In Short
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Investors provide capital to a business with the expectation of financial returns, which can be through loans, equity, or convertible instruments like SAFEs and convertible notes.
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Shareholders own part of a company by holding shares, granting them rights such as voting at meetings and receiving dividends.
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Not all investors become shareholders; some may lend money or invest without taking ownership, and may not have voting rights or equity in the company.
Tips for Businesses
When raising capital, it’s crucial to distinguish between investors and shareholders. Investors may provide funding without taking ownership, while shareholders have equity stakes and associated rights. Understanding these differences can help in structuring agreements and managing expectations effectively.
Investing in the financial market and participating in the ownership of companies are common activities for individuals and institutions seeking to grow their wealth. However, it is important to understand the difference between the two key terms: investor and shareholder. While both terms relate to a financial investment, they represent different aspects of ownership and participation in a business’s growth.
If you are seeking investors for your business, negotiations may quickly turn depending on how much risk the investor is willing to take and how much control you are willing to give up in your business. This article aims to clarify the differences between an investor and a shareholder and how they may impact your business growth.
What is a Shareholder?
A shareholder is a person or legal entity who acquires shares in a business from the business itself (following a share issue) or buys them from an existing shareholder. Shareholders are also referred to as ‘members’ of a company. A shareholder can acquire shares in either public or private companies. The shareholder will then own an equitable interest in the company. The shareholder will be entitled to vote on issues affecting the company, as a share represents an interest in the profits and losses of the business.
A shareholder can be the owner of different classes of shares in the company. The two most common types are ordinary and preference Shares. However, a company may issue any class of shares set out in its constitution. Such classes can have their own features, benefits or restrictions.
Anyone buying shares in a company will be a shareholder of that company and will likely need to sign a shareholders agreement.
Although shareholders come last in line if the company is in liquidation, they are also first in line when it is performing extremely well, and it is time to pay dividends.
What is an Investor?
Investors are individuals, institutions, or entities that commit capital or resources to an investment with the expectation of generating financial returns. Investors can engage in various investment activities, such as investing in shares, bonds, real estate, startups, or other assets. The primary goal of investors is to earn profits by allocating their resources to different investment opportunities.
Your business may be seeking an investor who helps support businesses to grow through a few traditional methods:
- Loans
- SAFEs (Simple Agreement for Future Equity)
- Convertible Notes
- Buying shares for an equity stake in the company
- ordinary shares; or
- preference shares.
Loan
A loan is a financial arrangement where a lender provides funds to a business to support its operations, expansion, or other specific needs. A loan agreement will outline the loan amount, repayment terms, interest rate, and other conditions.
A company can use the borrowed funds for various purposes and is responsible for repaying the loan amount and any agreed-upon interest and fees within the specified timeframe. Business loans are a vital source of financing for businesses to meet their financial requirements and achieve their growth objectives.
SAFE
A SAFE (Simple Agreement for Future Equity) is a type of investment used in early-stage startup financing. It gives investors the right to acquire company shares in the future, typically during a priced equity financing round. Unlike traditional loans, SAFEs do not accrue interest or have maturity dates. They simplify the investment process by deferring valuing the business until a later stage.
Additionally, SAFEs do not provide voting rights or control. Investors bear the risk of early-stage investments but have the potential for future equity ownership if the company succeeds. A written agreement between the investor and the company will outline the terms and conditions, including conversion triggers and valuation caps.
Convertible Note
A convertible note is a short-term loan commonly used by startups to raise capital. It can be converted into equity at a later stage, usually on a future capital raise or an exit event. The investor lends money to the company, and the note includes a maturity date and sometimes an interest rate. The conversion terms, such as the conversion price and any applicable discounts or caps, are predefined. The note may be repaid (with interest if applicable) if the conversion does not occur.
Convertible notes provide flexibility and act as bridge financing until a larger funding round or an exit is secured. Importantly, they carry both debt and equity risk, offering the potential for future growth and return. An agreement between the company and the investor will document the terms and conditions.
Investor or Shareholder?
As SAFEs and convertible notes do not provide investors with shares until they convert, it is important to include clauses that require the investor to accede to the existing Shareholders Agreement (if there is one) or sign a Shareholders Agreement when the SAFE or convertible note does convert. Furthermore, it is important to know that until they do become party to the Shareholders Agreement, they won’t be bound by the restrictions contained in a typical Shareholders Agreement. For instance, the SAFE holder might not be required to go through the pre-emptive rights process when transferring the SAFE. It is therefore important to include transfer restrictions in the SAFE document itself.
Depending on the method by which an Investor provides funding to the company, they might not be a Shareholder until a later stage, or in the case of loans.
Buying Shares for an Equity Stake in the Company
Businesses often sell two distinct types of shares to investors: ordinary and preference. Each class of shares grants different rights to investors.
Ordinary shares are the most common type of shares issued by a company. These shares represent ownership in a company and provide shareholders with voting rights and the opportunity to receive dividends.
On the other hand, preference shares are a class of shares that provide certain preferential rights and privileges to the shareholders. These shares typically offer preferential treatment in terms of dividends and capital repayment. If the company faces financial distress or goes bankrupt, preference shareholders have priority in receiving their investment back before ordinary shareholders. Unlike ordinary shares, preference shares generally do not come with voting rights. If they do, they are limited.
Therefore, it is typical to see founders and employees receiving ordinary shares, while preference shares are ideal for investors seeking guaranteed returns.
Continue reading this article below the formWhat Governs the Relationship Between Shareholders and Investors?
A shareholders agreement formalises the operational relationship between an investor and the business it invests in, if the investor is to be issued with shares. A company can use their shareholder agreement to negotiate with investors. Likewise, incoming investors will always review the agreement before receiving their investment.
Further, shareholders agreements outline the following:
- the decision-making process, including who can appoint directors, how many directors are allowed on the board, how many votes each director has and whether decisions are made by the board or shareholders (or a combination);
- the share issue process, including pre-emptive rights (giving existing shareholders the first opportunity to buy new shares being issued);
- share transfer process, such as pre-emptive rights (giving existing shareholders the first opportunity to buy shares being sold), drag along and tag along rights, restrictions on transfers to third parties, and mechanisms for valuing shares;
- dispute resolution among shareholders, including mediation, arbitration, or other dispute resolution mechanisms; and
- non-competition and confidentiality provisions.
A shareholders’ agreement is a crucial document that helps protect the interests of shareholders. This promotes transparency and ensures smooth operations within the company. Moreover, it provides clarity and a framework for the rights and responsibilities of shareholders, helping to minimise potential disputes and uncertainties.
Key Takeaways
Investors and shareholders can represent different aspects of ownership in your business. An investor is a broader term referring to individuals or entities that commit resources to various investment opportunities to generate financial returns. Investors can invest their money in exchange for:
- shares (equity);
- a loan (debt); or
- convertible instruments, such as SAFEs and Convertible Notes.
On the other hand, a shareholder is a specific type of investor who owns shares in a company. Shareholders also participate in a company’s profits, governance, and decision-making. Each type of investor class attracts different benefits and drawbacks, and the most optimal type depends on risk appetite.
Understanding these distinctions is crucial for individuals and institutions seeking to navigate the complex world of finance and make informed investment decisions. If you are considering taking on investors or need assistance with reviewing, drafting or understanding a shareholders agreement, our experienced business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to solicitors to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
Can all investors become shareholders?
Not always. Some investors lend money or invest without taking ownership, so they are not shareholders unless they buy shares.
Do shareholders have voting rights in a company?
Yes, shareholders usually have voting rights on key company matters, while investors who aren’t shareholders typically do not.
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