Thinking about issuing shares to directors and employees? Think carefully!

Retaining and incentivising key staff and directors is an important issue for all businesses. Sometimes this can be achieved by higher salaries or other employee benefits. But often, particularly in new businesses or SMEs where resources are scarce, business owners will look at offering key individuals shares in the company. However, it is not without risk.

The default provisions included within the Companies Act usually won’t give majority shareholders all the protections they would like (or assume they have!). Accordingly, it is important to ensure that the Company’s Articles of Association (its constitution document) is specially tailored before issuing any new shares. It may also be necessary to prepare bespoke shareholders agreements, employment contracts and option agreements.

Some (but by no means all!) of the issues to consider are:

Control

Shares usually carry a right to vote. Accordingly, even issuing a small number of new shares can significantly alter the balance of power in a company.

One way to address this is to consider issuing a different class of shares. A new class might not have the same (or any!) voting rights.

What happens if a shareholder stops working for the business?

Don’t assume that a shareholder will automatically have to give up their shares in the company if they stop working for it. Usually they won’t!

Consider a right to forcibly buy them out. This might be combined with a right to buy them out at different values depending upon the circumstances in which they leave (“good leaver/bad leaver” provisions).

What happens if the majority want to sell?

Usually, a buyer will want to purchase 100% of a company’s shares. This means that even a very small shareholder can potentially prevent a sale and effectively hold the majority to ransom.

To address this, consider including a “drag along” right to enable the majority to force a minority shareholder to sell out on the same terms.

Share options instead of shares?

Rather than grant key individuals any shares in the company on day one, consider granting them an “option” to acquire shares. Share options can be a very tax efficient way of incentivising employees and can be tailored so that the right to acquire shares is conditional upon a specified trigger event occurring. This could be an individual performance target or even a sale of the whole Company.

Conclusion

Used correctly, granting shares (or share options) can be a cost effective way of motivating and securing the loyalty of key individuals. However, it is important that specialist advice is taken and proper legal documentation put in place. Otherwise it can become very expensive indeed!