Business finance - Share capital and shareholders

Learning Outcomes

This article explains the concepts of share capital, different types of shares, and the rights associated with share ownership within UK private limited companies. It also covers the rules surrounding the maintenance of capital, the process for issuing new shares, transferring existing shares, and distributing profits via dividends. For the SQE1 assessment, you will need to apply these principles to practical scenarios, understanding the procedures, requirements, and implications of equity finance and shareholder rights under the Companies Act 2006.

SQE1 Syllabus

For SQE1, you are required to understand the core principles of equity finance and shareholder rights from a practical standpoint. This involves applying the relevant legal rules to company scenarios, particularly concerning private limited companies.

As you work through this article, remember to pay particular attention in your revision to:

• the nature and types of share capital (eg ordinary, preference, redeemable shares) and their associated rights
• the rules governing the allotment and issue of shares, including pre-emption rights
• the principle of capital maintenance and its key exceptions (eg share buybacks, reductions of capital)
• the requirements and procedures for lawful distributions (dividends)
• the distinction between share issue, share transfer, and share buyback
• basic shareholder rights and protections within a company structure.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. True or False? A private company limited by shares must always first offer new shares to existing shareholders before offering them to outsiders.
2. What is the main principle established in Trevor v Whitworth (1887) regarding share capital?
3. Can a UK private limited company issue shares for less than their nominal value?
4. Which type of shareholder resolution is typically required to approve a company buying back its own shares out of distributable profits?

Introduction

Companies require finance to commence trading, operate, and expand. One primary method of raising finance is through equity, which involves issuing shares to investors who become members (shareholders) of the company. This article focuses on the nature of shares and share capital within private limited companies in England and Wales, the rights and obligations attached to shares, and the critical rules governing the maintenance of a company's capital base, as required by the Companies Act 2006 (CA 2006). Understanding these concepts is essential for advising on company formation, funding, and governance.

SHARE CAPITAL

Share capital represents the investment made into a company by its shareholders in return for an ownership stake. It forms a core part of the company's funding and structure.

Key Term: Share Capital
The total nominal value of the shares issued by a company to its members (shareholders).

Types of Share Capital

Several terms describe the status of a company's share capital:

Key Term: Issued Share Capital
The total nominal value of shares that a company has actually allotted (issued) to shareholders.

Key Term: Called-up Share Capital
The portion of the issued share capital that the company has formally requested shareholders to pay.

Key Term: Paid-up Share Capital
The portion of the called-up share capital that shareholders have actually paid to the company. Shares can be fully paid-up or partly paid-up.

Key Term: Nominal Value
A fixed face value assigned to each share (eg £1 or 10p). Shares cannot legally be issued for less than their nominal value (s 580 CA 2006).

Key Term: Share Premium
The amount paid for a share that exceeds its nominal value. This amount must be credited to a separate 'share premium account' (s 610 CA 2006) and is generally treated as capital.

Classes of Shares

Companies can issue different classes of shares, each carrying different rights, usually defined in the company's articles of association. The most common classes are ordinary and preference shares.

Key Term: Ordinary Share
The most common type of share, typically carrying full voting rights, rights to dividends (if declared), and rights to participate in surplus capital on winding up after other claims are met.

Key Term: Preference Share
A share that grants its holder preferential rights over ordinary shareholders, usually concerning dividends (often a fixed percentage payable before ordinary dividends) and/or return of capital on winding up. Voting rights are often limited.

Key Term: Redeemable Share
A share issued on terms that the company can, or is obliged to, buy it back (redeem it) at a future date or upon certain conditions being met (ss 684-689 CA 2006). These must be issued as redeemable and there must be other non-redeemable shares in issue.

Understanding the different classes and their associated rights (e.g., voting, dividend, capital return) is essential when advising on company structure and shareholder matters.

Worked Example 1.1

TechStart Ltd has an issued share capital of 100,000 ordinary £1 shares. It issues a further 50,000 ordinary £1 shares to a new investor for £2 per share. What is the company's issued share capital and share premium account balance after this issue?

Answer: The issued share capital increases by the nominal value of the new shares: 50,000 x £1 = £50,000. The total issued share capital is now £150,000 (150,000 £1 shares). The premium is the excess paid over nominal value: (£2 - £1) x 50,000 shares = £50,000. This £50,000 must be credited to the share premium account.

