Key lessons in Australian crowd-sourced funding.

From set up to shareholders- understand your legal obligations to ensure success.

Part 4 of 5:  mechanisms to control how shareholders manage shares

In this, the fourth of a series of five articles, McCullough Robertson’s start-up expert, Partner Ben Wood examines some of the mechanisms a crowd-sourced funding (CSF) company can include in its constitution to assist in the handling of its shares, protecting both the company and its shareholders.

Rights of first refusal for transferring and issuing shares

The right of first refusal (also known as pre-emptive rights) ordinarily prevents a shareholder from transferring its shares, or the company from issuing shares, to third parties without first offering them to existing shareholders, proportionate to their current shareholdings.  By allowing existing shareholders the ability to accept or reject the offer of new or transferred shares, it gives them the opportunity to maintain their proportionate stake in the company, thus avoiding a dilution of their overall holding.

The decision about whether or not to include these rights in the constitution will be based on the needs of the company and its shareholders.  It may be the case that a company:

• wants discretion over who can be a shareholder of the company;
• would prefer to consolidate shareholders rather than have shares transferred or issued to third parties;
• may not want any pre-emptive rights included so shareholders can trade freely (perhaps on the basis that notice is provided to the company and a potential veto right is given to directors), and the company may issue new shares without first having to make offers to existing shareholders; or
• does not want to undertake the impractical task of having to make proportional offers to a large number of shareholders (which may be particularly difficult for a company that has undertaken an equity CSF raising).

Restricting transfers of shares

A company may also restrict the transfer of shares to particular people in specified circumstances.  This could apply where a shareholder offers shares to current shareholders (where there are pre-emptive rights) and none of the current shareholders wish to take up the offer to purchase those shares.  The shareholder could then go out and find a third party buyer; however, the company may wish to have a final say as to whether or not the selling shareholder can sell their shares to a particular party (as opposed to a listed public company, where shares can be freely traded on a stock market such as the ASX). 

A company may have any number of reasons for putting restrictions on who holds shares in the company.  For example, it may be part of the company’s branding or business model that the company remains wholly Australian-owned and, therefore, does not want its shares being held by foreign persons or companies.  Another valid restriction that may be imposed is to prevent a breach of any applicable legal restrictions on the issue or transfer of shares, such as the takeover rules.  The takeover rules prohibit the acquisition of a relevant interest in voting shares if, because of that transaction, a person’s voting power in the company:

• increases from under 20% to over 20%; or
• increases from a starting point that is above 20% and below 90%.

This restriction generally applies to listed companies, unlisted companies with more than 50 members, and listed managed investment schemes.  However, CSF shareholders will be exempt from the 50 member limit, as long as the company continues to satisfy the eligibility requirements mentioned earlier.  This should be monitored closely, in case a company becomes regulated by the takeover rules in the future.

Restricting the transfer of shares does not mean that a shareholder has no recourse to sell their shares, it only means that the company will have a say in who can purchase them. 

Drag along and tag along provisions

A tag along provision protects minority shareholders in circumstances where one or more of the majority shareholders would like to sell their shares to third parties.  Tag along rights give the minority shareholders an ability to also take advantage of the same offer and sell their shares on the same terms (so as not to be left behind as a shareholder in a newly owned company).  Tag along rights can be attractive to potential small investors, as is often the case with CSF investors, as they know their interests will be protected in the event that the company changes control.

Drag along provisions work in the opposite way to tag along provisions.  A buyer who decides to purchase a significant number of shares in a company may ultimately want to acquire all of the remaining shares at the same time.  A drag along provision will ordinarily provide that, where a majority of shares are being sold, the minority shareholders must also sell their shares on the same terms.  Drag along rights also assist the company where a potentially stubborn minority shareholder does not want to sell their shares, which could jeopardise a potential transaction. 

This may be the case in the context of a CSF company where a CSF shareholder has an emotional attachment to the company or its products.  If there were a shareholder who did not want to sell their shares on principle, a drag along provision would require them to sell their shares with the majority sellers.

Additional comments from Cake Equity

It’s good practice for the company to model hypothetical ownership scenarios when they are drafting their constitution before a CSF raise, to ensure they understand how the rules may apply. For example, the founders could use Cake to model how their fully diluted ownership would look following certain rounds and transactions, to ensure they will still have the required voting threshold to activate certain rights, such as drag along rights.

In the next article, Ben draws on his recent experiences to provide his insights into the building of a board of directors that fairly represents shareholders, large investors and, of course, the founders of a CSF company.  Ben also comments on some considerations that have been useful to facilitate the holding of director and shareholder meetings.