From set up to shareholders- understand your legal obligations to ensure success.

Part 3 of 5: defining the rights and obligations of shareholders in a CSF company

One of the complexities that we have dealt with in working with equity crowd-sourced funding (CSF) companies is reconciling the interests of existing shareholders with those of the incoming CSF shareholders.

In this, the third of a series of five articles, McCullough Robertson's start-up expert, Partner Ben Wood demonstrates some ways of framing the rights and obligations of shareholders that allow for the efficient and effective operation of a CSF company.

Share classes

The Act allows for the issue of only ordinary shares to CSF investors. Where a company has existing shareholders, there may be cause to establish different classes of shares with varying rights between them and the new CSF shareholders. In order to preserve the rights of the existing shareholders, it may be necessary to convert their shares to one or more new classes before undertaking a CSF offer. The purpose of establishing different share classes is not to deprive CSF shareholders of having appropriate input into the business, rather, it considers the practical realities of running a business and ensuring that it can be done efficiently and effectively.

Additional comments from Cake Equity:

If new share classes are created, the different types of shareholders can be clearly distinguished in your online share registry. This way, you will be able to filter announcements, documents and resolutions sent out through your registry, so that they only go to the relevant shareholders, based on share class or otherwise.

Thresholds for passing special resolutions

For important decisions that will affect the rights of shareholders, a company may require those decisions to be passed by a special resolution (e.g. 75% of votes eligible to be cast in favour of the resolution). For a CSF company, due to the potentially large number of shareholders (who may each have differing views on the running of the company), a lower threshold may be preferred. This gives the majority shareholders a greater degree of certainty about the outcome of a particular vote and aids in passing resolutions that are in the interest of the company as a whole.

Defaults by shareholders

A default event refers to a situation where, for example, a shareholder deals with their shares contrary to the wishes of the company; materially breaches the terms of the company constitution or shareholders' agreement (as applicable); or where having a particular person holding shares in the company may adversely affect the company's reputation. Default provisions will often also include how shares are to be handled if a shareholder becomes mentally incapacitated or passes away. Ordinarily, where a shareholder defaults and does not remedy that default, the shares will be mandatorily transferred (through a power of attorney mechanism) to existing shareholders for a designated price (or subject to an independent valuation).

In an ordinary company situation it is not unusual for all shareholders to have the ability to serve on another shareholder a default notice (a notice which outlines the circumstance of the default and allows the defaulting shareholder to remedy the default). Difficulties may arise in CSF companies if restrictions are not put in place to regulate who can give notice of a default. A company may not want a situation where default notices are being arbitrarily served on shareholders by other shareholders, and the company would also want to be able to keep track of any defaulting shareholders and how their shares are being dealt with.

One way to regulate the default process, and allow the company to better monitor defaults, is to designate particular persons who are able to issue default notices to shareholders, for example, founder shareholders may be such designated shareholders. This does not necessarily mean to exclude CSF shareholders from identifying defaulting shareholders, as CSF shareholders could still have a role in informing the designated shareholders, who would then decide the merit in issuing a default notice.

Dilution of shares

Dilution occurs where new shares are issued in the company that reduce the overall proportion of a shareholder's proportional holding in the company. For example, where a shareholder owns 10 of the company's total 100 shares, and the company decides to issue 900 new shares (through a CSF offer or otherwise), the shareholder's stake in the company may be reduced from 10% to 1% of the total share capital of the company (assuming that shareholder does not participate in the offer).

Dilution can affect what rights a particular shareholder has and reduce their voting capacity at shareholders' meetings. For instance, in accordance with the Act, any shareholder who own 5% or more of the shares in the company have the right to direct the company to prepare financial statements or cause the company to call a meeting where resolutions can be voted on. Holders of those 5% rights may not want to lose those rights by way of a dilution of their shareholding.

One way to prevent dilution of shares (often called anti-dilution provisions) is to first offer any newly-issued shares to current shareholders, to allow them to maintain their overall shareholding percentage in the company. Anti-dilution provisions are particularly important in allowing founders to maintain control of the company.

In the next article, Ben looks at how to manage the dilution of shares, as well as other mechanisms the company can use to control how its shares are handled by its shareholders.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.