpected compliance issues. If you’re going to be a Delaware corporation with California operations and shareholders, make sure your formation documents comply with both Delaware and California requirements, particularly around cumulative voting and distribution limitations.

Mistake 6: Underestimating the Option Pool. Creating a 5-10% option pool at formation and then scrambling to increase it before your Series A creates unnecessary founder dilution. Investors expect a meaningful post-closing option pool (typically 15-20%) and that increase will happen “pre-money” meaning it dilutes founders, not investors. Think ahead about your hiring plans and create an adequate pool early, or at least understand that you’ll be increasing it before you raise institutional capital and factor that dilution into your planning.

Mistake 7: Granting Options Below Fair Market Value. Issuing options with an exercise price below the 409A fair market value creates §409A violations and subjects option holders to penalty taxes. Always obtain a current 409A valuation and use it to set option strike prices. Refresh your 409A after financing rounds and at least annually.

Need help structuring your cap table or negotiating investment terms? Schedule a consultation to discuss your specific situation with an experienced California attorney.

Frequently Asked Questions

Should I incorporate in California or Delaware for my tech startup?

The default answer in Silicon Valley is Delaware, and there are legitimate reasons for that—Delaware corporate law is well-developed, the Court of Chancery has deep expertise in business disputes, and the entire venture capital ecosystem expects Delaware formation. But the decision is more nuanced than “always Delaware.”

If you’re building a lifestyle business or a services company with no plans for institutional venture capital, California incorporation is simpler and cheaper. You avoid Delaware franchise taxes, you don’t need to maintain a registered agent in Delaware, and your formation and maintenance costs are lower. California law provides perfectly adequate legal infrastructure for businesses that will remain closely held.

If you’re building a venture-backable technology company and you expect to raise institutional capital, Delaware is probably the right choice despite the additional costs and complexity. Venture capitalists are accustomed to Delaware entities, their lawyers know Delaware law, and the standard form venture documents (NVCA forms) are drafted for Delaware corporations. Trying to negotiate a venture financing as a California corporation adds friction and creates uncertainty around how California’s more restrictive provisions might affect investor rights.

The main counterargument is §2115. If you’re going to be majority California-owned and California-operated for the foreseeable future, you might be subject to California law anyway through the pseudo-foreign corporation statute, which means you’re paying for Delaware incorporation but not getting Delaware’s flexibility. In that scenario, some founders choose California incorporation, at least initially, with the understanding that they can reincorporate in Delaware later if their operations or shareholder base expands beyond California. Reincorporation is feasible but involves costs, potential tax implications, and shareholder approval requirements, so it’s not trivial.

My practical advice: if you’re genuinely uncertain about your funding plans and you’re trying to minimize costs, start with California and reincorporate in Delaware if and when you raise institutional capital. If you’re confident you’ll be raising venture capital within 12-18 months, start with Delaware and avoid the hassle of reincorporation later. And if you do incorporate in Delaware while operating in California, work with counsel who understands both Delaware and California law to ensure your governance documents comply with both regimes.

How do I handle equity compensation for contractors and consultants versus employees?

The distinction between employees and contractors matters enormously for equity compensation because of legal restrictions on who can receive incentive stock options and because of securities law requirements for consultant grants.

ISOs can only be granted to employees under IRC §422. If you misclassify a worker as an employee and grant them ISOs, but they’re actually an independent contractor under tax law, those options are automatically treated as NSOs, potentially creating unexpected tax liability for the recipient. You need to get the classification right upfront based on standard IRS factors: whether you control the means and manner of their work, whether they work exclusively for you, whether you provide tools and equipment, whether they’re integrated into your business operations, and whether the relationship is indefinite versus project-based.

True consultants and advisors must receive NSOs, not ISOs. NSOs create ordinary income tax at exercise based on the spread between exercise price and fair market value, so they’re less favorable than ISOs from a tax perspective, but they’re the only option for non-employees.

California securities law adds another wrinkle. Under Corp. Code §25102(o) and CCR §260.140.41, you can grant equity to consultants under your compensatory benefit plan, but there are specific limitations. The regulations cap consultant grants at a certain percentage of total offerings under the plan, and they impose additional disclosure requirements for consultant grants. You need to document that the consultant is providing bona fide services related to your business and that the grant is genuinely compensatory rather than an investment.

