Equity finance for start-ups

When setting up a limited company for your new business, you’ll need to consider equity and shares.

Shares represent ownership of your company and come with rights and responsibilities.

To form a limited company, at least one share must be issued.

The person who owns that share is the sole shareholder and, therefore, effectively owns the entire company.

Limited companies can be owned by more than one shareholder.

Think of your limited company as a cake, and the slices are shares.

You can keep the entire cake or cut it into as many slices as you want.

Before you decide on selling equity in your business it’s worth seeking independent, specialist financial advice on the implications of such a sale on your business.

When someone receives shares, they become a shareholder.

This means they own part of the company (equity) and are entitled to some of the profits.

Despite owning part of a company, a shareholder need not be involved in the day-to-day management of your business.

This may be left to you as the founder and any directors that you have appointed.

Who gets equity in a business?

Four groups of people typically get equity in a start-up:

• Founder(s), and their family members
• employees such as directors
• advisers

Why consider selling equity in your business?

Selling equity in your business could play a key role in its growth.

Although this reduces your ownership stake in the business, it could deliver the finance you need to scale your operations.

Early-stage start-ups sometimes struggle to access external finance, so selling shares to investors keen to back small businesses with potential for growth could be an alternative way to get the funding required.

Equity could also be used to incentivise existing employees and attract new staff members.

Equity structures

There are various types of shares which provide different rights to shareholders.

The rights for each class of share used by the company are outlined in the company’s articles of association and any shareholders’ agreement if there is one in place.

There are four main types of shares – ordinary, non-voting, preference, and redeemable shares.

Ordinary shares

These are the most common types of shares used by limited companies in the UK.

Each share provides one vote in the company’s general meetings of shareholders and the ability to influence company decisions.

Ordinary shareholders also have the right to dividends if the business makes a profit.

Non-voting shares

A holder of non-voting shares has a share of the company’s capital but is not entitled to a vote and cannot participate in general shareholder meetings.

Non-voting shares are often issued to employees and family members of shareholders.

They provide tax benefits to those who receive them but allow the principal shareholders to retain control of the business.

Preference shares

This class of share provides a fixed dividend which the recipient receives ahead of ordinary and other shareholders when dividends are distributed after a profit has been made.

They also have preference over other shareholders for repayment of their capital if the business goes into liquidation or is wound up.

Preference shares are typically issued by founders looking for new investments.

They are often issued to investors, such as venture capitalists, who want a fixed income.

Preference shares do not usually come with voting rights.

Redeemable shares

These shares are issued with the understanding that the company will buy them back after a set period or when the company decides it should happen.

The exact terms will be outlined in the company’s articles of association.

It is common for redeemable shares to be issued to employees with the condition that they will be bought back at their nominal value if the employee leaves the business.

Preference shares are also often redeemable.

When deciding which class or classes of shares to issue, it is recommended that you speak to an accountant to seek independent specialist advice.

Mezzanine finance

Mezzanine finance is a form of funding that blends elements of debt financing and equity investment.

You agree to repay the loan over a period of time with interest, much like a traditional business loan.

However, if your start-up is unable to meet repayments, the mezzanine debt could convert into equity or shares in your company.

The conversion from debt to equity is the characteristic feature of mezzanine financing.

For lenders, if your business prospers they receive interest on their loan.

If your business struggles, the lender gains a share of its equity.

This may sound ominous, but mezzanine finance could be a flexible and effective way to raise money for your start-up and could be useful when traditional avenues of funding might be difficult to obtain.

It’s also worth noting that mezzanine lenders may not have the same level of control as shareholders unless the loan converts into equity.

As with all the options discussed in this guide, be sure to seek independent, specialist advice before committing to any particular financial option.

Allotting and issuing shares

The provisions of the Companies Act 2006 regulate the allotment and issue of shares and before allotting and issuing any shares in the capital of the company, you may wish to seek independent legal advice.

Following a successful issue or transfer of shares, each shareholder must be given a share certificate and the company’s register of members must be updated.

Within a calendar month of shares being issued, directors must complete and submit a ‘Return of Allotment’ (SH01 form) to Companies House.

The names of the shareholders do not need to be included on the SH01 form, but you will need to do so on your next confirmation statement, a document that limited companies must file at Companies House each year.

You must also update the company’s statutory books when any shares are issued or transferred.

To prevent disputes and disagreements between shareholders, you should consider using a shareholders’ agreement, a private contract between the shareholders in a company.

There is no set template for shareholders’ agreements, but they typically cover:

• how decisions are made, and what involvement shareholders have in business strategy and development
• how disputes are dealt with, and what happens if disagreements can’t be resolved
• what happens to the shares if the shareholder dies, retires, or leaves the business.

It is recommended that you get legal advice when writing a shareholders’ agreement.

You can find a directory of solicitors on the Law Society website.

Share options

As your business grows, you may consider issuing share options (the right to buy shares in a business) to employees to incentivise your workforce.

Share options could also help you to attract new staff and stand out from other businesses that don’t offer equity.

They are particularly useful for early-stage startups lacking the funds to provide big salaries.

Enterprise Management Incentives (EMI) is one of the most popular employee share schemes in the UK.

It allows companies to offer total share options up to the value of £250,000 in a three-year period.

Share Incentive Plans (SIPs) and Company Share Option Plans (CSOP) are other options.

Read more details about employee equity options.

Equity implications

There are various tax advantages related to start-up equity and issuing shares.

Through Business Asset Disposal Relief, you pay a lower rate of 10% Capital Gains Tax if you sell shares in a trading company you work for and have at least 5% of the shares and voting rights.

For the EMI scheme, employees do not have to pay National Insurance or income tax if the shares were granted for at least the current market value.

If the shares were granted for less than market value, income tax or National Insurance must be paid on the difference.

When EMI options are exercised, a business can benefit from Corporation Tax relief on the difference between the market value when the shares are acquired and the amount the employee pays for them.

For a SIP, employees don’t pay income tax or National Insurance if the shares remain in the plan for more than five years.

For employees taking advantage of CSOP, no income tax or National Insurance is due if the shares are kept in the scheme for three years.

As a business grows and additional investment is required, the share structure may need to change.

For example, you may initially issue ordinary shares, but when new funding is required preference shares may be required to attract investors.

Speak to your accountant or another expert for advice.