If you’re thinking of setting your business as a limited company (or you’ve already done so), you’ll need to understand how share capital works. This is because shares come bundled with certain rights given to their owners, and if you want to change your share capital – because you’re raising venture capital, for example – there are certain rules that you must follow. You also use share capital to benefit your business, by creating certain classes of shares to attract investors and incentivise employees. Read on to discover the ins-and-outs of share capital and see how managing it effectively could help your business.
- What is share capital?
- What’s the nominal value of a share?
- Why set up a company limited by shares?
- What’s share premium?
- Where do I find share capital on a balance sheet?
- What’s allotted share capital?
- What’s issued share capital and how do I decide how many shares to issue?
- What are the advantages and disadvantages of raising share capital financing?
- Can I alter my share capital?
- What are pre-emption rights?
- How are shares transferred?
What is share capital?
The term ‘share capital’ means the funding provided by the owners of a limited company in exchange for a share in the business. All limited companies must have at least one share, and these are normally ‘ordinary’ shares with a nominal value of £1 each. So, the shareholders have to pay £1 for each share they are issued.
A company’s capital structure determines the degree of control each shareholder has over the company, the percentage of the profits they can receive and what they will get back on liquidation. So, if one share has been issued, then the owner of that share will control 100% of the company, will receive all the profits, and will get back 100% of the value of any assets if it’s wound up. If two shares have been issued, then each member has a 50% ownership share, and so on.
Shareholders are sometimes referred to as company ‘members’.
There’s no limit to the number of shares you can issue, and you can decide the maximum number when you set up your company. This upper limit (or ‘authorised share capital’) is contained in the Articles of Association of the company, and if you want to change this later on, you’ll need to change the Articles. Shares are ‘allotted’ to the shareholders once they pay for them.
As well as ordinary shares, companies can issue different classes of shares:
- Preference shares. The holders of these shares are entitled to be paid dividends before other shareholders, and also receive their money back first in a liquidation scenario. They may be ‘cumulative preference shares’ where the right to receive dividends is rolled over to subsequent years if dividends can’t be issued (because the company isn’t profitable that year).
- Redeemable shares. These shares are issued on the terms that the company can buy them back in the future.
If your company has external funding, your investors may ask for preferential shares.
What’s the nominal value of a share?
Each class of shares must have a fixed nominal value per share (for example, £1). A shareholder’s liability to contribute to the company, even in an insolvency situation, is limited to the amount of their initial investment (being the nominal value of their shares). The nominal value is not the same as the market value of the shares which can be significantly higher.
Shareholders will not usually get their share capital back unless the company is sold, but they will receive dividends from the company if the company is profitable. This is most commonly in the form of an amount of cash per share.
Why set up a company limited by shares?
There are several reasons why you’d want to set up a company limited by shares (otherwise known as incorporation):
- So that you’re not personally liable for a company’s debts if it becomes insolvent (unless you’ve given a guarantee to a bank or mismanaged the business).
- So that your company is taxed separately from you, personally.
- So that you can raise funding by issuing shares in the business as opposed to loans.
- So your business is easier to sell.
- So you can attract investment by taking advantage of investment schemes aimed at growing businesses, and/or issue shares to employees as an incentive.
What’s share premium?
As we’ve seen, the underlying or nominal value of a share is generally low. However, depending on how successful a company is, shares may be worth much more than their nominal value. The difference between the nominal value of a share and its actual value is called the ‘premium’, and when shares are issued at a price above their nominal value they are said to be issued at a ‘premium’.
If you issue shares at a premium, your company must put the amount of the premium into a separate account called a ‘premium account’ You can’t use this money to pay dividends, and they are known as ‘non-distributable reserves’. You can only use them in a limited number of circumstances.
Where do I find share capital on a balance sheet?
It’s listed under the ‘Capital and Reserves’ (sometimes called ‘Equity’) section of the balance sheet. If your company has issued premium shares, there will also be a reference to ‘share premium’, ‘share premium account’ or similar under the Capital and Reserves section of your company’s balance sheet.
What’s allotted share capital?
Shares are ‘allotted’ when a shareholder has the unconditional right to be included in the company’s register of members but doesn’t yet appear. This is normally when the prospective shareholder has asked the company for shares, and the company has notified them that they accept that request.
What’s issued share capital and how do I decide how many shares to issue?
When a shareholder is entered in a company’s register of members, the shares have been issued. So, if you allot new shares to existing or new shareholders, you must update your company’s register of members as soon as possible.
For small companies, you can decide how many shares to issue, and there are no hard-and-fast rules. If you’re a sole trader who’s decided to incorporate, you may decide to have a single share. Mostly, companies issue 100 shares that they divide up between the founders. The most important thing when starting out is to keep things simple and to be careful who you issue shares to in the beginning, as this can have implications later on. We recommend that new companies consider putting in place a founders’ agreement to cover the terms on which shares are issued.
If you want to issue new shares, this is the procedure to follow:
- Check that you have enough authorised share capital to issue the new shares.
- Make sure the directors can issue new shares. You’ll find this information in the Articles. If the directors can’t, then the shareholders will pass a resolution to issue new shares in a general meeting or by a written resolution.
- Make sure that there are no pre-emption rights in the Articles or in a shareholders’ agreement, that give existing shareholders a right to be offered the new shares first.
- Make an offer of shares to the prospective shareholders.
- Hold a meeting or pass a written resolution to issue the shares.
- When you’ve been paid for the shares, update the register of members and issue share certificates.
- Make a filing at Companies House.
What are the advantages and disadvantages of raising share capital financing?
