This post is going to be more technical than usual, but for a good reason. I have seen too many startup failing not because of a bad product, or for lack of clients, but because of disputes among co-founders. Not to mention that founders are often very naive in front of the investors. They are happy to delegate the legal (boring) stuff to lawyers, and too often the only lawyer in the room is working for the other party.
Do you remember Andrew Garfield in The Social Network lamenting “I thought they were my lawyers too”? Well, I do. I have seen it many times, and it wasn’t at the cinema. I have been wearing 3 hats in my career: programmer (mostly in the ’90s), lawyer and entrepreneur. Today the lawyer is talking. This is not a funny post, but hopefully it could save you some trouble one day.
How company shares work in England and Wales
Setting up shares is (apparently) very simple in England. If you have a startup, you probably set the company up yourself online at Companies House, or through one of the many company formation agents based in England.
All the shares are £1 shares, and the founders just need to agree to a percentage. So if Bob and Sally want to split the company 60%-40%, you 6 shares for Bob and 4 for Sally. If they want to split 51%-49%, Bob gets £51 and Sally £49.
Very simple, right?
British are very practical, and the online incorporation is a simple process, but from day 2 the rules are different. I will provide more details below, in the meantime check a few examples:
1) The minimum value of each share is not £1. You can issue shares of 1 cent, and even a fraction of a cent (actually the minimum is 0.00001).
Why is this important? In a startup, smaller shares are especially useful to motivate employees and bring advisers on board. For instance, you can have a company with a total capital of just £10 (thus risking only 10 bucks if you fail), but it’s made up of 10,000 shares of 0.1 cent. With such high number of shares, you can offer almost any percentages to employees and advisors (0.5% to one, 0.13% to the other, etc.). Sometimes being part of the company is motivating in itself, even if the percentage is not so big.
I have also seen a few bold founders offering a few shares to a famous TV or sport star just so they can say that they are on board.
2) You can create “future” shares. My old professor would not be pleased to hear that simplification “future shares”, so I’ll write down the technical term “vesting the share”. It means issuing the shares only when some milestone is achieved or some time passes.
Why is this important? Vesting the shares could be a very healthy practice when you are looking for co-founders. It’s popular in the US – where I work from time to time – but still almost ignored in Europe. It solves the typical issue of many startup: you want someone on board, but (a) you can’t pay him a salary and (b) you want to kick him out if he’s not as good as he says. Even long time friends could fail under the pressure of a startup, so you “vest their shares over time”.
Example. Your co-founder wants 5% of the company. You accept but with the following condition.
- He gets 2% if he releases a beta version of the app for iPhone in 3 months (milestone);
- He gets another 2% if he releases the android version the following month (milestone);
- And another 1% if he works in the company for 12 months (timeline). Just to be sure that he can stand the stress of being an entrepreneur.
So if he’s very good with the iPhone, and works night and day in the company for 1 year, but he has oversold his skills with android, he gets 2+1=3% and you have an extra 2% to offer to a good android programmer, or to keep for yourself.
3) In general, the UK is very business oriented and you can have (almost) any type of shares you want. You can issue shares in US dollars for your US investors, and in Euro for your European pals. You can issue shares without voting rights, and much more. In this post I have made a list of all the major tools. Read them and make a decision. Then delegate to your lawyer, go back to your startup and make an awesome product.
Just a note about the difference between England and the UK
I have used “England and Wales” in the title, and not “the UK”, because England and Wales is a different jurisdiction. I am sure you know everything, but in case you don’t, never admit it (especially if you are in England), and have a look to the summary.
- UK = England + Wales + Scotland + North Ireland (in other words, the whole island + North Ireland);
- Great Britain = England + Wales + Scotland (the whole island);
- England + Wales = a jurisdiction with it’s own register of companies. Scotland has it’s own register and slightly different rules;
- England = the state where London is located (most of the foreign tech startups are based there)
If you feel confused, don’t worry. You are not alone. British are practical people; I never said they are rational too. In short, when you set up your company in the UK, you need to pick one of the jurisdictions: (i) England & Wales or (ii) Scotland or (iii) Northern Ireland.
