Attracting talent is a challenge for any business — especially when you can’t yet offer the same competitive market salary or performance bonuses as industry incumbents. For cash-strapped startups, issuing options under an employee share scheme can help incentivise key team members. An option gives the team member a right to buy or sell shares in your startup in the future.
As a startup founder, you may need to raise capital to supercharge your growth and build your team. If you’re not bootstrapping your startup, you can raise money through equity (shares), debt (for example, a convertible note), or a simple agreement for future equity (SAFE). Although convertible notes and SAFEs are increasing in popularity, it is still standard practice to issue shares to investors in exchange for money during a capital raising round.
So, how does issuing shares or options work in practice?
1. Determine the Number of Shares and the Share Price
Whether you are issuing shares to an investor or share options to an employee, the first step is to determine how many shares you would like to issue and at what price.
As a general rule, you shouldn’t issue shares at less than their fair market value because there can be tax consequences. You should speak with a tax lawyer about whether any special valuation rules may apply, such as the safe-harbour valuation rules under an ESS or ESOP.
2. Determine What Approvals Are Required
The next step is to look at your startup’s governing documents to determine whether they set out a particular process that you must follow to issue shares. For example, the company’s constitution might outline that the board needs to approve a share issuance. Or, the company’s shareholders agreement might give the existing shareholders pre-emptive rights over the new shares. This means that the company would have to offer to sell the shares to the existing shareholders first, before offering them to a third party.
If you are issuing preference shares to an investor, you should also confirm that you have the right to do so under your company’s governing documents. Once your company or legal advisors have determined which approvals you require, either the board or the shareholders (or sometimes, both) must pass a resolution to approve the share issuance.
3. Prepare the Relevant Offer Document
What documents a company needs to issue shares to the incoming shareholder depend on the circumstances, but generally speaking, you will need the following.
|Document||When It’s Used|
|Share Subscription Agreement||An investor is subscribing for shares (i.e. buying newly issued shares). The share subscription agreement sets out the terms of the investment as well as company and investor warranties. The Agreement also includes an application form for shares.|
|Share Application Form||An existing shareholder, incoming founder or small-scale investor is applying for shares. But, if you are looking to raise a larger amount during a round or the deal involves more complex terms and warranties, such as different share classes for different investors, you should consider using a share subscription agreement.|
|Share Offer Letter||Your company will provide a share offer letter to an employee under an ESS, or to a shareholder that exercises their pre-emptive rights and buys shares. The letter will also contain an application form for the shareholder to apply for the shares.|
If the company has a shareholders agreement in place, the incoming shareholder should also sign on to this agreement via a deed of accession. If the company does not have a shareholders agreement, it should put one in place at the time the new shareholder comes on board. This is a very important document that governs the relationship between the shareholders and directors.
4. Receive All Signed Documents and Payment
Once the incoming shareholder has signed the relevant documents, they will transfer the money for the shares into the company’s nominated bank account.
5. Issue the Share Certificate and Complete the Required Updates
Once the funds have been received, the company should issue the new shareholder with a Share Certificate and update the Company Members Register.
You must also update the Australian Securities & Investments Commission (ASIC) of the new shareholder within 28 days of the change to avoid a late fee.
When issuing options, the first step is again to gather the relevant approvals from the shareholders or the board. The company’s constitution, shareholders agreement or both will set out the approvals required. If the company does not have either of these documents, the rules set out Corporations Act 2001 (Cth) will apply.
The documents you will need to issue options differ to a share issuance and also whether the issuance is part of an ESS or not.
For a non-ESS issuance, the company will need to prepare an option agreement which will set out the terms of the issuance, investment and future conversion into shares. Once the agreement has been signed, the company will issue an Option Certificate to the option holder and will update its Option Holders Register. There is no need to update ASIC that the company has issued options.
For an ESS issuance, the employee will receive the following:
- an Offer Letter which sets out the terms of the offer; and
- the Plan Rules which sets out how the scheme will operate and the conditions under which the employee can convert their options into shares.
Again, there is no need to update ASIC until the option holder becomes a shareholder, but you should update the company’s Option Holders Register.
Issuing shares or options can be a daunting task for many startups because of the important legal steps involved. But LegalVision’s startup lawyers can help guide you through the process and prepare the required documents. If you have any questions, get in touch on 1300 544 755 or fill out the form on this page.
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