If you’re looking for financing for your company, rather than obtaining loans you can issue shares instead. There are advantages and disadvantages to share capital financing:
- Unlike loans, a company doesn’t have to repay share capital to shareholders.
- A company doesn’t have to pay dividends.
- Shareholders can’t force a company into insolvency, unlike a creditor such as a bank.
- The company can do what it likes with this money. No obligation to pay dividends if it is not in the best interests of the company to do so.
- Shareholders cannot force a company into bankruptcy (unlike, for example, a bank if a company fails to pay its interest payments).
- The company can use the funds raised however it likes (a bank might specify that the funds can only be used for certain purposes).
- New shareholders can provide helpful expertise for your business (for example, venture capital funds can provide sector knowledge and may have a wide range of contacts that could help grow your business).
- If new shares are issued, the percentage holdings of existing shares will be ‘diluted’ –they’ll own a smaller percentage than before and lose an equivalent degree of control of the company’s.
- Interest paid on a bank loan or other debt can be deducted from taxes, whereas dividends can’t.
- Shareholders are the last to get paid in the event of bankruptcy and so they’re at higher risk than other creditors.
- There’s a special procedure for issuing shares.
Can I alter my share capital?
Because share capital belongs to the company and not individual shareholders, they can’t generally ask for it back. So, the directors must ‘maintain’ the company’s share capital.
There are a number of ways in which a company can alter its share capital. This process can be complicated, and we advise that you take professional advice.
Here are the main ways in which you can alter your share capital:
Reduce your share capital
You can reduce your share capital by reducing the number of shares, the value of issued shares, or the amount paid up on the issued shares. You can also reduce the share premium account, capital redemption reserve and certain other reserves.
You may reduce share capital to return surplus cash to shareholders or to reduce or eliminate accumulated losses in order to declare a dividend.
Provided it is not prohibited by the Articles, you can reduce your company’s share capital with the consent of its shareholders (by way of a special resolution with at least a 75% majority) and either, the consent of the court, or a solvency statement by the directors. You also need to file certain documents at Companies House.
Changing the currency of your company’s capital
You can change the nominal value of your company’s shares into a different currency provided that this isn’t prohibited by your company’s Articles. You do this by an ordinary resolution of shareholders (more than 50% agree). You’ll have to go through a special procedure and file documents at Companies House.
After a redenomination, you may want to cancel part of the share capital so that the value of the shares is suitable (for example, there could be fractions of shares in the new currency). You can reduce capital in these circumstances by way of a special resolution of the shareholders so long as:
- The resolution is passed within three months of the ordinary shareholders resolution that authorised the redenomination and
- the share capital reduction does not exceed 10% of the company’s allotted share capital immediately following the reduction.
If you reduce share capital following a redenomination, you must put an amount equal to the value of the reduction into a redenomination reserve (a non-distributable reserve).
Buying back shares
A share buyback is when a company purchases its own shares. Share buybacks are highly regulated, and if you don’t follow the rules, the buyback could be void and the company and its directors held legally liable. For a company’s officers this could mean an unlimited fine, a prison sentence of up to two years or both.
Some of the reasons why companies buy back shares are to increase earnings per share, increase net assets per share, return surplus cash to shareholders or provide an exit route for shareholders.
The process relating to a share buyback is complicated and should be carried out by a solicitor. The circumstances in which a private limited company may buy back shares are as follows.
Subject to any provisions in the company’s articles of association, a private limited company may only purchase its own shares if the shares are fully paid up and the purchase is funded out of:
- distributable profits
- the proceeds of the issue of shares made to finance the buyback or
- out of capital (in certain circumstances)
Once the shares are bought back, they must either be cancelled and the amount of the company’s issued share capital reduced by the nominal value of the purchased shares, or, if the purchase was funded out of distributable profits, held as treasury shares.
By allotting shares
Companies allot shares to raise new capital, bring in new shareholders, or offer existing shareholders new shares, for example. How you allot shares depends on your Articles, when your company was formed and how many share classes you have.
For companies incorporated after 1 October 2009 and with one class of shares, there’s a simplified procedure for allotting shares, so the directors can do this without the approval of the company’s existing shareholders. For older companies, the directors must get the consent of the existing shareholders to allot shares.
If you’ve more than one class of share, you can’t use the simplified procedure to allot shares.
What are pre-emption rights?
When you’re allotting new shares, you need to know whether the existing shareholders have existing shareholders’ rights of pre-emption. Pre-emption rights are a right of first refusal for existing shareholders to buy the new shares to avoid being diluted and maintain their current percentage of the company. Shareholders have the automatic right in law to pre-emption, but this right can be excluded in a private company’s Articles of Association. It is also possible to disapply the statutory pre-emption rights for specific allotments by way of a special resolution of the company’s shareholders or a provision in the Articles.
You can’t allot shares a discount to their nominal value.
There are several Companies House requirements for documentation and filing when you allot shares.
How are shares transferred?
If a shareholder has a physical share certificate, it’s usually possible to transfer them to someone else provided:
- The Articles allow this, and don’t contain any restrictions. This is to give existing shareholders some control over who can become a shareholder.
- If there’s a shareholders’ agreement in place, this doesn’t contain any restrictions. This will only apply to the shareholders that are party to the agreement.
When you sell shares, the usual process is that the seller and buyer enter into a share purchase agreement. Depending on the complexity of the transaction and the value of the shares, this can be a very simple or very complicated document.
There are then several additional steps needed to carry out the transaction, including the delivery of a stock transfer form, the payment of stamp duty and the ‘stamping’ of the stock transfer form. A new share certificate is then issued to the buyer, forms are filed at Companies House and the company’s register of members is updated with the new shareholders details.