As a sole proprietor, you have grown your business to a level that needs to be incorporated. After incorporation, you and your business become two separate entities. Your liability as the shareholder is limited to the cost of your shareholding, but your reward is the increase in the price of that shareholding.
A crude way of defining shares is giving the holder a share in the company’s ownership. Now you don’t want to share ownership in the business you worked so hard for with someone in exchange for money. But in reality, you need money to grow your business and attract the right talent. That is where share classes come into the picture.
Basis of Creating Share Classes
Going back to the point of ownership of a company, it can be in the form of
- right to vote,
- right to receive dividends, and
- right to acquire property in the event the company is dissolved.
As the business owner, you can determine which right you want to give to which share class. You can mix and match. For instance, one share class can have all three rights while another can have any of the two rights or only one. While incorporating, you have to define share classes, and the number of shares your corporation is authorized to issue in the articles of incorporation.
Why Do Startups Need Different Share Classes?
Share classes allow your business to distribute ownership without diluting your and your family’s interest. Over the lifetime, your business will see external funding, employees, acquisitions, spin-offs, mergers, and estate planning. Depending on your business objective, you can determine whom to allocate which share class.
While the share class structure looks simple, it is highly strategic and can make a difference in what you get from a deal. Talking to a professional business consultant when defining and issuing share classes is advisable. Let’s take some instances where the suitable share class can leave you with the sweet end of the deal.
Single Share Class Structure
If you are a single owner and hold 100% shares of your corporation with no intermediate plans to expand, the simplest structure is to have a single share class with common voting rights. One share, one vote. You distribute these shares to your family and partners. All those who own the shares of your company have the right to vote on significant decisions regarding the company’s operations, acquisitions, and dissolution.
You can use these shares to pay your non-working family members dividends from the business profit. Because paying a salary to a family member requires them to work for reasonable hours and get paid as per industry standards. You can also use these shares to transfer business ownership to your children or to sell your business.
When Would a Startup Need Multiple Share Class Structure?
You might wonder if common voting rights shares are enough and why you need different share classes. A multiple-share class structure allows you to award shares to employees, investors, and other business partners without diluting your ownership.
For instance, John, the owner of ABC Corp., wants to launch an IPO (initial public offering) to raise equity capital. He can issue Class A shares (where one share has one vote) and keep Class B shares (where one share has ten votes) with himself. He can also create Class C shares (non-voting shares with the right to get a share in the company’s profit) to distribute to his employees and attract the right talent.
You can also create a class of non-voting shares with the right to receive dividends. These shares can be kept in family trusts and give your dependents, like spouses or grandchildren, a source of income from the business without actively participating.
How Are Preferred Shares Different From the Above Common Shares?
Apart from the common (voting /non-voting) shares, there is another type of share called preferred shares. They don’t have voting rights but get preference over other common equity shareholders when it comes to claiming the dividend. They also get priority on the remaining property at the time of the dissolution of the company.
You can issue preferred shares to your spouse or family members, giving you and your family preference in payment if the company gets acquired or dissolved.
As a small business owner, you can create these basic share classes depending on your business requirement. For example, you may have a single share class structure and might want to move to a multiple share class structure. But that would require amending the articles of incorporation and approval of existing shareholders. Instead, talk to a business consultant to explore the possibilities and challenges with different share class structures and find the one apt for your business.
Contact Edelkoort Smethurst CPAs LLP in Burlington for Professional Help
We at Edelkoort Smethurst CPAs LLP can provide you with designing your article of incorporation, share class structure depending on your business needs, and help you amend the structure if required. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with your share structure, contact us online or by telephone at 905-517-2297.