The Class Struggle

The Class Struggle: Understanding Share Classes for Start-Up Companies

Deciding to incorporate is an important step in the lifecycle of your business. When incorporating, one of your key considerations will be what the share structure of the business should look like. Questions that can arise during this process include:

• Who will I be issuing shares to?
• Why do I need different classes of shares?
• What rights should each class of shares include?

 
Who Will I Be Issuing Shares To?
Before you decide what the share structure of your business will be, you need to know who is going to be owning those shares. In a start-up company, there are three primary categories of shareholders:

1. Founders
2. Employees
3. Investors

Why Do I Need Different Classes of Shares?
Founders, employees, and investors are likely to have differing needs and wants when it comes to compensation for their respective contributions to your start-up. For this reason, corporations in Alberta (and throughout Canada) are empowered, through their articles, to establish more than one class of shares. In fact, there is no limit on the number of classes of shares that can be set out in the articles.[1]
There are several rules respecting what rights and restrictions can be placed on shares. Two of the most important rules are:

1. If there is more than one class of shares, the rights, privileges, restrictions, and conditions for each class must be indicated in the articles[2]; and
2. At least one class of shares must have:
3. The right to vote;
4. The right to receive dividends; and
5. The right to receive the remaining property of the corporation on dissolution.

However, these rights can be split up among the share classes, so long as they each appear in at least one class.[3]
Without multiple classes of shares, your business will likely be unable to satisfy the unique needs and wants of the founders, employees, and eventually investors.
 
To authorize new share classes after incorporation, your company would need to amend its articles.[4] Amending articles involves the passage of a special resolution[5] and, depending on the structure of your business, may not be an appealing proposition. For this reason, authorizing multiple classes of shares and setting out general terms during the incorporation process can save a start-up from costly and frustrating article amendments down the road.
What Rights Should Each Class of Shares Include?
Founder’s Shares
Founder’s shares are typically the first to be issued in any new start-up. Due to the fact that Common shares traditionally include voting rights, they are a natural fit for founders who primarily desire control over the direction and decision making of the company. This first round of Common shares may also include the right to dividends as well as the right to receive remaining property of the corporation on dissolution.
Depending on the maturity of the business and relative bargaining power of the founders, the founder’s shares may also include a class of common shares that house special rights such as the right to convert into preferred shares at the same price and with the same conditions as the company’s future investors. Alternatively, founder’s shares may be “super voting” shares – granting the founders more control over the company without the corollary increase in returns.
Employees
Employee Share Ownership Plans (“ESOP”) are used to give employees an equity interest in your company. These plans are important as they incent key employees to a) think like a founder, and b) to stay employed with a business exhibiting upside potential. Traditionally, ESOPs take the form of either equity shares or stock options – both fulfilled with Common shares of the business that do not grant any special dividend or super voting rights. ESOPs can typically represent anywhere from 1 to 10% of the total outstanding shares depending on the maturity of the company.
Perhaps the most important consideration for founders establishing an ESOP is a vesting schedule. The vesting schedule determines how long your employees need to work or what performance targets they need to hit for their shares to vest. Different vesting schedules can have significant impacts on both a company’s share structure as well as employee incentives.
Investors
Early stage investments are inherently risky. It seems appropriate then, that venture capital and angel investors typically demand rights-heavy Preferred Shares. While there are many different Preferred Share rights, some of the most common include:

• Liquidation Preferences
• Dividend Preferences
• Right to convert to common stock
• Anti-Dilution Protection
• Veto rights
• Rights of First Refusal
• Right to appoint board members
• Information and inspection rights

The Preferred Shares that include these rights are often issued in sequence to accommodate different funding rounds (Class A Preferred, Class B Preferred, etc.).
Conclusion
There are many different contributors to a start-up company. Accordingly, it makes sense to have several classes of shares that cater to each contributor’s investment needs. Founders, employees, and investors will all demand unique rights when it comes to ownership of the company’s shares.
However, authorizing your company to issue different classes of shares is an exercise best undertaken during incorporation, not after. Otherwise, you may find yourself issuing an unwieldy special resolution to amend your articles each time you bring on a new investor or wish to reward your employees with company shares.

Blair Wentworth is a member of the BLG Business Venture Clinic, and is a 3rd year student at the Faculty of Law, University of Calgary.

References:
[1] ABCA 26(4)
[2] ABCA 26(4)(a)
[3] ABCA 26(4)(b)
[4] ABCA 6(1)(b)
[5] ABCA 173(1)