There is something magical and even beautiful about an old stock certificate. It conjures up romantic feelings of working hard for equity. For entrepreneurs it is a reminder of the reason they fight for success so hard and a harbinger of what could happen if things go their way.
But unfortunately for paper-lovers, paper stock certificates are becoming relics. The disappearance of paper stock certificates has created a cottage industry of collectibles–there was even a run on Pixar’s stock certificates when they discontinued them in 2007.
There is even a word now for collectible paper-stock securities: scripophily.
If you have a brokerage account, you probably know that the vast majority of public companies have stopped issuing paper stock certificates to investors. When is the last time you got a paper certificate after making a trade in your online brokerage account?
But you may be surprised to learn that many private companies have continued to issue paper stock certificates. But even that is changing now…
A lot of private company startups are issuing their stock digitally rather than on paper stock certificates. It only makes sense since the entire world of public companies ditched most paper stock certificates in the 1970s.
Bonus: Click here to download the step-by-step guide to issuing electronic shares. You’ll get specific instructions on switching over and even sample legal language to make the process fast and seamless.
If you are reading this article, you have probably decided to go ahead and issue your securities electronically. If you are still deciding, you might want to read our article about the three options for issuing digital securities.
So congratulations, you are joining an elite group of companies that are modernizing private-company equity management. But before we pop out the bubbly let’s make sure you avoid the pitfalls that have become apparent as more private companies have adopted electronic systems.
Based on our experience of working with over 4,000 companies to manage their equity electronically, we have identified the following 7 potential pitfalls:
- Handling Legacy Paper Certificates
- Investor Concerns
- Auditor Issues
- Enforceability of Transfer Restrictions
- State-Level Legal Issues
- Custody Concerns
- Tendering Shares
Before we jump into the meat, let’s define some terms. Shares issued without paper stock certificates are called digital or electronic shares.
Shares issued with certificates are called certificated shares.
Shares issued without certificates are called uncertificated, or book-entry, shares.
Certificated shares can either have a paper stock certificate (like the Ford certificate displayed above) or a digitally signed PDF. So some certificated shares are digital and some are not.
Uncertificated, or book-entry, shares are always digital. These shares are managed through entries in a ledger the same way money is recorded in your bank account or the way your public-company shares are recorded in your brokerage account.
You can learn more about the electronic shares here or read about the different ways companies can issue electronic shares here.
#1 Handling Legacy Paper Certificates
At Capshare, we have spoken with hundreds of companies looking to migrate to uncertificated shares. One of the first questions is: “Can we legally have both uncertificated and paper certificated shares?” The answer is yes.
Though most brand-new startup companies will probably never want to issue a share using a paper stock certificate, many private companies have already issued some paper stock. So, if these companies want to move toward digital shares without recalling all of their paper stock certificates, they will need to use a system that handles both paper and non-papered stock.
Depending on the vendor you select, electronic solutions can work very well with existing paper records. And, if you choose a vendor that supports paper and electronic shares, you can convert any legacy paper shares over to electronic shares on your own timeline.
If you have already issued paper stock certificates and don’t want to recall them, make sure to pick an equity management solution that can handle hybrid stock and paper environments without making you re-issue all of your shares. Re-issuing shares is a long, complicated, and expensive process.
Legally there is absolutely no problem issuing and managing both paper and electronic shares. However, you will need to make sure that your share registry system tracks which shares have been issued on paper and which shares have been issued electronically.
#2 Investor Concerns
Many companies are worried that, if they issue electronic stock only, they will find it difficult to convince investors to accept the stock. The truth is that most sophisticated investors actually prefer receiving electronic stock.
“I have told every startup I invest in that I will no longer accept paper stock certificates. They need to send me electronic shares. I simply return the paper stock until I get digital shares.” –Jeremy Andrus, CEO of Traeger Grills, former CEO of SkullCandy, and active angel investor
It turns out electronic stock is easier for investors to track and manage as well.
Usually investor concerns are fueled by the simple novelty of an electronic-only solution or legal concerns. Show them the research in this document and they often become totally fine with the solution.
Occasionally, you may run into an old-school investor that requires a paper stock certificate. As long as you have chosen an electronic system that can handle both paper and electronic stock, you shouldn’t have a problem issuing a paper stock certificate to that one investor.