1. Is It Possible to Have Non-voting Shares in England and Wales?
Yes, you can have non-voting shares in England and Wales, and it’s not too difficult.
This is one of the most common questions I get asked when I teach startups, and its popularity is directly connected to the characteristics of our market. In fact in Europe angel investment is not yet as sophisticated as it is in the US, and many startups raise money on the so called FFF market (Friends, Family and Fools). You don’t want to watch your Mama on a shareholder meeting shouting at the investors “Don’t you dare vote against my baby!” Or that rich idiot Uncle John voting against you (sorry Uncle John, we love your money not you).
How to set up non-voting shares in England and Wales
Your accountant, lawyer, or whoever is in charge shall apply to Companies House (form SH01), and the company is usually going to issue “Ordinary Shares Class B”. If the startup is in a more advanced stage, the shares will probably not be Ordinary but Preference shares. I will not go into more details, because I know programmers (yes, I am talking to you), and if I provide all the details, you’ll try to do everything by yourself, You will probably try anyway, but it’s not a smart decision. You don’t want to be approached by a Venture Capital 2 years from now, and find out Uncle John has veto power. Because when millions of dollars are at stake, you can be sure that Uncle John will go through the papers with his lawyer. John’s not your rich uncle by a coincidence.
Scotland and Northern Ireland have non-voting shares too
I focus to England and Wales, because it’s where I have all my British startups, and it’s where I am a registered attorney. However companies from Scotland and Northern Ireland have very similar rules. Still, if you plan to do business in those jurisdictions, make a call to a local professional. Don’t be greedy.
2. Is It Possible to Have Shares in Euros or US Dollars?
Yes, it’s possible to have shares in a currency other than British Sterling. This is a common question among non-British Europeans. In fact, the easiest way of raising investment for your startup is often among friends and family, and if you weren’t born in the UK, your family probably gets a salary in Euros. Short answer: yes you can. You can change your share capital from GBP (British Sterling) to Euros, to USD (US dollars), or any other currency, including currencies from non European countries
Case study: Is it good to issue shares in the currency of the investor?
One startup I advise got funded by an investor in Dubai, where the official currency is the Dirham. The company was based in England, and it’s still there, with shares in British Sterling divided among the founders. Thus we had three possibilities:
- Issue new shares in Sterling (asking the investor to wire his money to a Sterling bank account);
- Issue new shares in Dirhams (having shares in two currencies, Sterling for the founders and Dirhams for the investor);
- Cancel all the existing shares, and issue shares in Dirhams.
Actually we didn’t do any of them. Multiple choice tests exist in school but rarely in business. In the words of Yirui, my friend from Shanghai “Don’t think outside the box, just realize that there is no box”. That’s what we did. We decided to cancel all the existing shares (in Sterling), start from scratch and re-issue new shares for everybody in a neutral currency: US Dollars. Each shareholder had his preferred currency, but – when I asked – the US dollar was the second best choice for all of them (side note: never give anything for granted in a startup, ask questions!). Also, at the time, the shareholders had more connections to potential investors in Continental Europe and the Middle East, than in the UK.
I am not suggesting to change your share capital to US dollars all the time. On the contrary, my advise is to consider each company and its background.
What’s the best currency for your shares?
In theory it’s possible to have (almost) any currency, and (almost) any type of mix between them. You can set up a startup where the British founders have shares in Sterling, the foreign founders in Euros, the investors in US Dollars and Chinese Yuan, etc.
In practicality, however, I would avoid that (if possible). Multi-currency shares need a very sophisticated shareholder agreement to count the votes, and in a startup there is no need to waste your time and money on complex legal matters. That’s what I usually do.
- My preference is usually to issue shares in British Sterling for everyone.
- However, if it’s very important for the investors to have a different currency (for instance, if their currency is very weak against the British Sterling, or they are not used to work in Sterling), than I tend to prefer Euros for everyone, or US Dollars for everyone.
These are just my preferences, and specific cases require specific solutions. I am very flexible when the goal is raising investment. The usual advice stands: if you have a complex case, call a professional.
