It’s an exciting time in your startup – you’ve just successfully raised $1 million in your first formal seed round.
Now the focus is on allocating that investment capital to pursue your growth target. It’s easy to get giddy with excitement about betting this capital.
But what about the rights of your new shareholders? They now have rights to the company’s dividends and distributions, capital returns and can now vote at general meetings.
At this stage in a company’s lifecycle, all too often their data is captured in a simple spreadsheet that is easily corrupted or subject to manipulation or version control, or worse, kept in ASIC records that are rarely updated.
This is not a trivial matter.
Under the Corporations Act 2001, directors can face severe penalties if those rights are not adequately respected, especially the ability to appeal to shareholders who believe they are subject to oppressive behavior.
Control and Dilution
Shareholding ultimately dictates control; Directors under the Corporations Act have the authority to issue shares if they believe it is in the best interests of the company, but at the cost of diluting the voting rights and economic interest in the company of the existing shareholders .
Consequently, an existing minority shareholder may cynically view such issuance of shares as an unfair advantage to major shareholders, however well-intentioned that share increase may be. In short, the percentage of shares allocated to each shareholder can be a point of contention for growing entrepreneurial companies.
Therefore, it is essential that a stock register is a source of truth for shareholder rights, fully respecting the integrity of their investment in the company.
This source of truth should also extend to other types of equity instruments issued by the company that can be potentially dilutive.
Consider the following: Options, stock loans, performance rights and warrants issued under an employee stock plan, which, if exercised, convert to common stock; and Issuance of convertible bonds or SAFE bonds to seed capital investors that are also potentially convertible.
These, too, represent rights of potential voting interests that must be carefully managed and secured, just as rigorously as the company’s common stock register.
Respect your value
By respecting the sanctity of a stock register, directors also respect the value of a company.
On the most fundamental basis, a company’s market value represents the number of shares issued multiplied by its market price.
When there are quirks about what that exact quantum is, even on a diluted basis (i.e.: taking into account contingent equity), investors, both current and potential, may wonder how much the directors consider the company and their own professional reputation as its ambassadors. .
Founder tax issues
One last side note: a light-hearted attitude to a stock register can present an inconvenient and unwelcome tax problem for a company’s founders.
Let’s say a company is founded with only 100 shares. Then there is an initial capital increase to issue 10 million new shares to raise $1 million at 10 cents per share.
The founders suddenly realize that their stake has now been diluted to next to nothing while simultaneously issuing 10 million shares to maintain a 50% stake in the company. The tax office may view this arrangement as compensation for those founders and they may be subject to income tax on the $1 million market value of the stock they issued, or possibly capital gains tax on their entire shareholding.
In addition, this approach may jeopardize the company’s ability to carry forward losses. What if, on the other hand, prior to the increase those original 100 shares were split into 10 million shares? The story in terms of the pattern of facts presented to the tax authorities can change significantly.
In short, savvy founders and company secretaries recognize the importance of a sacred stock register from the start of a company and understand that a standalone spreadsheet can only have limited capabilities when the stock register can move dynamically as a company raises capital and manages its management with contingent equity arrangements.
At William Buck, we see that those companies with the best corporate governance structures and plans for success in raising capital transfer their stock register to a specialized outsourced supplier earlier rather than later in the piece, and those companies that generally successful capital have events to host and are much better placed for the rigors of an IPO.