SHAREHOLDERS AND THEIR RIGHTS

Shareholders (members) are the owners of the company. Their ownership interest is represented by the shares they hold.

Basic Rights

Key rights typically associated with shareholding (especially ordinary shares) include:

• Voting Rights: The right to vote at general meetings on shareholder resolutions (e.g., changing the articles, removing a director). Usually, this is one vote per share on a poll vote (s 284 CA 2006).
• Dividend Rights: The right to receive a share of the company's profits when a dividend is declared (subject to the class rights and company performance).
• Information Rights: The right to receive certain company information, such as annual accounts and notice of general meetings.
• Return of Capital: The right to a share of the company's surplus assets upon winding up (liquidation), after all creditors have been paid (priority depends on share class).

Limited Liability

As discussed in earlier materials, a key feature for shareholders in a limited company is limited liability. Their liability for the company's debts is generally limited to any amount unpaid on their shares. If shares are fully paid, the shareholder usually has no further liability to the company's creditors upon insolvency.

Minority Shareholder Protection

While company decisions are often based on majority rule, UK law provides protections for minority shareholders against unfairly prejudicial conduct by the majority (s 994 CA 2006) and allows shareholders to bring derivative claims on behalf of the company in certain circumstances (ss 260-264 CA 2006).

CAPITAL MAINTENANCE

A fundamental principle of UK company law is that a company must maintain its share capital. This is primarily to protect creditors, who rely on the company's capital base as a fund from which debts can be paid.

Key Term: Capital Maintenance
The legal principle that a company's share capital cannot be returned to shareholders except through specific, regulated procedures, ensuring it is preserved primarily for creditors.

The main rules governing capital maintenance include:

• Prohibition on issuing shares at a discount: Shares cannot be issued for less than their nominal value (s 580 CA 2006).
• Restrictions on distributions: Dividends can only be paid out of distributable profits (s 830 CA 2006), not capital.
• Restrictions on share buybacks: A company purchasing its own shares reduces its capital and is strictly regulated (ss 658-737 CA 2006).
• Restrictions on capital reductions: Reducing share capital requires specific procedures involving either court approval or a solvency statement procedure for private companies (ss 641-653 CA 2006).
• Prohibition on financial assistance (Public Companies): Generally, a public company cannot provide financial assistance for the purchase of its own shares (ss 677-683 CA 2006). This prohibition largely does not apply to private companies.

Worked Example 1.2

Growth plc made a trading loss last year but has significant accumulated profits from previous years shown in its accounts. Can it lawfully pay a dividend to its shareholders this year?

Answer: Yes, potentially. Dividends must be paid out of 'distributable profits', defined as accumulated realised profits less accumulated realised losses (s 830 CA 2006). Even with a loss in the current year, if the company's overall accumulated realised profits exceed its accumulated realised losses, a dividend payment may still be lawful.

SHARE ALLOTMENT AND ISSUE

Allotment is the process by which a company creates new shares and agrees to issue them to specific persons (allottees), usually in return for payment (consideration).

Authority to Allot

Directors need authority to allot shares.

• Private company with one class of share: Directors generally have authority under s 550 CA 2006, unless restricted by the articles.
• Other companies (Plcs or private with multiple classes): Directors need authority either from the articles or an ordinary resolution of shareholders (s 551 CA 2006). This authority must state the maximum number of shares and is usually valid for up to 5 years.

Pre-emption Rights

When issuing new ordinary shares (or securities convertible into ordinary shares) wholly for cash, a company must generally offer them first to existing ordinary shareholders in proportion to their existing holdings (s 561 CA 2006). This is the statutory right of pre-emption.

Key Term: Pre-emption Rights
The right of existing shareholders to have first refusal on the issue of new shares for cash, proportionate to their current shareholding, to prevent dilution of their ownership.

These rights can be disapplied or modified by a special resolution of the shareholders (ss 569-571 CA 2006) or excluded in a private company's articles (s 567 CA 2006).

Worked Example 1.3

Innovate Ltd, a private company with one class of ordinary shares and standard Model Articles, wants to issue 10,000 new ordinary shares for cash to attract a new investor. It currently has 100,000 issued shares held by 5 shareholders equally (20,000 each). What must the directors consider?

