By Rushda Niyas
What’s a share?
Having shares in a company means that you have an ownership stake in that company in proportion to your shares.
Shares can be issued to founders, investors, employees, or even the general public.
They are a way for individuals to have a stake in the company’s success and share in its profits and are usually referred to as “Shareholders”.
When you own a share, it signifies that you have a portion of ownership in the company. Each share represents a fraction of the company’s total ownership.
Along with ownership, shares also carry certain rights that shareholders are entitled to. These rights can vary based on the type of shares and the company’s bylaws, but there are a few basic rights commonly assigned to shares.
- Voting Rights: Shareholders often have the right to vote on significant company matters, such as electing the board of directors or approving major decisions. The number of votes typically corresponds to the share percentage.
- Dividend Rights: Shareholders may be entitled to receive a portion of the company’s profits, known as dividends. Dividends are typically distributed to shareholders in proportion to their shareholding percentage.
- Information Rights: Shareholders have the right to access certain information about the company, such as financial statements and annual reports. This ensures transparency and helps shareholders make informed decisions.
- Preemptive Rights: Preemptive rights, also known as rights of first refusal, give shareholders the opportunity to purchase additional shares before they are offered to external parties. This allows shareholders to maintain their ownership percentage.
How do you become a shareholder?
When it comes to becoming a shareholder in a company, there are two primary modes through which it can happen: share issuance and share transfer.
Share issuance is the process of creating and allocating new shares in a company. This usually occurs during fundraising rounds or when the company decides to increase its capital.
Share transfer involves the buying and selling of existing shares between shareholders. It allows individuals or entities to acquire shares from current shareholders, and become a shareholder themselves.
While these concepts may seem similar, there are important distinctions between the two.
In this article, we will explore the key differences between share issuance and share transfer, to help founders gain a clear understanding of these concepts and their implications.
Share issuance happens during the setting up of the company when the founders are each allotted shares in percentages they agree on and also whenever the company decides it needs to raise more funds. The company can do this by creating additional shares and offering them to investors or existing shareholders.
Founders should understand the implications to them when there is a share issuance.
Issuing new shares can dilute the ownership percentage of existing shareholders, as the newly issued shares are added to the total share capital.
Let’s break this down using an example.
John and Jane are the initial co-founders of RMS Ltd. They each hold 500 shares and a 50% ownership stake.
They need money to scale their operations and extend customer reach, so they decide to issue 500 new shares to Steve, an Investor.
How will this impact the share structure and the ownership percentage of each founder?
With the issuance of 500 shares to Steve, the total number of shares in the company increases to 1,500.
While John and Jane still hold 500 shares each, their ownership percentages will now be based on their 500 shares in relation to the new total of 1,500 shares, which translates to a 33.33% ownership stake for each of them.
The ownership percentage of John and Jane was diluted because their shares now represent a smaller proportion of the total shares in the company.
What are the implications of dilution and what can you do to protect yourself?
While the number of shares remains the same, the founder’s ownership stake in the Company has diluted,
Dilution affects the voting power of founders. As the ownership percentage decreases, so does the influence on decision-making processes within the company.
Dilution also has financial implications. Founders may face a decrease in their share of future profits and dividends as their ownership percentage diminishes.
Founders can take several measures to protect against the dilution of share percentage. Here are some strategies you can consider.
- Founder Vesting: Implement founder vesting agreements, which include time-based or milestone-based vesting schedules. This ensures that founders earn their shares over a specific period or upon achieving certain goals. If a founder leaves the company prematurely, unvested shares can be forfeited, minimizing the dilution impact.
- Anti-Dilution Provisions: Include anti-dilution provisions in shareholder agreements or the company’s articles of incorporation. These provisions can provide protection to founders by adjusting the conversion ratio or issuing additional shares if new shares are issued at a lower price, reducing the dilution impact.
- Preemptive Rights: Grant founders preemptive rights, also known as rights of first refusal or subscription rights. Preemptive rights allow founders to purchase additional shares before they are offered to outside investors, enabling them to maintain their ownership percentage by investing more capital.
- Dilution Awareness and Negotiation: Stay informed and actively participate in decisions related to share issuances and equity-related matters. Founders should negotiate and discuss the terms of any potential dilutive events, ensuring they have a say in the process and can safeguard their ownership percentage.
Share transfer takes place when a share that is already existing is sold or transferred by the current shareholder to a new shareholder. It involves the transfer of existing shares from one shareholder to another. Shareholders may choose to transfer their shares for various reasons, such as raising capital, restructuring ownership, or for any other personal reason.
Share transfers can occur between individuals, entities, or even between shareholders within the same company.
Let’s take the example of RMS Ltd to illustrate how this could affect the existing shareholders.
Steve, the investor decides to transfer 250 of his shares to his partner, Sara. Does he have the right to do it?
While shareholders have a right to dispose of their shares when they want to do so, as a founder or existing shareholder there are certain measures you can take to ensure that share transfers are subject to certain terms and conditions to protect your interests.
- Shareholder Agreements: Founders should have well-drafted shareholder agreements in place that outline the terms and conditions surrounding share transfers. These agreements can include provisions related to rights of first refusal, tag-along rights, and drag-along rights, which help protect the interests of founders in the event of a share transfer.
- Right of First Refusal: Founders can incorporate a right of first refusal clause in the shareholder agreement. This gives them the opportunity to purchase any shares being sold by another shareholder before they are offered to external parties. It allows founders to maintain control.
Ensuring that you have clearly drafted agreements among all stakeholders identifying the rights and responsibilities assigned to each shareholder is crucial to protect your interests in the management and operation of the company.
Founders must possess a keen awareness of the concepts surrounding share transfers and other related considerations to ensure they navigate the process of raising funds with confidence. While raising capital is essential for startup growth and expansion, understanding the risks, rights, and protections associated with share issuance and share transfers empowers founders to negotiate from a position of strength and secure favorable deals.
By being well-informed and proactive in implementing measures such as shareholder agreements, and rights of first refusal, you can safeguard your interests while attracting the necessary investment to fuel the company’s growth.