It’s an exciting time in your startup – you have just successfully raised $1m in your first formal seed round. Now attention goes to spending that investment capital to pursue your growth objective. It is easy to get giddy with excitement about deploying this capital.
But what about the rights of your new shareholders? They now have rights to the company’s dividends and distributions, return of capital and can now vote at general meetings.
Too often at this stage of a company’s life cycle their details are recorded on a simple spreadsheet that is easily corruptible or subject to manipulation or version control issues – or worse, maintained in ASIC records which are only infrequently updated.
This is not a trivial matter. Under the Corporations Act 2001 directors may face severe penalties where those rights are not adequately respected, especially the potential for recourse to shareholders who believe they have been subject to oppressive conduct.
Control and dilution
Shareholding ultimately dictates control; directors under the Corporations Act have the power to issue shares if they believe this is in the best interest of the company – but this will be at the cost of diluting the voting and economic interest in the company of its existing shareholders. Consequently, some existing minority shareholder may cynically view such issuing of equity as unfairly benefitting major shareholders, no matter how well-intentioned that share raise is.
In short, the % interest of shares allotted to each shareholder can be a bone of contention for growing entrepreneurial companies. Consequently, it is vital that a share register should be a source of truth for shareholder rights, which fully respects the integrity of their investment in the company.
Contingent share equity
This source of truth should also extend to other types of equity instruments issued by the company that are potentially dilutive. Consider the following:
- Options, share loans, share performance rights and warrants issued under an employee share scheme, which if exercised convert into ordinary shares; and
- Convertible notes or SAFE notes issues to seed capital investors that also are potentially convertible.
These, too, represent rights of potential voting interests that should be carefully managed and secured just as rigorously as the company’s register of ordinary shares.
Respecting your Value
By respecting the sanctity of a share register, directors also respect value of a company. At a most fundamental basis, a company’s market value represents the quantum of shares issued multiplied by its market price. When vagaries exist as to what that exact quantum is, even on a diluted basis (i.e.: taking into account contingent share equity), investors, both current and potential, may query how much the directors really value the company and their own professional reputations as its ambassadors.
Founder tax issues
As a final aside, a flippant attitude to a share register may create an awkward and unwelcome tax problem for a company’s founders. Let’s say a company is founded with just 100 shares. Then a seed capital raise takes place to issue 10m new shares to raise $1m at 10 cents per share. The founders suddenly realise that their interest is now diluted to almost nothing and concurrently issue themselves 10m shares to retain a 50% interest in the company. There is potential that the tax office views this arrangement as remuneration to those founders and they may be subject to income tax on the $1m market value of shares that they have issued, or potentially capital gains tax on their entire share interest. Furthermore, this approach may jeopardize the company’s ability to carry-forward losses.
What if, on the other hand, prior to the raise those original 100 shares were split into 10m shares? The narrative in terms of the fact pattern submitted to the tax office may change markedly.
In-short, smart founders and company secretaries recognise the importance of a sacrosanct share registry from the inception of a company and understand that a stand-alone spreadsheet can only have limited facility when the share register may move dynamically as a company raises capital and incentivizes its management with contingent equity arrangements.
At William Buck, we see that those companies with the best corporate governance structures and plans for capital raising success transition their share register to a specialised outsourced provider earlier, rather than later in the piece, and that those companies that tend to have much successful capital raising events and are much better placed for the rigour of an IPO. For more information, contact your local William Buck adviser.