Answer:

1. Authority: As it's a private company with one class of share, directors likely have authority under s 550 CA 2006 (assuming articles don't restrict it).
2. Pre-emption: As the shares are ordinary shares issued for cash, statutory pre-emption rights (s 561) apply. The 10,000 new shares must first be offered to the 5 existing shareholders (2,000 shares each).
3. Disapplication: If the company wants to issue directly to the new investor, the shareholders must pass a special resolution to disapply the pre-emption rights (s 569).

Exam Warning

Pre-emption rights under s 561 CA 2006 apply only to equity securities (mainly ordinary shares) being issued wholly for cash. They do not apply, for example, to issues of non-convertible preference shares or shares issued in exchange for property (non-cash consideration). Always check the type of share and the consideration.

SHARE TRANSFER

Share transfer refers to the sale or gift of existing shares from one shareholder to another. Unlike allotment, this does not involve the company issuing new shares or receiving new capital.

The process typically involves the transferor signing a stock transfer form, which is then given to the transferee (often with the share certificate). The transferee pays stamp duty (if applicable) and sends the form to the company for registration.

Directors of private companies usually have the power under the articles (e.g., Model Article 26) to refuse to register a transfer, often without giving reasons. This allows control over who becomes a member.

SHARE BUYBACKS

A share buyback occurs when a company purchases its own shares from a shareholder. The shares bought back are usually cancelled, reducing the issued share capital.

Key Term: Share Buyback
A transaction where a company repurchases its own shares from existing shareholders.

Buybacks are subject to strict regulation due to the capital maintenance principle:

• The company's articles must not prohibit it (s 690 CA 2006).
• Shares must be fully paid up (s 691 CA 2006).
• Payment must generally be made out of distributable profits or the proceeds of a fresh issue of shares (s 692 CA 2006).
• Private companies have a limited ability to buy back shares using capital, subject to a complex procedure including a solvency statement and special resolution (ss 709-723 CA 2006).
• The buyback contract usually requires approval by an ordinary resolution of shareholders (s 694 CA 2006), with the selling shareholder's votes often disregarded (s 695 CA 2006).

Revision Tip

Distinguish clearly between allotment (new shares, company receives funds), transfer (existing shares, shareholder receives funds from another shareholder/donee), and buyback (existing shares, company pays shareholder, shares usually cancelled).

DIVIDENDS

Dividends are the primary way shareholders receive a return on their investment from the company's profits.

Key Term: Dividend
A distribution of a portion of a company's profits to its shareholders, usually in cash, proportionate to their shareholding and share class rights.

Key rules governing dividends:

• Must be paid out of distributable profits (accumulated realised profits less accumulated realised losses) (s 830 CA 2006).
• Directors usually recommend a final dividend, which must then be declared (approved) by shareholders via ordinary resolution (Model Article 30). Directors can often pay interim dividends without shareholder approval.
• Shareholders receiving an unlawful dividend (knowing or having reasonable grounds to believe it was unlawful) may be liable to repay it (s 847 CA 2006).

Summary

Table: Key Equity Finance Concepts

Key Point Checklist

This article has covered the following key knowledge points:

• Share capital is the equity funding raised from shareholders, categorised by its status (issued, called-up, paid-up).
• Companies can issue different classes of shares (ordinary, preference, redeemable) with distinct rights defined in the articles.
• Shareholders possess key rights including voting, dividends, information access, and pre-emption rights, alongside limited liability.
• The capital maintenance doctrine restricts returning capital to shareholders, impacting dividends, buybacks, and capital reductions.
• Allotting new shares requires director authority (s 550/551 CA 2006) and adherence to pre-emption rights (s 561 CA 2006) unless validly disapplied/excluded.
• Share transfers involve existing shares changing hands between shareholders, often subject to directors' approval in private companies.
• Share buybacks are strictly regulated, usually requiring funding from distributable profits and shareholder approval (OR).
• Dividends must be paid only from distributable profits (s 830 CA 2006).

Key Terms and Concepts

• Share Capital
• Issued Share Capital
• Called-up Share Capital
• Paid-up Share Capital
• Nominal Value
• Share Premium
• Ordinary Share
• Preference Share
• Redeemable Share
• Capital Maintenance
• Pre-emption Rights
• Share Buyback
• Dividend