3. Can a UK Company Buy its Own Shares?
Yes, a limited company based in England or Wales can buy its own shares. In general, any UK company can buy it’s own shares, but I strongly advise checking with a local attorney for companies based in Scotland or Northern Ireland. Buying back shares is a common practice even in traditional companies, when a director or a working shareholder retires, and it could be very useful in a startup where the founders split: i.e. one or more of them don’t believe in the project anymore, and want to leave, but the rest of the founders want to keep going.
Warning! That doesn’t mean that your company can buy back shares all the time. In fact there are two main effects in a buy back (i) the share capital is reduced, and (ii) the company leaks cash. Both effects are a potential danger to the creditors. So if you have unpaid credits, before doing a buy back, talk with your accountant (and be sure that he understands this issue).
How to buy back the shares
Usually shares may be redeemed or bought back by the company out of the distributable profits (meaning the potential dividends). To have dividends, you need profits and that’s not very likely in a startup. However, if you have set up your startup share capital properly, it’s a very small amount (often £10 or £100), and the surviving shareholders could cover the loss with personal funds and guarantee the creditors.
A buy back follows the same rule in a traditional company and in a startup, but it’s often used for two different goals. While in a traditional company the working shareholder retires and wants to cash out thousands of pounds, in a startup the buy back focuses on protecting the project.
Example: John, Sally and Bob are the founders of a startup with respectively £3, £3 and £4 shares. They have agreed (in writing) since the beginning that if one of them wants to leave the startup, he/she will simply give back the shares. John gets an offer from a big company with a great salary and decides to go back to the corporate life. The company buys back £3 at a nominal value (£3) and the project continues.
A startup story: The example is not so different to the true story of Apple and its three founders: Steve Jobs, Steve Wozniak and Roland Gerald Wayne. If you are thinking “Roland who?” that’s because the third gentleman asked the company to buy back his 10% share for $800, so he could return to his life as an employee. In 2011, the online magazine Gizmodo calculated that had Mr. Wayne kept his shares they would have been worth $35 billion. But that’s another story.
An alternative system for buying back the shares in a startup
In the example above our startup has an initial share capital of £10. John quit after 6 months and the company bought back £3. Sally and Bob keep the remaining £7. Everything is perfect in theory. However John spent a lot of time working for the company in those 6 months and he’s not happy that he only got £3 back. On the other hand, the remaining founders would love to use his help in his free time, but they can’t afford to pay him for a while.
This is quite common in a startup. One of the founder quit from time to time, but he can still be very helpful as an advisor or part time consultant. If you are in the same situation, maybe you can consider paying John an extra bonus in “convertible notes”. I will write in detail about this subject in another post, until then, if you are not familiar with convertible notes, consider them as a cheque that you can’t cash for a while.
- If the startup fails, your convertible note is worth nothing;
- If the startup succeeds, your convertible note is paid (usually with interest);
- If the startup gets investors, your convertible note is also paid (usually with interest) or it can be exchanged for new shares.
In our example, the startup agrees to pay £10,000 for 1 years worth of John’s time. He has already worked full time for 6 months, but over the next 6 months he will work only from time to time. John can have his salary and a small piece of the startup, the surviving founders are not going to lose his experience. Win/win!
Bad news: a convertible note should be done properly with the help of a professional. Good news: it’s an excellent tool. Although not yet used much in Europe, it’s the most common form of financing for early stage startups in the USA.
Ordinary Shares vs. Preference Shares
Further shares coming in the next days. Come back to this web page or subscribe to the newsletter on the right column (no spam, I promise).
Disclaimer: I hate disclaimers, it’s a way of saying to the reader “I don’t trust you and I want you to know”. So I am not going to write any text in legalese but a simple business tip. All the rich entrepreneurs I know (and I mean really rich, not just someone with a private jet and a yacht) delegate specialist works to specialists. Be like them. This post is not a source of legal advice, but a public resource for general information that I am happy to share (for free). I trust you and I am sure you’ll use it in the proper way. Cheers!
Image source: OakleyOriginals at Flickr.com