This is a guest post by Maria Panayi, Associate at Joelson. Maria is a qualified solicitor and joined the corporate and commercial team at Joelson in 2017. Maria has experience in a variety of sectors (including, food & drink, technology) and regularly advises on mergers and acquisitions, joint ventures and equity/debt investments by angel investors, VCs and crowdfunders.
Many founders often ask the question: “What share classes should I be offering to my investors?”. As with many things in life, a one-size-fits-all answer does not exist.
Generally speaking, early-stage startups tend to stick with a single class of shares – ordinary shares. The main reasons for this decision are:
- To keep things simple and cost-effective – the more classes, the more complicated the company’s constitutional documents will be.
- It seems fair to offer the same rights in voting, dividends and exit – so, whichever rights the founder has, the investors enjoy too.
- Crowdfunding platforms tend to encourage offering ordinary shares to investors and often do not offer their nominee structure for different classes – this could potentially leave founders with an administrative burden.
- Ensuring you don’t void your SEIS or EIS tax relief.
- A general lack of understanding about different classes of shares and what they can offer.
So, what other types of shares are there, and what are their main characteristics?
Types of Share Classes
The distinction between share classes is made by looking at three main elements, the shareholders’:
- Voting rights.
- Entitlement to dividends.
- Entitlement to the capital on a winding up of the company, or an exit.
Here comes the fun part. There are no restrictions in law on the name you can give to share classes. Even though generally companies tend to go with traditional names, such as ordinary shares, preference shares, etc. If you wanted to, you could call yours “Royal Shares”. You could also attach a different nominal value to each class of shares. For example, one class could have a nominal value of £1 per share whilst another has £0.01 each.
There are a few commonly used share classes, and the most popular are:
- Ordinary Shares: These shares typically entitle their holder to dividends and capital on a winding up of the company. They normally carry voting rights, such as one vote per share. You sometimes see alphabet shares (A ordinary, B ordinary, etc.) – this is done to separate dividend distribution or apply different rules, such as pre-emption rights on a transfer, leaver provisions, or voting rights applying to A ordinary shareholders but not to B ordinary shareholders.
- Preference Shares: These shares have a right to receive a fixed amount of dividend every year. If the business is sold or liquidated, preference shareholders will get their money first and may be entitled to any arrears on dividends. They are normally non-voting shares.
Preference shares can be participating or non-participating. On the winding up or sale of the company, non-participating preference shareholders will receive their initial investment and accrued dividends. If they would receive more value per share by participating in the ordinary share pool, then they can convert their preference shares into ordinary and split the liquidation or sale proceeds with the rest of the holders of ordinary shares in proportion to their shareholding. By choosing to convert, they would be giving up their right to receive their initial investment and accrued dividends.
Participating preference shareholders have their cake and eat it – they get their money first, as well as accrued dividends, and then they also participate along with the rest of the ordinary shareholders and receive the balance based on their shareholding proportion.
- Redeemable Shares: These are preference shares with an option for the company to buy them back out of distributable profits or the proceeds of a new share issue.
- Deferred Shares: These shares are non-voting and will receive a dividend once other classes have been paid a minimum amount. In practice, often shares that need to be returned by a shareholder (e.g. because they have started competing with the company or are a leaving employee) are converted into deferred shares. Essentially, their potentially valuable ordinary shares become worthless so that there is no share capital reduction in the company as a result.
- Growth Shares: This is a special class of shares, normally made available to the company’s employees or consultants, and it allows its holders to benefit from the growth in the value of the company. They typically do not have rights to voting, dividends or capital entitlement in the event of a sale or liquidation.
Reasons to Consider Different Classes
You are probably thinking that it all sounds interesting, but why would you go into the trouble of setting up a different share class for your startup?
The reasons vary on the circumstances of each company. The main ones are:
- To attract investors, or to close a deal.
- To split dividend rights so that one class is entitled to dividends and another is not.
- To restrict certain shareholders from having a say in shareholder decisions by not giving them voting rights.
- To differentiate the treatment for employees, e.g. by giving them growth shares or attaching leaver provisions to their share class.
I Have Decided to Create a New Class – What Next?
You’ve guessed correctly; as you embark on your startup journey, your lawyer and accountant will become your new best friends. Before settling on your company’s share structure, you need to speak to your tax advisors about the potential implications on SEIS and EIS entitlement, entrepreneur’s relief and other tax considerations. In some recent cases, HMRC has shown its teeth and the point to take away from this is that depending on the characteristics of preference shares, they may significantly impact on the entrepreneur’s relief that ordinary shareholders are expecting to receive on a future sale.
Your lawyer will then handle the rest. Broadly speaking, whether you are creating a new share class and issuing new shares, or converting existing shares into a new class, the company’s articles of association will need to be amended, board and shareholder resolutions will need to be passed, and a couple of Companies House forms to be filed. Where the rights of a share class are being affected by the creation of the new class of shares, you will need to get the consent of the holders of at least 75% of that class of shares (or more, depending on what your articles of association say).
The Importance of Speaking to Your Lawyer
SEIS and EIS relief is the gem that startups based in the UK offer to investors who pay taxes in the UK. It is important to make sure that if you are offering SEIS or EIS shares, the share structure does not prejudice your investors’ tax treatment. This would have tax consequences for your investors, leaving them dissatisfied and potentially giving a bad reputation to your company. One of the qualifying elements of SEIS and EIS shares is that they should not give shareholders a preferential claim on dividends or liquidation. Your lawyer will be advising you on the Do’s and Don’ts and will be making sure that the drafting achieves the desired result and one which is acceptable by HMRC.
The decision of your startup’s share structure can be tricky. If you are an early-stage company and can keep things simple, then continue with ordinary shares. Other share classes will become relevant as you grow past your pre-seed and seed investments.