Shares (preferred and common): A guide to share capital for startups
After incorporation, how do founders structure ownership rights among the venture’s stakeholders (co-founders, employees, consultants, and angel or venture capital investors)? It serves entrepreneurs well to understand the basics of creating a startup’s share capital structure.
What are “shares”?
Every corporation must have one or more classes or series of “shares.” Shares are bundles of rights provided to their owners (shareholders) against the company and its assets.
What are “common shares” and what are “preferred shares”?
“Common shares” is the legal term that typically refers to the corporation’s class of shares that holds the minimum rights described above (right to vote, right to receive dividends, right to residual value of the corporation’s assets upon the corporation’s liquidation).
“Preferred shares” is the legal term that typically refers to a class of the corporation’s shares that includes a fixed liquidation preference, required to be paid in priority to any payment on the common shares. Of course, preferred shares can also include any of the other rights described above (voting rights, for example).
How do classes or series of shares differ?
As a whole, a corporation’s share capital must provide one or more shareholders with:
- The right to vote
- The right to receive dividends (distributions of cash or other assets from the corporation’s annual profits)
- The right to receive the residual value of the corporation’s assets upon the liquidation of the corporation
Aside from these constraints, founders have significant flexibility in creating a share capital structure that suits their or their investors’ requirements. The different types of rights that can be allocated to various classes or series of shares include:
- Voting rights
- Right of class or series to elect directors
- Dividend rights
- Rights to exchange or convert shares of class or series
- Fixed liquidation preferences (in other words, the right to receive certain sums from the company’s assets upon the corporation’s liquidation in priority to the holders of other classes or series of shares)
- Rights to require or enable the company to purchase shares held by a shareholder
How do I create and issue shares?
A corporation’s articles or certificate of incorporation must describe its authorized shares at the time of incorporation. To create a new class or series of shares after incorporation, the articles or certificate of incorporation must be amended. The amendment can occur at any time subject to the approval of the corporation’s existing shareholders.
Once a class or series of shares is created and authorized, the board of directors of the corporation issues the shares by a resolution process. In Canada and Ontario, the board can only do so for consideration (in return for assets) in the form of cash, property (for example, real estate, computers, intellectual property) or past service.
What does a typical startup’s share capital structure look like?
Which shares do the founders get?
In a typical start-up share capital structure, founders, employees, consultants, directors and officers receive common shares. It is rare for any of these stakeholders to receive a preferred share as consideration for their participation in the venture (unless they actually invest cash to get it).
The actual number of shares doesn’t matter, but you should choose a sufficient amount (say, 1,000,000 or more) that allows the flexibility to share equity rights among a broad set of stakeholders.
What do the investors get?
Institutional venture capital investors generally invest in voting preferred shares with a fixed liquidation preference and the right to convert such shares into common shares (as a tool to access unlimited investment returns).
Angel investors are less predictable. Some angel investors will invest directly in common shares. Others require preferred shares with essentially the same terms and conditions as institutional venture capital investors.
This article was produced by James Smith and Shane MacLean and is made available through the generosity of Labarge Weinstein Professional Corporation.