Disadvantages Of Share Capital: Legal Implications For Businesses

Raising capital by issuing shares is a popular way for businesses to secure funding. However, while share capital can offer financial benefits, it also comes with legal risks and challenges that businesses must consider. This article will explore the potential legal downsides of share capital and what businesses should be aware of when raising funds through shares.

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Dilution of Control

Issuing shares means giving away a portion of the business’s ownership. For small businesses, especially those led by a few founders, this can result in a loss of control. As new shareholders come on board, the influence of existing shareholders may decrease, potentially leading to them no longer having the majority vote on key decisions.

Loss of control can complicate major decisions like mergers or acquisitions. Minority shareholders can legally challenge significant business moves, leading to disputes or legal action.

Increased Legal and Regulatory Burden

Once shares are issued, businesses must comply with strict legal and regulatory requirements. These can include rules related to financial reporting, shareholder meetings, and corporate governance under the Companies Act 2006.

Keeping records of shareholder meetings, filing financial statements with Companies House, and getting shareholder approval for major decisions like issuing new shares or changing the company’s structure. Legal risks of failure to comply can include:

• penalties, such as fines or being struck off the company register; and
• invalid decisions and disputes over legal actions.

Risk of Shareholder Disputes

The more shareholders you have, the higher the risk of disagreements. This is especially true when the interests of minority shareholders conflict with those of the majority. Common causes include:

• disagreements over company direction;
• profit allocation; and
• disputes over major business decisions.

However, minority shareholders are protected in certain circumstances under the Companies Act 2006 and can file claims if they feel their rights are being ignored. This may lead to court orders forcing the company to buy back shares. Moreover, disputes can be costly, time-consuming, and damage the business’s reputation.

Increased Liability for Directors

Issuing shares increases the responsibility of directors to act in the best interest of the company and its shareholders. As the shareholder base grows, directors will face more scrutiny. Directors’ duties consist of the following:

• avoid conflicts of interest;
• ensure decisions are made in the company’s best interest, not their own; and
• comply with company rules, such as those outlined in the articles of association.

Directors may face personal liability if they breach fiduciary duties, meaning they could be sued or removed from their position. If directors fail to act in good faith, they could be held responsible for losses caused by their actions.

Restrictions on Future Fundraising

Existing shareholders often have the right to buy new shares before outside investors. If a business issues shares without offering them to existing shareholders, it could result in legal disputes and the issue of shares being deemed to be invalid and unwound.

If shareholders feel their ownership is being diluted unfairly, they can take legal action. Disputes over the valuation of shares may arise, causing delays or complications in future fundraising efforts.

Key Takeaways

Issuing share capital may be a helpful way for businesses to raise funds, but it’s essential to be aware of the legal risks and challenges involved. From dilution of control to shareholder disputes and regulatory burdens, businesses must carefully consider the legal implications before issuing shares, such as ordinary shares and preference shares. Seeking professional legal advice and drafting an explicit shareholder agreement can help businesses navigate these challenges and ensure compliance.

However, directors face increased responsibility, and failing to manage conflicts of interest could lead to personal liability. Moreover, existing shareholders have legal rights that may complicate future capital raises. If you have any questions regarding share capital, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.

Frequently Asked Questions

How can I protect my business from losing control when issuing shares?

In the case of a limited company, one option is to issue different classes of shares, which can grant different voting rights. This can allow key founders or shareholders to retain control over significant business decisions.

What legal protections do minority shareholders have?

Minority shareholders are protected under the Companies Act 2006, which allows them to challenge decisions they believe are unfair or prejudicial to their interests. They can also ask the company to buy back their shares in certain cases.

What are pre-emption rights?

Pre-emption rights allow existing shareholders to buy new shares before they are offered to outside investors, thus protecting their percentage of ownership. These rights can prevent dilution without their consent.