For advisors (typically people who provide strategic guidance but don’t perform ongoing services), the standard arrangement is a restricted stock or option grant that vests monthly or quarterly over 1-2 years, with total compensation in the 0.1% to 1% range depending on the advisor’s seniority, involvement, and stage at which they join. The Founder Institute publishes a widely-used “FAST” agreement (Founder/Advisor Standard Template) that provides reasonable market terms for advisor equity.

Be extremely conservative about classifying workers as consultants rather than employees for equity purposes. The IRS and California taxing authorities are aggressive about reclassifying workers, and if someone you’ve treated as a consultant is later determined to be an employee, you could face payroll tax liability, penalties, and benefits obligations. When in doubt, treat them as an employee or get a determination letter from the relevant agencies.

What’s the difference between broad-based and narrow-based weighted average anti-dilution, and which should I accept?

Anti-dilution provisions protect preferred stockholders from dilution in down rounds by adjusting the conversion ratio between preferred and common stock. When the company issues shares at a lower price than the preferred investors paid, the anti-dilution formula adjusts how many common shares each preferred share converts into, effectively giving preferred stockholders more common shares to compensate for the dilution.

The two main formulas are full ratchet (extremely investor-friendly and rare in venture deals) and weighted average (the market standard). Within weighted average, there are two variants: broad-based and narrow-based.

Narrow-based weighted average anti-dilution uses only the common stock outstanding (and common equivalents like options) in the denominator when calculating the adjustment. Broad-based weighted average includes the entire fully-diluted capitalization including all classes of stock, options, warrants, and other convertible securities in the denominator.

Mathematically, broad-based is more founder-friendly because the larger denominator results in a smaller adjustment to the conversion price. Here’s a simplified example: If you have 8 million common shares outstanding, 2 million Series A preferred shares, and 2 million options reserved, the fully-diluted cap is 12 million shares. If you then do a down round issuing 2 million Series B shares at half the Series A price, the broad-based formula would divide that 2 million new shares by the full 12 million denominator, resulting in a smaller adjustment than a narrow-based formula that divides by only the 8 million common shares outstanding.

The industry standard for balanced venture deals is broad-based weighted average anti-dilution. This is what appears in NVCA form documents and what most sophisticated investors and founders expect. Narrow-based weighted average is more investor-friendly and less common. Full ratchet anti-dilution is extremely punitive to founders (it treats ANY down round, no matter how small, as if all previous shares were issued at the new lower price) and is typically only seen in distressed financings or in deals with significant investor leverage.

If you’re negotiating a term sheet and the anti-dilution provision says “weighted average” without specifying broad or narrow, you should clarify which variant applies and push for broad-based. If investors propose narrow-based, understand that they’re asking for something more favorable than market standard, and you should push back unless there are other terms being negotiated in your favor. If anyone proposes full ratchet, you should seriously question whether this is the right financing partner unless your company is in genuinely distressed circumstances where you have no better options.

One final point: anti-dilution provisions almost always carve out certain issuances that don’t trigger adjustments, including option pool increases, stock splits, dividends, and issuances in connection with acquisitions, equipment financing, or bank debt. Make sure these carve-outs are included in your anti-dilution provision to avoid unnecessary adjustment triggers for routine corporate actions.

How do I value my common stock for option grants when we don’t have a 409A valuation yet?

You don’t. If you’re issuing compensatory stock options to employees or consultants after your company has any meaningful value, you must have a 409A valuation completed before you grant options. Granting options without a current 409A valuation exposes your option holders to penalty taxes under IRC §409A and exposes the company to potential IRS challenges.

The only exception is in the first few weeks after incorporation when the company has no assets, no revenue, no IP, and no realistic value beyond the nominal cash put in by founders. In that narrow window, you might reasonably conclude that the common stock has a value equal to par value or nominal value (say, $0.001 per share), and you could grant options at that strike price. But even in that scenario, many lawyers and accountants will recommend getting a 409A valuation immediately to create a defensible record.