But keep in mind, many of the reasons the investor thinks she needs a paper certificate relate to the concerns we address below. If you adequately address these concerns, you may find your investor doesn’t really want a paper stock certificate anymore.
#3 Auditor Issues
Some industry commentators have suggested that auditors prefer paper stock certificates because they are somehow easier to audit. In our experience, the opposite is true. Paper stock certificates are not centralized and so tracking them down for auditing purposes is pretty much impossible.
Also, it is much easier for paper stock certificates to become inaccurate. For example, let’s say you grant Lisa a paper stock certificate with 100,000 shares of Series A preferred stock in your company. Lisa later sells some shares, transfers some shares and earns some additional shares because the stock has accruing PIK dividends.
Paid-in-kind (PIK) dividends are a feature of some securities where the holder receives dividends or interest which the company pays to the holder in the form of more equity or debt rather than in cash. For example if you purchased 100,000 shares of equity with 6% simple PIK dividends, the company would pay you an additional 6,000 shares each year. These instruments are much more common in private-equity deals rather than in venture capital deals.
Ensuring that her paper certificate accurately represents her up-to-the-minute share count could probably keep a lawyer employed full-time.
Auditing the records of uncertificated stock is as easy as granting your auditor access to your share register. If you are using a web-based ledger system like Capshare, this is as simple as entering an e-mail address and clicking a button.
#4 Restrictions Enforceability
Some very intelligent people have questioned the enforceability of restrictions on uncertificated shares.
Here’s an example from a recent Quora article.
After weeks of research and conversations with scores of attorneys, we simply feel like this view is unfounded. Public companies have issued uncertificated restricted stock for decades without any significant enforceability issues.
Nearly every state’s laws have language to this effect: “Except as otherwise expressly provided by law, the rights and obligations of the holders of uncertificated stock and the rights and obligations of the holders of certificates representing stock of the same class and series shall be identical (my emphasis).1)Delaware Code, Section 8, § 151f”
Since no laws say that transfer or other restrictions on uncertificated stock should be different than those on certificated stock, the idea that somehow transfer restrictions are unenforceable seems completely off-base.
Now, to be sure, nearly every state requires that you notify an uncertificated shareholder about restrictions in an opening statement.
The legal language from Delaware goes like this: “Within a reasonable time after the issuance or transfer of uncertificated stock, the corporation shall send to the registered owner thereof a written notice containing the information required to be set forth or stated on certificates….2)Delaware Code, Section 8, § 151f”
An opening statement, or initial transaction statement, is a notification sent in writing (e-mail counts) to a new uncertificated shareholder. This opening statement will include:
So you will need to send a written notice that contains the sames information about restrictions that you would have included if you had sent a certificate instead.
Delaware and Texas take it a step further and completely invalidate the argument regarding enforceability by saying: “A restriction placed on the transfer or registration of the transfer of a security of a corporation is specifically enforceable against the holder, or a successor or transferee of the holder, if: … with respect to an uncertificated security, the restriction is reasonable and a notation of the restriction is contained in the notice sent with respect to the security….3)Texas Busines Organizations Code, TItle 2, Sec. 21.213. Delware’s is very similar. You can find it here: Delaware Code, Section 7, § 218a”
Though we believe that it is clear that restrictions are enforceable against uncertificated shares, you should still download our step-by-step guide to implementing an electronic stock solution at your company. This guide will make sure you take all of the necessary steps to comply with whatever state-level laws are required for your company based on where it is domiciled to ensure enforceability.
For more information download our Electronic Stock for Private Companies: The Step-by-Step Implementation Guide
#5 State-Level Legal Issues (Specific to the United States)
This concern is specific to companies domiciled within the United States.
There is a lot of misinformation floating around the internet about how you always need to check your state’s laws to see if your state even allows uncertificated shares.
Well, we went ahead and did that for you. It turns out that the laws of every single state in the country specifically allow for uncertificated shares and highlight that the rights and obligations of uncertificated shares, unless specifically otherwise stated, are identical to those of certificated shares.
We would characterize the laws of all 50 of the states as friendly to uncertificated shares, if not downright encouraging companies to shift to uncertificated shares.
Several states are pushing so hard for “dematerialization”–which is just a fancy word for eliminating paper stock certificates–that they have made their laws border-line unfriendly to paper stock certificates.
