When a company is established, it typically issues "ordinary shares" to the initial shareholders. However, when seeking new investors, the company may opt to create multiple classes of shares. Understanding the different rights and privileges each share class offers is crucial for both existing shareholders and potential investors alike. This piece examines the intricacies of different share classes to help guide you on structuring your company's equity.
By carefully selecting the appropriate share class structure, a company can effectively balance the interests of all stakeholders, ensuring a level of control and financial flexibility that supports growth and scalability. Each class, from ordinary shares to preferred shares, presents unique rights and strategic benefits.
Ordinary Shares
Ordinary shares are the most common type found in many companies. They typically possess the following characteristics:
One Vote Per Share: Each share generally confers one vote in company meetings, influencing key decisions like electing board members and approving acquisitions.
Dividend Rights: While not guaranteed, ordinary shareholders may receive dividends declared by the company, often contingent on profitability and board discretion.
Residual Claims: In the event of company liquidation, ordinary shareholders are last in line to claim assets, after debts and preferred shareholders have been settled.
When no distinctions are specified between shares, it is assumed that all shares hold equal rights. For example, in a company with a share capital of $100 divided into 100 shares of $1 each, all shares have identical rights.
A company has the option to assign specific rights to various shares, such as dividends, capital return, or voting. For example, share classes can range from original shares with voting rights to those without. The latter is commonly granted by startups to employees as part of an incentive plan, allowing the employees to benefit from the company's growth and financial success without compromising the founders' control over strategic decisions.
Why Create Different Classes?
Creating various share classes allows a company to raise capital while tailoring rights to suit different stakeholders' interests. For instance, new investors might be attracted by equity that grants economical benefits without undermining the control held by the founders or initial investors.
Different classes of shares can serve to:
Incentivise Strategic Partnerships: Certain shares can offer specific benefits like guaranteed dividends, attracting partnership investments from venture capital firms or angel investors.
Preserve Founder Control: Startups can issue non-voting shares to new investors to maintain founders' decision-making power.
Optimise Economic Outcomes: Some share classes may have preferential rights to dividends or liquidation proceeds, ensuring certain investors are paid out first.
Share Class Variations
The array of different share classes that can be created offers a wide range of customized options, each crafted to fulfill specific requirements. Typical types of share classes comprise:
1. Preference Shares
Simply put, a preference share is a share that takes priority over ordinary shares, whether in terms of capital, dividends, or both. These often carry no voting rights but Investors are often drawn to preference shares because holders receive priority over holders of ordinary shares to dividends and asset claims.
2. Non-Voting Shares
Non-voting share are not as common in private companies but are gaining popularity among startups as a way to reward and motivate employees. This type of share can also exist in public companies.
The primary reason for introducing non-voting shares is to let current shareholders keep control of the company while new investors can purchase only non-voting shares. This allows non-voting shareholders to contribute to the share capital of the company and benefit from the company's financial success (e.g. through dividends), while the original shareholders maintain autonomy over decision-making.
3. Redeemable Shares
These are shares that a company has agreed it will, or may, buy back at a future date. If directors opt to issue redeemable shares, they typically need to include a special provision in the company's constitution outlining the terms and conditions of issuance. For instance, shares can be redeemable at the shareholder's or company's discretion.
The company's constitution should detail the redemption terms and process. Normally, redeemable shares are repurchased from distributable profits, though private firms may use capital if allowed by their constitution. Redeemed shares are considered canceled.
Venture capital investors often utilize redeemable shares to secure a clear exit strategy from companies they invest in. Typically, they seek a straightforward exit within three to five years to retrieve their investment and profits.
4. Management Shares
With multiple votes per share, this class of share can be used to empower key stakeholders, often founders or executives, to retain control over company decisions.
Commercial Considerations
When structuring share classes, the commercial objectives of the company must be at the forefront. The allocation of voting rights, dividends, and other economic interests can greatly affect the business's ability to attract the right type of investment and shape the power dynamics within the ownership structure.
Variables such as market conditions, the nature of the investor pool, and competitive strategy should guide the decision-making. Ultimately, the share class design should align with the company's ambitious, long-term strategies while offering the flexibility to adapt to changing circumstances.
Legal Nuances
The creation and issuance of different classes of shares are subject to a company's constitutional documents and prevailing laws. Legal considerations include:
Statutory Compliance: Issuance of shares must conform to corporate laws and securities regulations, which vary by jurisdiction.
Shareholder Agreements: Terms governing share classes often reside in shareholder agreements, imposing contractual obligations on top of statutory requirements.
Company’s Constitution: Amendments may be necessary to a company’s constitutional documents to reflect the rights of new share classes.
Regulatory Disclosures: Depending on where the company is incporated, the shareholder structure and the company's size, certain share class arrangements may necessitate disclosure filings with applicable licensing and regulatory bodies.
A comprehensive legal review is crucial to steer clear of issues and ensure that the share structuring is both legally compliant and optimal.
Final thoughts
Strategic planning of share classes is a crucial element for scaling a startup successfully. Whether it's about maintaining founder control, motivating talent, or attracting investments with varying terms, careful consideration of each class’s attributes is invaluable.
Whether you're a founder preparing for your first equity financing round or an investor seeking insights into your potential investment, understanding share classes is essential. Our team are adept at helping clients navigate this intricate landscape confidently, and develop a share structure that aligns with your strategic vision and business objectives.
For more information, contact Jamie Tredgold, Managing Principal.
This material is provided for general information only. It should not be relied upon for the provision of or as a substitute for legal or other professional advice.