Have you incorporated a company with two or more co-founders? Perhaps you decided to keep it simple and issue three shares – one to each co-founder. You now all own one-third of the company. But if your startup is one of the 14% that goes on to raise outside investment, you will likely need to change your initial share structure to bring on investors.
Why Would I Want to Increase the Number of Shares?
When you issue new shares to investors, you want the shareholding percentage to alter proportionally. For example, a new investor wants to buy into your company which currently consists of three shares. They intend to purchase a 10% stake in your startup, but you’ve only issued those three shares to the founders. How can you amend the share structure so that they’re able to purchase a 10% holding?
You will need to increase the number of shares so that when you issue new shares to the investor, the existing directors’ total shareholding is diluted to 90%.
How Can I Increase the Number of Shares?
You can legally issue new shares or split existing shares. As is often the case, there are tax implications for each shareholder following a new share issue. The tax liability will depend on several factors including the amount paid for the newly issued shares and the difference between this amount and the market value of the shares.
Who Determines the Market Value?
Determining your company’s value is difficult – particularly if you are pre-revenue. If you have negotiated an investment from an investor, then the ATO may use this sum as a benchmark for the value of your business and the shares. If you’re offered, for example, $50,000 for a 5% stake, this indicates your company is worth $1,000,000 at that point. If your share structure changes, so too does your tax liability. You could then calculate your tax liability for any changes made to the share structure. If you do need to increase the number of shares in your company and want to avoid the tax implications of doing so, you have three options.
1. Issue Shares When Market Value is Negligible and Pay the Value
If you’re looking to issue new shares and your company’s value is not yet existent, you can issue the shares to founders for free, or for nominal consideration. The formula used to calculate tax liability is based on the difference between what you paid for the shares and what they’re worth. If they’re worth nothing, or you pay the value when it’s next to nothing, then it’s unlikely that a tax liability will arise. If the market value increases, this option becomes less viable depending on your cash flow and willingness to pay.
2. Split the Shares
Imagine each co-founder having one share is like a block of chocolate that is then divided into smaller portions. If the co-founders divide the shares equally, then you are still holding the same share (albeit in much smaller pieces). You are just splitting the number of shares you already own, not issuing any new shares.
For example, each co-founder bought their one share for $10. You can split each share into 1000. Instead of 3 shares valued at $10 each, you have 3,000 valued at $0.01.
3. Employee Share Option Plan (ESOP)
If you’re an eligible startup, you could consider issuing shares and leverage the startup exemption when offering shares or options to purchase shares at a discount through an ESOP. This exemption allows for deferring tax on options until the point at which a financial benefit is derived.
It’s sensible to speak with a tax adviser about whether any tax exemptions apply at the time you are considering changing your share structure.
You must notify ASIC if you change your share structure – whether you split your existing shares or issue new shares to investors, you will need to ensure that you update your members register within 28 days.
If you have any questions about how to change your share structure to bring on board investors, get in touch with our startup lawyers on 1300 544 755.
The tax information contained in this article is not tax advice and should not be relied on as such.
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