Guest post by Linda Chan, Head of Content at Dragon Law, the cloud-based legal software trusted by more than 15,0000 small and medium businesses.
As a business owner, managing your shareholding is a fundamental part of running your business. Unfortunately, that can also be one of the most challenging pieces of the puzzle to figure out.
Can I have an arrangement where some shareholders have more powers than others?
Must I seek anyone’s approval if I want to issue shares to a new shareholder?
What is the difference between issuing shares and transferring shares? Which way should I choose?
These are some of the questions business owners may have, and understandably so, since shares represent ownership and decision-making power in a business. Here, we list five considerations you should have when issuing and transferring shares.
- Get familiar with the terminology
Before you start a discussion about issuing or transferring shares, make sure you (and the persons who will get shares) understand these terms right:
- A share is a bundle of rights in a company. A share represents ownership in a company - how much ownership does a share represent? This varies - depending on the number (and classes, see below) of shares issued.
- The terms “share” and “stock” can generally be used interchangeably, they both refer to ownership in a company.
- A stock market or a stock exchange is a marketplace where shares of companies are traded publicly. The shares traded on these markets are said to be listed.
- A company issues shares by creating new share certificates, giving them to the shareholder, and recording the issue in a record book known as a “register of members”. Issue of shares generally require the approval of existing shareholders in the company.
- Shares may be transferred from one shareholder to another. That implies, these shares are not “fresh” from the company, they have been owned by someone else.
- When you talk to investors or potential shareholders about getting shares in your company, it is important to agree on whether new shares will be issued to them, or existing shares will be transferred to them. You will need different documents for each.
- It is important to understand by issuing shares, the company gets the money from the new shareholders. By transferring shares, the original shareholder who is selling the shares gets the money.
- “Equity” has a few common meanings, used in different context. In a fundraising context, equity means raising money by issuing shares, as opposed to raising money by issuing debts.
- Know the different classes of shares
It is a core concept in company law that the shareholders are treated equally, as long as they hold the same class of shares. Within the same class, each share carries equal rights. When a company is formed, the initial class of shares that it will have will be ordinary shares (or “common stock”). An ordinary share entitles the holder to the following basic rights:
- The right to vote (one share carries one vote);
- The right to receive a share of the company’s profits (known as “dividends”);
- The right to receive important information about the company (e.g. annual reports and accounts);
- The right to receive a share of the remaining assets of the company when it winds up (note here “remaining” assets means what’s left in the company after its assets have been distributed according to statutory requirements; i.e. all the creditors and employees with unpaid salaries will be paid first, before the assets are shared among shareholders).
As a company grows, the owners may wish to have different classes of shares for different purposes. For example:
- some businesses like to have non-voting shares, which means the holders will still receive dividends but won’t be able to vote. For example, you may wish to reward your employees by giving them shares, so that they can share in the success of the business, but you don’t want them to be able to vote on important decisions of the business;
- most investors like to have preferred shares - shares that carry “preferences”, which means these shares will “rank above” the ordinary shares. This could happen in different ways. For example, preference shares may give their holders the right to receive a fixed rate of dividends, and the right to receive remaining assets ahead of the ordinary shareholders. Or, preference shares may give their holders more voting power than that of ordinary shareholders (the “super-voting shares”).
It is crucial to understand that there are so many different ways to structure the rights of a particular class of shares. If you are not familiar with this you should seek professional advice. It is also very important that whatever these rights are, they must be set out very clearly in a document (typically in the company’s constitutional document).
You should also note that when the business grows big and you wish to apply for listing on a stock exchange, the share structure will be scrutinised by regulators and you may need to make some adjustments. Again, professional advice will be necessary.
- Think about what your shareholders bring to the table
If you are a small business owner with substantial decision-making power about who you bring on board as shareholders, it is beneficial to think about what each individual shareholder brings to the table. Depending on the terms set out in the Shareholders’ Agreement, your shareholders would have a say in making certain key business decisions, such as whether to adopt a proposed business plan or whether to approve a transaction above a certain value. Just bringing on board one additional shareholder has the potential to change the dynamic of how decisions are made and influence the direction the company takes.
It is helpful to think about shareholders’ contributions in three main buckets:
- Money. As a small business, your equity investors are a significant source of capital. Think about whether your investors would be willing to step up in times of trouble
- Information. Given that they have an interest in the health and profitability of the company, shareholders can potentially offer crucial information, analysis and advice that may aid management in the running of the company.
- Discipline. Directors of a company are officers of a business and make day to day decisions. Where directors are not owners of the business, the owners need to guard against the possibility that the directors are acting in the interest of themselves but not of the business (or its owners). Active shareholders will monitor the performance of the board and ensure the directors are doing their job well.
In evaluating whether to bring on board a certain shareholder, think about the value that the shareholder could bring. This could be prior experience or industry expertise, or business connections that will bring new opportunities.
Related reading: Angel investors vs venture capitalists
- Get your documentation done right
Whether the new shareholder will get new shares issued by the company or existing shares transferred by another shareholder, clear documentation of the rights and obligations of each party involved is paramount.
The first questions to ask would be:
- Are you issuing new shares or transferring existing shares to the investor?
- Which class of shares will be issued or transferred?
- Are there restrictions on issue or transfer of shares (for example, in the company’s constitution or an existing shareholders’ agreement)?
If you wish to issue new ordinary shares to the investor, you may use:
- Term Sheet for Ordinary Shares;
- Seed Investment Agreement;
- Shareholders’ Resolution to issue Ordinary Shares;
- Share Certificate; and
- Shareholders’ Agreement (or a Deed of Adherence if there is an existing Shareholders’ Agreement)
If you wish to issue preferred shares to the investor, you will need to make sure the rights attached to the preferred shares are clearly set out. We recommend you to get professional advice if you wish to issue preferred shares.
If you wish to transfer your existing shares to the investor, you may use:
- Share Purchase Agreement;
- A board resolution to approve the formality of transferring shares;
- Instrument of Transfer;
- Contract Notes; and
- Deed of Adherence if there is an existing Shareholders’ Agreement.
In transferring shares you may need professional advice on the warranties that you will give (or if you are buying shares, on the warranties that you should demand). Also check if stamp duty applies and if so the transfer may not be legally effective unless stamp duty is paid.