The company’s structure can be designed to enhanced shareholder rights. Our specialist solicitors work with private companies, investors and shareholders and use the experience amassed over many years which is passed onto you. We prevent and unravel problems taking account of where the balance of power and your interests lie. We can review or draft agreements picking up on commercial and tax aspects.
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How to organise the shareholder rights
How to organise shareholder rights – share capital
Standard articles downloaded upon incorporation come with one class of shares. However, it is possible for companies to provide different groups of shareholders with different shareholder rights. For example different shareholder rights could be given to different groups of shareholders such as:
- The founders;
- Investors; and
The shareholder rights capable of variation within the company structure include:
- Dividend rights;
- Voting rights; and
- Capital rights. Capital rights are the right to receive capital following a sale of the company, liquidation or upon receipt of capital following an asset sale. It is common to see different rights for different shareholders and preferences.
Managing shareholder rights for different groups of shareholders
In order to provide different rights to different shareholders the company’s share capital or constitution will need to be set up into different classes of shares. The rights will need to be set out in the articles. Each class of shares created can then be used to provide different rights.
Shares held by founders
In many cases the founders are the last to be paid. Employees and directors receive fixed salaries reflective of the commercial rate. Founders take what profit is left after staff and creditors have been paid. Or, founders may retain profits for investment and not take out surpluses. The founders may well want to reward key employees and directors with shares. Being a shareholder can be motivational. There are a wide variety of tax efficient ways to reward employees.
Example of typical shareholder rights given to founders
If the founders or directors hold a different class of shares to the employees the share rights can be varied.
- For example, founders could be issued with A shares which permit a higher (or lower) rate of dividend to be paid compared to the B shares issued to employees.
- The B shares could include compulsory transfer provisions on leaving employment which do not apply to the A shares.
- The permutations between rights to voting, dividend income and capital are limitless.
Shares held by investors
Investors often require a special class of share is created within the company structure. Rights can be built into shares held by investors to hedge the risk of investment. This is particularly common in start up businesses. Investors often hold a different class of shares to those held by other shareholders to enhance their rights.
Example of typical shareholder rights given to investors
- Investors could be issued with C shares providing a preferential claim over capital compared to the A and B shares. On a sale or liquidation of the business the C shares could receive a higher rate of return and in preference to other classes of shares.
- The C shares could confer powers of veto. A list of matters requiring investor approval can be built into the share right.
- A different class of shares can facilitate a mixed loan and equity deal. It is possible to provide rights for loans to be converted into equity and agreed valuations.
Care is required where the investment is under the SEIS or EIS tax relief schemes for investors. The SEIS and EIS legislation does not permit a preference for investors.
Shares held by family members
Creating new classes of shares can be used to pass ownership of a business to family members. The type of share used to achieve succession planning are often called “freezer shares”. Freezer shares can be used to lock in existing value. Dividends can be tailored to provide certainty of income to cover items such as nursing homes.
Example of typical shareholder rights for different family members
For example, a new class of E shares – freezer shares – could be issued to the next generation and form part of the company’s constitution. The E shares could provide:
- A right for the company to buy back shares from the senior generation at a pre-agreed value and or pre-agreed dates.
- A right to receive a preferential dividend ahead of other dividend payments. The idea is the older generation will have enough to live on profits permitting.
- In cases where the older generation is concerned about divorces or irresponsible family members breaks can be built into the shares. The break would deny prescribed rights such as dividends and or capital.
- It is possible to pass the shares on death to spouses on terms which remove voting rights. This works where the spouse is not part of the business and avoids the risk of meddling.
Preparing for the sale of the company – exit strategy
Sometimes, the shareholders bring in Mr New Talent to get the business ready for sale. The intention is the premium reward is made when the business is sold. A new class of shares can be created to incentivise a shareholder to work towards the sale by rewarding him with capital rights. This type of share is often called a “growth share”.
Example of a growth share within the company structure
- A growth share, for example E shares, can provide that the New Talent is only entitled to share in capital upon a sale of the business. New Talent does not have voting rights and does not have an entitlement to income. The amount of capital New Talent receives on his growth shares can be designed to fit in with the total value for which the business is sold.
- Growth shares are sometimes referred to as flowering shares. If there is no flower – i.e. exit – then the shares have no value.
- Payment can be layered to encourage efforts to achieve the highest price possible for other shareholders.
- A timescale for achieving sale can be fixed. The rights to capital can be fixed under the growth share to lapse on an expiry date. The rights attaching to other classes of shares held by shareholders (in this example the A, B, C and D shares) need not be impacted.
Minority shareholder rights
Often one or two shareholders, who together own the company outright, are used to making unfettered decisions. There is a culture change when additional shareholders have voting rights.
Minority shareholders often enjoy protections embedded in the shareholders agreement and articles off association.
Example of shareholder rights that can be reserved for minority shareholders
Key protections for the minority shareholders which can be built into the class of share held by them can include:
- Power to appoint a director to represent their interests;
- Power to dismiss a director;
- Power to force the directors of the company to take action, or refrain from taking action in certain circumstances;
- Power to initiate an exit route, e.g. a company buyback in the event of a dispute; or
- Force the directors to disclose certain dealings of the company, force an audit, or seek disclosure of the company’s accounts.
Avoiding shareholder deadlock
Shareholder deadlock is unfortunately common in owner managed businesses. Often there is no agreement about how to resolve disputes. The shareholders have never got around to agreeing a shareholders’ agreement setting out the process for resolving disputes. We are familiar with the issues this presents.
To avoid problems, the company’s articles and or shareholders’ agreement should include provisions relating to:
- Dispute resolution – so if the parties fall out, then a mediator will first come in and settle the issue;
- Board control – if an equality of votes, an expert is given the final decision at board level. This is not dissimilar to having a non executive director who is a specialist in the company’s sector;
- Casting votes – so that one director has the final say;
- Issue of a further share – which has just voting rights attached to it. The share is issued to an independent third party who can vote to pass decisions at shareholder level.
- The approach to be taken on pricing the shares being sold by a shareholder who is exiting.
How to issue new classes of shares
The Companies Act 2006 contains several provisions to consider:
- Do the directors have authority to allot?
- Is there sufficient share capital to allot?
- Will any existing shareholders waive their right to automatic allotment, called waiver of pre-emption.
You will need to document shareholders’ approval and make a filing at Companies House.
Existing articles of association
We recommend a review the company’s articles of association. The rights attaching to any class of shares (including alphabet shares, restricted shares, freezer shares, growth shares or flowering shares) have to be set out in the articles. You may need to pass an appropriate resolution to grant the board authority to:
- Allot shares;
- Exclude statutory rights, because:
- Existing shareholders have statutory rights of pre-emption on new shares.
- Reclassify existing shares into new classes;
- Change the share’s nominal value;
- Create new share classes;
- Make bonus or rights issues.
The shareholders’ agreement
The shareholders’ agreement can impose restrictions on:
- Introducing new share classes;
- Certain pre-emption rights;
- Altering share capital;
- Sale and transfer of any class of shares.
We do work through requirements and recommend workable clauses for the actual situation. What is best, depends upon the personalities and objectives behind the creation of alphabet shares