Once you’ve raised any amount of financing, hired employees, developed technology, or achieved any business milestones, the company has value and you need a professional 409A valuation to establish the fair market value of common stock. The IRS provides a safe harbor for valuations performed by qualified independent appraisers using reasonable methodologies. If you follow the safe harbor, the IRS presumes your valuation is reasonable unless they can show it’s “grossly unreasonable.”

A 409A valuation for an early-stage startup typically costs $2,000 to $5,000 and takes 1-2 weeks to complete. The appraiser will review your cap table, financial statements, business plan, and information about recent financings and comparable companies, and will prepare a report concluding on the per-share value of your common stock. This valuation is typically valid for 12 months or until a material event (such as a financing round) that would affect value.

I understand that $2,000-5,000 feels like a lot of money when you’re bootstrapping, but it’s a necessary cost of having employees and properly compensating them with equity. Skipping the 409A valuation to save money in the short term can create vastly larger problems down the road if the IRS challenges your option grants and assesses penalty taxes on your employees. Pay for the 409A valuation and set option strike prices based on defensible valuations.

As a related point: never, ever backdate option grants or try to manipulate 409A valuations to artificially suppress the value of your common stock. The IRS takes this very seriously, and executives have faced criminal prosecution for stock option backdating schemes. Get honest valuations, grant options at fair market value based on those valuations, and document everything properly.

Can I buy back shares from a departing founder who hasn’t fully vested, and how does the repurchase price work?

Yes, and you absolutely should exercise your repurchase rights when a founder leaves before they’re fully vested. The mechanics and pricing depend on what your restricted stock agreement says and on how you structured the vesting arrangement.

There are two common structures for founder vesting: restricted stock with repurchase rights, and options that vest over time. The structure you chose determines how the buyback works.

Under the restricted stock model, founders receive actual shares at formation, but the company has the right (and often the obligation) to repurchase unvested shares at the original purchase price if the founder’s service terminates. For example, if a founder paid $0.0001 per share for 4 million shares subject to four-year vesting, and they leave after one year, the company can repurchase the 3 million unvested shares for $300 (3 million × $0.0001).

This is what makes the 83(b) election critical: even though the founder paid only $0.0001 per share and the stock might now be worth $1.00 per share, the company’s repurchase price is the original purchase price, not current fair market value. The founder loses the unvested shares and gets back only what they paid. This creates the economic effect of forfeiture while technically being a repurchase.

The restricted stock agreement should specify whether the company’s repurchase right is optional or mandatory. In some agreements, the company “may” repurchase unvested shares, giving the board discretion to let the founder keep unvested shares if they leave on good terms. In other agreements, the company “shall” repurchase unvested shares, making it automatic and non-discretionary. Most investors prefer the mandatory version to ensure that equity pools back to the company when founders leave and can be re-granted to replacement team members.

Under the option model, founders receive options that vest over time rather than actual shares. When a founder leaves, unvested options terminate automatically and the founder keeps only vested options (which they typically must exercise within 90 days of termination or they expire). This achieves the same economic result as the restricted stock repurchase model but without requiring the company to pay anything—unvested options simply disappear.

Regardless of which structure you used, the key is to exercise your repurchase rights promptly. Most restricted stock agreements give the company a limited window (often 90 days) to exercise the repurchase right after termination. If you don’t act within that window, you may lose the right to buy back the unvested shares, leaving the departed founder with equity they didn’t earn.

From a tax perspective, repurchasing unvested shares at the original purchase price shouldn’t create any tax consequences for the founder (they paid $X and received $X back, so there’s no gain). The company should issue a termination notice, calculate the number of unvested shares, prepare a stock repurchase agreement, and transfer the repurchase price (even if it’s nominal) to clean up the cap table.

One final consideration: if the departing founder is leaving under acrimonious circumstances and might challenge the repurchase, make sure your documentation is airtight. The restricted stock agreement should be signed by both the founder and the company, should clearly spell out the vesting schedule and repurchase mechanics, and should specify that the shares remain subject to the company’s repurchase right until they vest. If you discover gaps in your documentation when a founder leaves, consult with counsel about your options and about the risks of proceeding with the repurchase versus negotiating a separation agreement that clarifies the terms.

