Cap table management: the perils of a large number of shareholders
Last year saw record levels of equity investment into Australian startups and scaleups1.
This has created an exciting environment for founders seeking to take their business to the next level. The abundance of equity capital being raised by Australian high-growth companies from a diverse range of investors – from friends and family, to sophisticated funds – means that we frequently encounter proprietary companies with significant numbers of shareholders on their registers.
Competition for talent in a tight labour market also means that equity is increasingly being used as a tool to attract and incentivise a growing pool of talent. While the vast majority of startups will use options to incentivise their employees, there will come a time when those options vest and become exercisable for shares in the company. As this occurs, the startup can find itself with a very large number of shareholders.
A large cap table creates legal complexity, particularly if the startup has more than 50 shareholders
Although the Corporations Act 2001 (Cth) (the Act) prohibits a proprietary company from having 50 or more non-employee shareholders, the exemption afforded for employee shareholders does not apply to the application of Chapter 6 of the Act. Chapter 6 governs acquisitions of voting shares in, and takeovers of, Australian companies.
When Chapter 6 applies, a company's ability to raise capital and regulate transfers of shares will be subject to the highly prescriptive limitations and obligations set out in Chapter 6. These limitations are significantly burdensome for proprietary companies, and can create considerable headaches for startups looking to raise capital (let alone embark on a sale process, which would need to be undertaken by way of takeover offer or court-approved scheme of arrangement).
Where a company has more than 100 shareholders, that company will also become subject to the continuous disclosure regime – an unduly onerous obligation for a privately held company to be subject to if there are other options available.
So what are the other consequences and how do we avoid them?
One consequence of the application of Chapter 6 of the Act is that typical features of a shareholders' agreement that deal with transfers of shares (eg drag and tag along provisions, compulsory transfer provisions arising from events of default) would have the effect of each shareholder of the startup being deemed to hold a 'relevant interest' in the securities of each of the other shareholders over whom eg a drag or tag right may affix, resulting in a breach of Chapter 6.
To avoid these consequences, a startup may seek to limit the number of shareholders on its share register by:
- structuring (or amending) its incentive plans to ensure that options cannot be exercised other than in connection with a liquidity event;
- limiting grants of options and shares to key employees only; or
- establishing an employee share trust or other custodian structure, under which the shares of employees who exercise their options once vested are held. Legal advice should be sought to ensure such a structure is appropriate for your company in the circumstances.
If your startup (or a startup you've invested in) is coming up against any of the issues raised above, feel free to contact our team below.