Hiring new employees is a great time to evaluate how your company has been issuing stock. The proper issuance of stock for these transactions is essential in protecting your business. Take the correct steps now to avoid a headache later.
What is stock?
Stock (or “shares”) constitute the equity stake of the owners of a corporation. In a privately held company, stock is represented by a stock certificate. The stock certificate itself is a preprinted form that a third party prints as part of the company’s corporate kit (which is provided upon formation of the entity). The act of authorizing the issuance of the stock certificate and completing the stock certificate are the required steps for documenting the issuance of stock. This procedure is identical regardless of the size of the company.
The company’s Certificate of Incorporation states how many shares of stock the corporation is entitled to issue, commonly referred to as “authorized” stock.
How does a corporation issue stock?
First, the issuance of stock must be authorized to be issued by the Board of Directors of the Corporation. Such authorization must be evidenced by a written instrument – a “Written Consent of the Board of Directors” – that must be approved by all directors of the company.
Once stock issuance is approved, the company must execute the proper stock purchase agreement. Keep in mind that vesting provisions must be carefully accounted for. “Vesting” refers to the agreed schedule that shares becomes available to the recipient of the stock. For example, if an employee is granted shares as part of their compensation package, it is likely that it will vest in accordance to the amount of time that person is employed (i.e. 1/4th of the shares will become available after completion of 1 year of working for the company). A stock purchase agreement that includes specific vesting provisions is referred to as a “Restricted Stock Purchase Agreement”.
Both parties must execute the stock purchase agreement, and the receiving party must contribute capital equal to the purchase price for their shares. A newly issuing company will often use a nominal value such as “0.001”, which alleviates cost burden for shares.
The stock certificate itself then must be completed. A company does this by inserting the name of the stockholder, the number of shares owned, and obtaining the President’s and Secretary’s signature. A restrictive legend must be included in the stock certificate if it is indicated as such in the purchase agreement. Legends may indicate the class of stock being issued or certain security law disclaimers.
The corporation must also maintain a “ledger”. This is often to an excel spreadsheet; it states the names, addresses and number of shares owned by the stockholders. Additionally, there are many online options for managing stock ledgers and certificates.
The importance of maintaining an up to date ledger for your corporation should not be overlooked, as disputes may arise in the future regarding the true ownership distributions of the company.
Why should you care?
If you fail to follow the correct procedures when issuing stock and that issuance is challenged by another stockholder (for example (i) if a stockholder believes he or she owns a larger percentage of the corporation than indicated in the ledger or (ii) if a stockholder wants to challenge a decision made by the board of directors), a court could void the purported issuance. This results in the shares issued pursuant to that transaction to be null and void.
Here is a hypothetical, let’s assume two stockholders (Stockholder A and Stockholder B) each own 50 shares in a company. The board of directors then issues an additional 50 shares to Stockholder A, but fails to document the issuance in writing. Stockholder A and B subsequently get into a heated argument over a corporate decision. Stockholder B goes to court, challenges the issuance and wins. While it was intended that Stockholder A owned 100 shares and Stockholder B owned 50 shares, the actual result is that Stockholder A owns 50 shares and Stockholder B owns 50 shares.
Often times, new employees will not receive shares immediately, but may be offered the option to purchase shares at a date in the future. Managing grants and vesting schedules for employee stock options makes the proper documentation of share issuance that much more important. The issuance of options and other types of equity grants will be discussed further in our next post.
This post is intended to be an educational guide on the issuance of stock, and should not be interpreted as legal advice or the formation of an attorney-client relationship.