Corporate shareholding percentages: catching a red herring

Posted: 06/10/2017

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The key corporate shareholding percentages are often believed to be either 50% or 75%. These shareholdings are perceived  to dictate ‘control’ within a company, with the Companies Act stipulating this level of votes as being necessary for ordinary or special resolutions. However, focusing on share ownership of 50% or 75% can be a ‘red herring’. Several other key percentages may have an equally if not more important impact on a company’s operations.

Non diluted vs fully diluted
Shareholders often focus on the final column of a cap table which  sets out fully diluted shareholdings - namely what percentage of the company each shareholder will own after completion of a proposed investment round and after the exercise of share options.

The ‘end game’ is important for determining how proceeds are divided on exit, but looking at the possible future share capital is irrelevant, indeed a ‘red herring’, in determining whether the company currently qualifies for a range of tax reliefs, certain immigration matters and hurdles for corporate decision-making.

So what are the important percentages? Here are just a few:

10%

This is important for immigration purposes.

Unless they are a very high earner (over £159,000 pa), a skilled migrant cannot obtain a Tier 2 visa, with a shareholding over 10% in the sponsoring employer. In contrast a very high earner can hold over 10% of their employer’s shares and still be sponsored under Tier 2.

This is often a challenge with academic entrepreneurs who move from being sponsored by a university  (Tier 2) to be key Founders of (and employed by), a spin-out. A Tier 1 (Entrepreneur) visa needs to be considered as an option if a Founder’s shareholding is in excess of 10%. This visa can work if they have venture capital funding of at least £50,000, other investment of over £200,000 or else University endorsement (Graduate Entrepreneur route).

A Tier 1 (Entrepreneur) visa presents its own challenges. It will only lead to long term residence  if the business meets certain performance targets, which needs to be taken into account when setting the business plan.

25%

SMEs enjoy a generous level of R & D Tax credits in comparison to larger entities but many people don’t realise the impact of a 25% shareholding on eligibility.

For R&D tax relief purposes, an SME is a company with less than 500 employees with either:

• annual turnover under €100 million
• balance sheet under €86 million

A company will not qualify as an SME if it’s part of an enterprise that, taken as a whole, would fail these tests. Critically, if a corporate shareholder owns over 25% of the company’s issued share capital then the size of this shareholder’s enterprise also needs to be considered when determining whether R&D Tax Credits are available, and at what rate. For a research-intensive company this can be significant financially.

30%

If an investor intends to seek SEIS or EIS relief then they cannot own more than 30% of the shares in a company (generally either before or in the three years after the date of funding): to do so would invalidate their eligibility for the relief.

Where founders plan to claim EIS relief they should be aware of this rule when the company is incorporated and initial shares are allocated pending any investment. Founders often form companies prior to investment with individual shareholdings of more than 30% (eg where three founders have split the equity equally) but they are usually unaware of the issues this can cause. Often they focus on the shareholdings retained after an investment round. As mentioned earlier,  it is vital to look at the current state of share capital, not the intended future state.

The 30% rule is one of many which must be observed in order to maintain these reliefs and appropriate professional advice should be sought.

50%

This percentage is most often regarded as being key for ‘control’. This in itself can be a red herring (see below), but at 50% a company is regarded as a subsidiary of a parent. As well as the accounting issues resulting from being a group company, a number of other consequences arise:

• If an entity takes ownership of over 50% of shares then the company no longer qualifies for EIS and SEIS. If investors have claimed this relief and an entity subsequently obtains a 50% shareholding within the three years then there will have some very unhappy investors. The company may also be exposed to claims under any investment agreement where assurances are given as to the maintenance of the relief for the necessary time. There are technical mechanisms which can be employed to allow somebody to have a shareholding of over 50% whilst maintaining SEIS and EIS tax reliefs but these require careful drafting and the agreement of all concerned.
• Companies often use EMI Schemes to attract and retain staff. It is a tax efficient and widely recognised scheme and senior executives usually expect that they will be granted such options. However, if an entity acquires more than 50% of a company, then the company is no longer eligible to offer an EMI scheme. Not only does this mean that it cannot grant new options under an existingscheme, it also means there will be disgruntled employees who have been granted options under the scheme historically but who will now be unable to receive the EMI benefits. Again, there are technical mechanisms which can be used, in some circumstances, to alleviate the impact of a 50% shareholding on an EMI Scheme but these require detailed advice and drafting.
• If the controlling number of shares in the business changes this will have immigration consequences that can impact on overseas skilled workers that the business sponsors under a Tier 2 visa. In this situation the company would have a duty to notify the Home Office of the change of control and a new sponsorship licence application may then be necessary. Alternatively if the controlling shareholder itself is a business it might seek to add the company to its existing sponsorship licence. Appropriate professional advice should be sought to ensure the situation does not prejudice the ability of the company to continue to use skilled migrant workers.

The elephant in the room...

One key percentage changes from investment to investment but is fundamental to each.

Shareholder agreements often provide a series of veto rights (or consent rights) to certain shareholders, meaning a company cannot do certain things without key stakeholder consent, irrespective of the views of the majority of the board/shareholders (whether 50% or 75%). This mechanism ensures the involvement of key stakeholders in the direction of the company.

There is no set rule as to what gives a stakeholder this right. Sometimes it is linked to the percentage holding. Sometimes it is linked to a time period for which a party is a shareholder irrespective of the level of shareholding (particularly where the shareholder is intrinsic to the business but is expected to be diluted quite quickly). Sometimes it attaches to a shareholder because of who they are, irrespective of level of shareholding or any time period.

Careful negotiation of these rights is critical when considering their consequences on the company’s operations. No one wants a grid-locked company, unable to follow a course of action because, on a practical basis, they can’t get hold of a shareholder to obtain the necessary consent, or because, on a commercial basis, one shareholder has a different view from all other investors/ the management team. 

Conclusion

Whilst we would certainly not dismiss 50% or 75% as important shareholdings for a company, we think there are many more which need to be in the forefront of shareholders’ minds when negotiating investment rounds, engaging overseas personnel or claiming certain tax reliefs.

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