Not all shares in a company are created equal.
A company can issue shares with a unique ‘bundle’ of rights and obligations, and this bundle can be different to other bundles of rights and obligations attaching to other shares.
All shares with the same bundle of rights and obligations are referred to as a ‘class’ of shares. It is common for a class to be given a specific name, for example ‘Ordinary’, ‘A Class’, or ‘Preference’. However, it is not necessary for a class of shares to be given a name for the shares to constitute a separate class.
The thing that creates the class is the common set of rights and obligations as between those shares.
The same logic applies in reverse. Simply giving shares a different name or label, e.g. ‘A Class’ will not create a distinct class unless those shares have a different set of rights and obligations to other shares. This is something that some people miss when they seek to create a class of shares without considering the associated rights and obligations – while shares may have a unique name they will still be part of one big class if they do not have a set of unique rights and obligations.
What are ‘Ordinary’ class shares?
The most common class of shares in Australia is referred to as ‘Ordinary’ shares.
Ordinary shares typically have a broad range of rights, including:
- The right to attend and vote in a general meeting (i.e. a meeting of shareholders);
- The right to dividends declared on ordinary shares in common with other holders of ordinary shares;
- The right to a return of paid-up capital in common with other holders of ordinary shares; and
- The right to participate in any ‘surplus’ capital or profits on a winding up of the company.
In short, Ordinary shares represent the main ‘residual’ body of ‘ownership’ in the company.
Most companies only have one class of shares, and these shares are generally ordinary shares. In the absence of a name for the single class of shares in a company, the shares in the company will be ‘ordinary’.
For companies without a constitution, and which adopt the ‘Replacement Rules’ in the Corporations Act 2001 (Cth), there is no provision that creates a class of ‘ordinary shares’ (see section 141 for a list of the Replaceable Rules.) Instead, the various Replaceable Rules and other sections of the Corporations Act collectively operate to confer on the holder of ‘shares’ in the Company similar rights to those usually associated with ordinary shares. For example, the right to 1 vote per share (section 250E), the right to dividends (section 254W(2)), and the right to appoint directors (section 201G).
For companies with a constitution, it is common for the rights and obligations of ‘ordinary shares’ to be clearly set out in the constitution. It is also common for the constitution to set out the bundle of rights and obligations that will attach to other popular classes of shares.
Why create a different class of shares?
You may be asking, why would you bother complicating things with a new class of shares? The reasons are many and varied. This question is best answered by looking at some of the more common classes of shares issued by companies.
Perhaps one of the better known ‘other classes’ of share is the ‘preference’ share. As the name suggests, preference shares give the holder some ‘preferential treatment’ over and above the rights held by ordinary shares.
This preference can take many forms, including:
- A periodic return in the form of an annual preferential dividend of a specified amount. This amount is usually expressed as a percentage of the amount of capital paid-up for the share, and must be paid before any profit distributions to other members;
- A preferential right to a return of the capital paid-up on the share, before capital can be returned on other shares. This applies if the company is wound-up, but may also set a date prior to this for the return of the capital; and
- Preferential voting rights if certain conditions are met, usually if the preferential dividend or return of capital has not been paid.
Preference shares usually do not give the holders the right to participate in any ‘surplus’ assets of the company on a winding up. With regard to capital, all the holders of preference shares get back is the amount they originally paid to acquire the share. The holders of preference shares may also have limited voting rights if the other rights on the shares are being adhered to, e.g. if the preferential dividend is being paid on time.
Many people think that ‘a preference share is a preference share’, i.e. they are all the same. However, not all preference shares are created equal. For example, sometimes the preferential dividend is only payable if the company has sufficient profits in each year. Whereas, others have a ‘cumulative dividend’ right that carries forward any unpaid dividend into future years. Sometimes the preferential dividend is set with reference to the amount paid for the share, and other times it is set as a proportion of the profits of the company. It is critical to read the constitution or the resolution creating the preference shares to clearly understand the actual rights and obligations.
In essence, preferential shares have rights somewhere between ordinary shares and the rights held by the providers of debt to the company. The return to preference shares rank ahead of ordinary shares, but behind the rights of the holders of traditional debt. For this reason preference shares are sometimes referred to as ‘hybrid’ securities.
