A company needs capital to grow, which is why company owners may turn to family members and friends for support. If you have been asked to invest in your friend or family member’s company, you should consider what that entails. You should also understand your rights and obligations as someone who is investing in a company. This article sets out the key steps involved when investing in a friend or family member’s company.
What Does It Mean to Subscribe for Shares?
When a company brings on a new shareholder, the company does not sell or transfer existing shares to them. For example, a shareholder who owns 100 shares does not sell or transfer 50 shares to the new investor so each has a 50/50 split.
Instead, a company issues or ‘creates’ new shares for the incoming investor. For example, if a company has 100 shares, it can issue another 100 shares to the new investor, meaning there are 200 shares in total. This will mean that the new investor will have a 50% stake in the company. In this example, the investor is subscribing for 100 shares. In other words, the investor is signing up to receive 100 shares.
What Does It Mean to Be a Shareholder?
Subscribing for Shares is Not a Loan
If you lend money to a company, then the terms of the loan will set out:
- when the company will repay you; and
- the interest rate that you can expect.
When you invest in a company, you buy shares. The company (and shares) may increase or decrease in value. There is no guarantee that if the company is dissolved or ends, the shares will be worth what you paid.
You May Be Entitled to Dividends
To become a shareholder means you become a part-owner in the company. If the company is in a comfortable financial position, it may choose to use some of its profits to reinvest in the company and some of its profits to pay money to its shareholders (known as dividends). If you are a shareholder, then you are entitled to dividends.
You Can Sell Your Shares
Subject to a shareholders agreement, you can generally sell your shares to existing shareholders or third parties. If you invested in a company that has been successful, then the value of the company should have increased. If so, you may be able to sell your shares for more than what you had initially invested. However, if the company is unsuccessful, you may sell your shares at a loss, or you may not be able to find a buyer.
Understand the Risks
It is important to understand the financial risk of subscribing for shares. It is possible that your shares will decrease in value. This is why the first round of raising capital is often referred to as ‘friends, family or fools’. However, friends and family have the advantage of knowing the founders and their ability to successfully carry out the business.
What Are Your Rights as a Shareholder?
Your rights as a shareholder are governed by:
- Australian law (i.e. the Corporations Act) or the company constitution; and
- the shareholders agreement.
It is common practice for incoming shareholders to request a copy of these documents.
Under the Corporations Act, you will have some inherent rights including:
- voting on certain matters;
- entitlement to final distributions of money if the company winds up or ends;
- participation in corporate actions such as issuing shares; and
- the right to sue to make the company act lawfully.
The shareholders agreement is a document created for the company that sets out shareholders rights including:
- who has the right to appoint a director;
- vesting clauses for key founders (i.e. clauses that protect the company by allowing the company to purchase shares back from a founder who leaves the company); and
- who can vote on critical business matters. For example, which decisions are for directors (unanimous or by majority vote) and which are for shareholders (unanimous or by majority vote).
If you have the right to appoint a director, then you can participate in the direction of the business. However, if you do not have the right to appoint a director, then you may want to consider whether there are any critical business matters that are reserved for shareholders so you can participate in key decisions.
What Are the Steps to Subscribe For Shares?
1. The Company Prepares and You Sign a Share Subscription Agreement
It is best practice for a company to prepare a share subscription agreement for incoming shareholders. For earlier rounds, this document will typically be a short document which will include:
- the number of shares you are subscribing for;
- the price of shares;
- that you agree to be a member of the company and agree to comply with the company’s governing documents (e.g. constitution and shareholders agreement, if the company has these); and
- when the company will issue the shares and undertake the other legal steps.
A share subscription agreement can also include warranties and representations made by the company for the benefit of the investors. These may be simple or detailed. The company may guarantee that the:
- information provided by the company is accurate and complete;
- company owns or licenses all relevant intellectual property; and
- company is not aware of any risk of being sued.
A share subscription agreement can also include warranties and representations made by you for the benefit of the company. For example, an important warranty is that the company can issue shares to you without disclosure documents (e.g. a prospectus).
If the company breaches any of the terms of the share subscription agreement, then you may take legal action against the company.
2. You Sign the Shareholders Agreement
The shareholders agreement is the agreement that governs the relationship between all shareholders. Once you become a shareholder, it is a requirement that you sign the shareholders agreement and once you sign it, you are subject to its rules.
As noted above, the shareholders agreement sets out how shareholders work together including processes to follow in certain situations. Some of its key clauses in this context include:
- how decisions are made (by directors or shareholders or by a certain majority);
- the process to issue new shares and transfer shares;
- the steps to take to issue dividends; and
- what happens if one of the shareholders dies or is unable to act as a shareholder.
3. The Company Proceeds to Take Steps to Issue Shares to the Investors
To issue shares, the company takes administrative steps including:
- shareholder or board resolutions to approve the issue of shares;
- share certificates for each new shareholder;
- updating the company register of shares; and
- updating ASIC’s register.
The share subscription agreement sets out the company’s obligation to take these steps and formally issue shares to investors.
Investing at the early stages of a company can be risky. Therefore, it is important to understand what it means to subscribe for shares so you know what to expect. Furthermore, there are a number of documents that you should be familiar with, such as the shareholders agreement and share subscription agreement. If you have any questions about investing in a company or your rights, you can contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.
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