In a previous legal insight we discussed the basic concept of shares. In this post, we will briefly touch on how these precious units can be used and structured commercially to maximise the potential and protection of your growing business.
As previously discussed, shares are the basic units through which a company is owned. As a business owner, when you are the sole shareholder in your company, the structuring of your shareholding and share capital is certainly something that often is, and admittedly, can be left on the backburner. However, as your business grows, this becomes an increasingly important consideration, particularly when it comes partnering up with other individuals or investors. When this happens, the prudent business owner must seriously consider briefing their own lawyers to put the right documents in place to best protect their business and their rights.
Below we will briefly discuss three mechanisms that you can use, or should be aware of, in structuring the shares and shareholder rights in your company, with examples.
Shares
When a business owner is approached by a potential investor or partner in their business journey, often a small business owners first instinct is to bring such a person or persons into the business by offering them ordinary shares in the company, with all the same bells and whistles (i.e. same voting rights and all). Ordinary shares, however, are not the only kind of shares that can be offered by the business owner, and the new potential shareholder doesn’t necessarily always need to be offered the same rights in the company as the business owner has through such ordinary shares.
In any given company, you may find different classes of shares. These classes of shares are set out in the memorandum of incorporation. The different classes of shares have different rights attached to them. Examples of such classes are ordinary shares, non-voting shares, redeemable shares and preference shares, among others.
Holders of preference shares, for example, possess an advantage over the common shareholders in that dividends are issued to them first. If a company is liquidated, preference shareholders receive proceeds from redeemable company assets. The right that arises for shareholders of these kinds of shares is “prioritised” over the right of an ordinary shareholder. In some instances, this kind of share can be sold at a higher price than ordinary shares.
These kinds of shares can be offered to an investor who is just interested in making money out of the business for a set period of time and is not necessarily interested in the voting rights that come with the ordinary share etc. The different classes of shares and the rights that would be attached thereto can be changed and adjusted in the company’s memorandum of incorporation to suit the business owner’s commercial preferences and needs.
Ordinary shareholder rights
In relation to shareholders of the ordinary shares (i.e. ordinary shareholders), the percentage of shares held by a shareholder brings in a different power dynamic. In this regard, there are various ways that a business owner can get ahead of these dynamics by way of clever drafting in the shareholder’s agreement. As an example, there are drag along tag along rights (also known as push and pull rights). The former exists for the advantage of the majority shareholder and the latter for the minority shareholder respectively.
Drag along rights can be exercised when the majority shareholder wishes to sell all their shares in the company. This type of right allows the majority shareholder to force the minorities to sell their shares as well. Such a right is usually set out in the shareholder’s agreement. This type of right is advantageous to the buyer of the shares especially in instances where the buyer wants to buy the whole company as opposed to merely being a majority shareholder. It is important for business owners to be able to identify such rights if, for example, a business owner of a high potential business is approached by an investor. Most especially if the investor wishes to buy the majority of the shares in the company and requires that a shareholders’ agreement is signed as a condition to that investor investing in the company. Often times, business owners get lost in the excitement of someone believing in their idea or business enough to invest in it that they do not necessarily pay attention to things like the terms of the agreement, or much less understand when a drag along right is incorporated in a contract. The existence of such rights in a shareholder agreement can create the perfect atmosphere for a “hostile” take-over, of sorts, of your business.
Tag along rights on the other hand allows minority shareholders to sell their shares when the majority shareholder wishes to sell its shares. The minority shareholders have the right to sell their shares at the same price and upon the same conditions as the majority shareholder. This serves as an advantage to the minority shareholders in that majority shareholders are firstly able to get a good price or favourable conditions for the shares and secondly, when the majority shareholder gets such a price or favourable conditions, the minority shareholder can force the majority shareholder to tag them along in the deal. Such a right can be used by a minority shareholder that wishes to dispose of their shares in the company at a good price, or if that minority shareholder does not wish to remain in the company if a certain or different majority shareholder comes into the picture.
The above are basic, high level examples of the different considerations that come into play when thinking of ways that a business owner’s shares can work best for the business. Contact us for a more in-depth discussion on how to use the law to maximise your business potential.
Deborah Mutemwa-Tumbo, Chairwoman, Tumbo Scott Inc