Are you starting a business and incorporating a company?
It's fair to say this is a huge event in your life. Or perhaps you've done this before and you're having another go at it being slightly wiser, and ready to avoid the mistakes of the first round.
Either way, you'll need to think carefully about shares in your limited company.
Why? The reason is the decisions you make now about the types and class of shares can either set you up for long-term flexibility, or potentially turn into an expensive mess down the line. In my experience of advising clients, you really don’t want to be untangling such problems when investors are circling and you're trying to raise some much needed finance.
The choices you make now can be far reaching as to how your business is run and the decision making process. In this post I explain how shares work in a limited company, getting the admin right, the do's and don'ts, and examples of how things can get complicated. So, be sure to read on in order to take your start-up forward with confidence!
Shares are how the ownership of a limited company is allocated. It's a case of who owns what (akin to how a pie is divided into slices), what their say is in how the company is run, and how much they're likely to receive if they sell.
Where you have a scenario of several shareholders with various amounts of money invested, then different types of shares can be allocated with different ownership, conditions, and rights.
Types of shares can impact on shareholders in terms of their rights regarding voting, dividends, and capital in a sale. Within those types you can also create different classes to establish a more bespoke ownership mix (more on that later).
The 4 most common types of shares include:
Ordinary shares are the most common setup. They work on the principle of 1 share = 1 vote. If your company makes a profit and then pays out dividends, ordinary shareholders get a cut of it. If the company is sold, or wound up, they also get a slice of the proceeds.
Most business owners issue this type of shares. However, it’s also possible to break these shares down into different classes.
These tend to be issued to employees as they carry no right to vote on company decisions and also have no right to attend general meetings. This makes them a way to reward your people but without having to hand over any control.
Preference shares usually come with a guaranteed dividend which is often a fixed amount that's paid before ordinary shareholders receive anything. Keep in mind that these shares don't usually have voting rights.
These can usually be bought back by your company at a later date. They're often used in employee share schemes whereby when someone leaves the shares are bought back at the price they were issued at.
Classes of shares enable a degree of flexibility.
They are subject to shareholders consent, but you can create many different classes, known as alphabet shares, (A, B, C etc.) to control:
As an example, maybe you have a colleague who did a lot of coding to help implement your concepts and research findings when you were at the ideation phase. Later, as you start to trade, you may then reward them for this by issuing them with B shares.
Those shares enable full voting rights but limit their dividends through access to profits. Their reward is a say in how the business is run and remuneration is through the appreciation in the value of their shareholding over time at the point they sell them.
Whilst these are legal matters, it's vital that you understand them as getting it wrong can cost you later, especially if you:
Here's what you need when incorporating your business:
Even if it's just you, the memorandum of association means you must have a minimum of 1 share per shareholder, usually priced at £1.
If you have other shareholders, or you plan to soon, you don't need to distribute equal shares necessarily. Instead you can align your share classes with your strategic goals.
Here are some examples of how things can potentially get messy, and that may provide some useful food for thought if you're in the early days of setting up your business. This is why you need to think very carefully about this process and what the most optimal set up will be for both your current, and future aspirations.
All seems fair and equitable right? That is until your co-founder exits the business in year 2 but they have a 50% stake. You then face the scenario of having to buy them out of your company which may mean raising finance to do so! Not exactly ideal for an early stage enterprise already operating under budgetary constraints.
You issued preference shares to an investor to receive much needed funding. To secure it you offered a fixed 8% annual dividend and a priority claim on profits over ordinary shareholders. You then experience a downturn in trade and profits suffer accordingly.
Unfortunately the preferable dividends are payable before ordinary ones creating a cash flow squeeze. The issue being the terms state you must always meet your obligation to your shareholder, even when profit levels are low.
Say you set up A shares for you and your founder (with voting rights and dividend rights). Then you set up B shares for your early employees (non-voting, but dividend rights only). This then becomes an issue when you look to raise finance later on for expansion of the business.
It all means that your lawyers have to draft, very carefully, new articles of association and shareholder agreements for every funding round you action. Investors may then look at it all later and want to simplify the structure for a future sale. That could mean converting or buying back B shares and aligning rights, requiring legal advice, tax clearance, and shareholder approval.
The above work would incur accountants and advisory fees, potential Capital Gains Tax exposure, and maybe even mean having to compensate some shareholders to agree to such changes.
Square had a group of private investors whose shares provided specific guarantees. One of the clauses was that there would be an appreciation in the value of those shares to a specific price when the time came to publicly list the business on the stock market.
When Square was subjected to the traditional valuation techniques of corporate finance advisors, the price per share came in below what was originally promised to some of its backers. A clause in the guarantee then kicked in issuing those investors with more shares to make up for the deficit.
This in turn diluted the holdings of other shareholders, who then faced smaller dividend pay outs from lower earnings per share, and reduced voting power as their ownership percentage was cut down due to the increase in the total number of outstanding shares!
| Entitlement to dividends | This is about the right to profit distribution. It can be equal with other normal shareholders or preferential, so paid before other share classes, or only paid in certain circumstances. |
| Entitlement to vote | Can the shareholder vote? It may be one vote per share or weighted, or tiered, votes in some circumstances. |
| Entitlement to capital on exit | This is a case of who gets what when the company is sold or wound up. Different classes of share may have different rights to capital distribution. |
A big start-up myth is that you can fix the share structure later. Yes, you can but at what cost!? It's far easier and cost effective to start with a well-considered share setup that can grow with your business.
This is why you need to align with any co-founders, ask the right questions, take time over it, and obtain the advice of an accountant and / or lawyer. I'd suggest you plan for the long term because as this blog post has demonstrated, things can get complicated quickly.
Share options are also a way to reward your staff through an equity based incentive plan. Known as Share Incentive Plans, employees are able to purchase shares in the organisation, and usually at a discounted price, after a certain period, or upon meeting specific goals.
If you offer share options, you can then align the interests of employees with the success of your business. This can potentially result in them having a sense of ownership and added motivation to contribute to future growth.
This may also be a useful mechanism available to you whereby you're able to reward employees without it immediately impacting on your cash flow. The reason being options are usually exercised at a later date. You need to consider:
This post was created on 26/07/2016 and updated on 04/12/2025.
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