The 5 mistakes UK businesses make when it comes to their equity
For many private businesses, their equity is like the drawer in the kitchen you’re a bit scared to open. You’re sure there are many useful things in there, but there are also so many unknowns that you think if you open it, you’ll be there for hours sorting it out.
Keeping that drawer shut is one of the biggest mistakes UK businesses make when it comes to their equity, but it’s easily resolved. In fact, all the misunderstandings that commonly occur in the world of equity can easily be resolved, you just need to know where to look for answers.
Our fast track guide to getting more from your equity, Equity Fundamentals, is a good place to look for those answers you need.
1. I’ve set up my company with too few shares
A company can have any number of shares (literally), but most companies are incorporated with either 1, 10, 100 or 1,000 shares. It doesn’t really matter how many shares a company is incorporated with, as they can be relatively easily subdivided at a later date. You do this by passing a shareholder resolution and then submitting a form (SH02) to Companies House.
Having said that, it’s much easier just to set up your company with enough shares so that it’s flexible moving forward.
You want to be able to issue 1% of your equity to someone in future — so how many shares do you need now, and what nominal value should they have?
- If you have only 10 shares then you can’t give someone just 1% — that doesn’t equal a whole share.
- When you issue a new share (making the total 11 shares) that share will equal almost 10% of your whole business.
But, if you start with a higher number such as 1,000…
- 1% of 1,000 is only 10 shares, so you’re not giving away too much of the total shareholding.
Then, if you’ve started with a low nominal value, say £0.01 you don’t need to put much capital into the business at the outset (total number of shares multiplied by nominal value = 1000 x £0.01 = £10 in this example).
The main reasons you’re likely to issue more shares is if investors are putting money into your company in return for shares, or to give shares to team members who are part of developing the business.
2. The only use for my equity is to sell it to investors in return for cash
At the beginning of a business’ journey this is probably the road you’re going to want to go down. You need cash for things like overheads, to feed and clothe yourself and your general survival. But there are other options.
A) You might have seen a post one of our clients, Tom Nixon, wrote about us. Like most startups, Tom’s didn’t have much cash flow, so he wanted to use his equity to pay the people working with him on the business.
‘Finding an early stage investor isn’t easy because betting on an unproven idea is risky. It takes a lot of time and effort to secure the funding. You’ll probably need advisors, and there’s legal work to be done. It’s all time spent not getting closer to customers and developing your product. Startup accelerators have their place but they aren’t for everyone. And it still creates work to apply, get accepted and get their money.
Without cash, the obvious solution is to use a different form of currency — the equity in the company. Rather than sell a share to an investor and use the funds to pay people, why not give the equity directly to contributors?’
B) If you’ve lost a valued team member to a competitor, then you know it stings. Setting up a share scheme for your business is one way to reduce the potential of this particular pain. Share schemes for team members reward long-term commitment and are a great human motivator.
C) We’ve also seen businesses use their equity to grow their customer base or create a loyal band of ambassadors. When you start thinking of equity as a currency the possibilities are endless.
3. I haven’t kept track of my different share types and classes
Ordinary shares are what most people have. At their simplest, they give the holder of each share the same rights to dividends, capital and voting in the company. Most companies are founded with and issue only ordinary shares.
Preferred shares (often known as ‘prefs’) typically give their holders rights to specific dividends ahead of all ordinary shareholders, and may also give them rights to a specific amount of the capital at a winding up of the company ahead of any ordinary shareholders.
You’ve also got growth shares, which are issued at a ‘hurdle price’ that represents the value of the company at that time, and only share in the capital appreciation (its growth in value) in the business from that point on.
There a number of common rights that are varied from class to class of ordinary, preferred or growth shares.
Voting or non-voting shares
Although the standard approach is that all shares have equal voting rights, it’s very common that certain classes of shares don’t. This may be to ensure that voting control sits with a certain section of the shareholders or maybe to limit the administrative burden of dealing with numerous shareholders in a particular class.
Again, usually all shares have equal rights to dividends, but it’s not unusual that certain classes will be excluded from them for a particular reason.
Although the rights of the shares are usually set out in the Articles of Association, they can be changed by a Shareholder Resolution (including a majority of the holders of that particular class of share), and the subsequent submission of a form (SH08) to Companies House.
4. I’ve got my share dilution wrong
As part of the incorporation process the company has to decide how the shares are split between the founders of the company.
As an example, let us assume that a company has 100 shares and they are split between
- Jane who has 60 shares (60%)
- Dave who has 40 shares (40%).
The company decides to issue 25 new shares to Rachel in return for a £20,000 investment. This means that:
- Rachel then has 25 out of a new total of 125 shares, so 20% of the business (and implies that the business, post investment, is now worth £100,000)
- Jane’s share will now be 60 out of 125 shares, or 48%
- Dave’s share will be 40 out of 125, shares or 32%
Each time more ordinary shares are issued, the same dilution process happens and the stakes of existing shareholders in the company reduce accordingly.
5: I keep putting the management of my equity at the bottom of my priority list
The sooner you get a share scheme in place the better it is for your business. If you’ve looked into it in the past I don’t blame you for thinking it’s a hassle that you’d rather not think about. Traditionally, it has been. It would take weeks to figure out with your accountant or lawyer what you wanted to do. Then weeks for you to talk to your board members and existing shareholders. Followed by the agony of printing documents, signing them, posting them and waiting for them to be signed and posted back. As a business owner you’ve got loads of demands on your time, sorting all this out is just another piece of admin that gets lost by the wayside.
But by the time you get it sorted that team member you really valued has left. The advisor you really wanted to collaborate with for equity has had other offers.
To help business owners avoid these mistakes and get the most from their equity we’ve put together a few things that will help. Some of the answers above were taken from our series of free ebooks — Equity Fundamentals.
- What exactly are shares?
- How many should I have?
- What rights to shareholders actually have?
- What is equity dilution?
- Why would a company issue new shares?
- What are the alternative ways of issuing shares?