What happens to my option pool and cap table math when I raise a Series B after my Series A?

Each new financing round requires adjustments to your cap table and potentially to your option pool, and understanding the mechanics is critical for modeling dilution and negotiating terms with new investors.

Let’s say you raised a Series A with a post-closing option pool of 20% of fully-diluted capitalization. Between the Series A closing and your Series B, you’ve granted options to employees, reducing the available pool. You’ve also had some employee turnover, and some unvested options have been forfeited and returned to the pool. By the time you’re negotiating your Series B term sheet, you might have 8% of fully-diluted capitalization available in the pool (ungranted options) and 12% actually granted to employees and vesting over time.

Series B investors will typically require that the option pool be refreshed to a specified percentage of the post-Series B fully-diluted capitalization—often 15-20%, though this varies based on your hiring plans and your headcount at the time of financing. Just like with your Series A, this pool increase happens “pre-money,” meaning it dilutes existing stockholders (founders, Series A investors, and employees with vested options) proportionally before the Series B investors come in.

Here’s simplified math: Assume your pre-Series B cap table shows 10 million common shares outstanding (founders, employees, early investors), 2.5 million Series A preferred shares outstanding, and an option pool with 1 million shares available. You’re raising $5 million at a $20 million pre-money valuation on a fully-diluted basis. The Series B term sheet requires increasing the option pool to 20% of the post-closing fully-diluted cap.

To solve for the required pool increase and the number of Series B shares, you need to work backwards: Post-closing fully-diluted shares = Pre-closing common (10M) + Pre-closing preferred (2.5M) + Option pool increase (X) + Series B shares (Y). The Series B investors want 20% of the post-money company for their $5M investment at the $20M pre-money valuation, which means they’ll own 20% post-closing ($5M investment / $25M post-money valuation). You also need the option pool to equal 20% post-closing.

Working through the algebra: if Series B owns 20% and the pool is 20%, then existing stockholders own 60%. You know the existing stockholders currently hold 12.5M shares (10M common + 2.5M preferred). If those 12.5M shares represent 60% post-closing, the total post-closing shares = 12.5M / 0.60 = approximately 20.83M shares. The Series B shares = 20% of 20.83M = approximately 4.17M shares. The option pool needs to be 20% of 20.83M = approximately 4.17M shares. Since you currently have 1M available, you need to add 3.17M shares to the pool pre-closing.

The dilution calculation: Pre-Series B, founders and early investors owned 100% of 12.5M shares. Post-Series B, they own 60% of 20.83M shares, having been diluted by the option pool increase (3.17M new shares created pre-closing) and by the Series B issuance (4.17M new shares created at closing). Series A investors who owned 20% pre-Series B (2.5M / 12.5M) now own 12% post-Series B (2.5M / 20.83M).

This math gets more complex when you factor in anti-dilution adjustments (if the Series B price per share is lower than the Series A price, triggering anti-dilution), option exercises between rounds, and different treatment of outstanding versus available pool shares. Most founders use cap table management software (Carta, Pulley, AngelList) to model these scenarios rather than calculating by hand.

The key strategic point is that option pool increases always dilute existing stockholders, not new investors. When you’re negotiating a term sheet, pay close attention to the pool size requirement and understand that increasing the pool from 8% to 20% means creating 12% more shares pre-money that dilute you and your existing investors. Sometimes you can negotiate with Series B investors to accept a smaller pool increase if you can demonstrate that you’re well-staffed and won’t need aggressive hiring, or you can negotiate to defer part of the pool increase until a future financing. But in most cases, the pool requirement is relatively non-negotiable because investors have reasonable concerns about ensuring adequate equity compensation capacity for the team you’ll need to build between this round and the next.

About the Author: Sergei Tokmakov is a California-licensed attorney (CA Bar #279869) since 2011, representing technology startups, online businesses, and foreign entrepreneurs. He has completed 1,750+ Upwork projects with a 4.9/5 client rating across 692 reviews. His practice focuses on business formation, contract drafting, equity compensation design, and venture capital transactions.