If you are thinking about creating different share classes for your company, call us on 1300 654 590 or email us. We can help you get the finer details right.
Shares with the ‘same’ rights, but operating differently
Another class of share common in start-up companies is ‘employee class shares’. These shares may not carry the right to vote or receive dividends until certain ‘vesting’ conditions are met, for example, until the employee has worked at the company for a specified period, or until the company has achieved various benchmarks. These shares may be ‘forfeited’ under certain conditions, for example, if the employee leaves before the shares have vested, or if the shares do not vest within a specified period.
There are two attributes to employee class shares that illustrate the complexity of share classes.
First, although all of the shares of this class notionally have the ‘same’ bundle of ‘rights and obligations’, at any point in time one share within this class may be operating differently to another share in the same class – depending on the circumstances of the company and the holder. For example, if the holder has not satisfied the vesting conditions, then the holder will not be able to vote or participate in dividends, whereas if shares have vested the holder will have those rights.
There is nothing particularly special about this ‘differential operation’ of rights and obligations within a single class. It is common for ‘party-paid’ ordinary shares to lose their voting rights if the holder fails to contribute further capital when it is called up by the company.
The second thing employee class shares illustrate is the ability for a share to automatically ‘change’ classes. For example, an employee class share may become an ordinary share when the vesting conditions have been satisfied. If this change in class is ‘built-in’ to the employee share class from the outset, the ‘share’ itself continues, it is just that its bundle of rights and obligations morphs into the same bundle as ordinary shares – and therefore the share ceases to be unique.
Some share classes are drafted to automatically morph between classes, whereas others are drafted to include the ‘right’ to convert or swap a share of one class for a share of another class if certain conditions are met. This difference in drafting can have a material (and often adverse) impact on tax and other commercial outcomes.
Are you concerned about the rights attached to your shares? Call us on 1300 654 590 or email us to get clear advice about where you stand.
‘Differential dividend’ shares
As noted above in the context of preferential dividends, shares can have different rights to dividends. This attribute is often used to create a class of share that is only entitled to receive dividends that are ‘declared on that class’ from time to time – but not also declared on other classes.
For example, a company may create an ‘A Class’ share that is entitled to receive those dividends declared by the company on ‘A Class’ shares. If a dividend is declared on ordinary shares, then the holders of A Class shares get nothing. Similarly, if a dividend is declared on A Class shares, the holders of ordinary shares (and other classes) get nothing.
Creating shares with a unique right to dividends is often referred to as a ‘differential dividend right’. The constitution of the company also needs to include a provision that empowers the company to declare and pay a dividend on one class of shares to the exclusion of other classes.
The Tax Office does not like the flexibility that differential dividend class shares offer. The Tax Office sees any flexibility as an opportunity to minimise tax as a result of being able to selectively pay dividend to people on lower marginal rates of tax – in a similar way to how discretionary trusts allow distribution flexibility.
That said, the use of share classes with differential dividend rights has existed for centuries. This strategy is often associated with arm’s length commercial arrangements between unrelated parties, and/or asset protection strategies that have nothing to do with saving tax.
Setting your company up for success
Companies remain a fantastic entity through which to achieve a wide range of commercial and family objectives. Whether it be an operating entity for your business, or the trustee of a business or investment trust, companies are an essential element of a robust legal structure.
However, you must understand the full implications of the share structure you adopt in your companies. How you set your companies up will have a material impact on the commercial control, commercial return, tax, asset protection and estate planning outcomes you achieve.
Call us on 1300 654 590 or email us to discuss the best way to set up your companies.
Some super useful resources!
Check out these useful resources about companies:
If you want to go back to basics, read this article about how companies work.
Want to set up a company? Read this article about setting up a company in Australia.
Wondering if your company needs a constitution? Read about what a company constitution can cover here.
If you are wondering the best way to implement a governance framework for shareholders in your company, read this article about implementing Company Constitutions v Shareholders’ Agreements.
The information contained in this post is current at the date of editing – 17 November 2022.