For example, in 2005, Delaware changed its law regarding shareholders rights to receive a paper stock certificate upon request. Here is the synopsis of the change:
Section 2. The amendment to Section 158 eliminates the requirement that a corporation with uncertificated shares issue a certificate for such shares upon the request of the holder of such shares. Notwithstanding this amendment, a corporation with uncertificated shares still is permitted to issue a certificate upon the request of a holder, but the corporation is not obligated to do so
This basically means that if a company does not want to issue paper stock certificates, they no longer have to, even if a shareholder asks for it.
We will follow this article with a more detailed review of the state laws but we went ahead and created a graphic to give you our assessment of the relative friendliness of each state in the United States toward uncertificated. Remember, all of the states are friendly, but some, like Delaware, are flat out trying to phase out paper stock entirely.
Most sophisticated startups incorporate in Delaware already but if you ever needed another reason, here is yet another one.
Uncertificated Shares: State of the Union
(How Friendly Different States Are Toward Uncertificated Shares)
For more information on state-level regulations download our step-by-step guide.
We have also created a Google spreadsheet that provides state by state specifics about the laws in that state regarding uncertificated shares. The spreadsheet contains links to our information sources as well. Please be sure to check back frequently since we will be keeping this information updated often.
#6 Custody Concerns
A frequent and legitimate concern around uncertificated shares involves the concept of “perfecting a security interest.”
Perfecting a security interest is a process whereby a party claims interest in a security as collateral in such a way that no other party could ever claim the same interest in the same security as collateral. Put more simply, perfecting a security interest allows a lender or a creditor to make sure nobody else can use some pledged shares as collateral.
The idea is the code in many states requires that for a security interest in some stock to be perfected, the party seeking collateral needs to get their hands on the physical stock certificate. So basically if you wanted to pledge your shares as collateral to a bank, you would need to give them a physical certificate.
The laws weren’t as clear about how to perfect a security interest in uncertificated securities.
Thus, many experts considered the original laws regarding uncertificated shares passed in the 1970s inadequate to address the problems of uncertificated shares. However, with significant advances in equity management technology, many now view this as a non-issue.
Despite this, organizations like the Uniform Law Commission (which advocates for making the state laws in the United States increasingly similar and consistent), have advocated for clarifying language.
For example, this is what the Uniform Law Commission said about the issue in 1994:
The 1977 Amendments also authorized the registration of a pledge as a means of attaching and perfecting a security interest in uncertificated securities. Taking a security interest in an uncertificated security could be accomplished by registering the pledge, or by registering the secured party as a transferee (my emphasis). Registering the pledge preserved, automatically, the equity ownership rights and income from the security to the debtor.
The fact is that these are matters that can be left to agreement between parties and other law (my emphasis). Specifying them in law merely limits the flexibility of issuers and investors. So the specific provisions for the ITS and registering the pledge have been removed from revised Article 8.
The traditional and exclusive way to perfect a security interest for a certificated security is for the creditor to take possession of the security. When uncertificated securities were introduced into Article 8 in 1977, perfection required registration of the pledge or of the ownership of the secured party on the books of the security’s issuer. But these are inadequate methods for perfecting a security interest in the broader category of investment property. Therefore, the amendments to Article 9 provide for two ways to perfect. The first is by filing a security statement as is done for most personal property subject to Article 9. The second is by taking “control” of the investment property. These options are now available to secured creditors (my emphasis).
“Control” is the broader term that incorporates possession of a certificate for certificated securities, and registration on the books of the issuer for uncertificated securities (my emphasis). “Control” also can be taken over securities accounts and commodities accounts by agreement between account holders, intermediaries, and creditors that ensures the power of the creditor over such accounts to give instructions to the intermediary without the consent of the account holder.
So basically, the idea is that perfecting a security interest can currently be accomplished by simply transferring the ownership record holder’s name to the name of the person or organization who will control the security as collateral. This is currently a completely legal and acceptable solution.
However, the language also suggests that there may further simplifications that could work just fine. In other words, as long as the person wanting to pledge a security and the pledgee agree, nearly any legal binding agreement could work.
So, in practice, there are several quite simple ways around this problem:
- Use a system that supports hybrid environments (see #1 above) and print off a paper certificate for the shareholder who needs collateral
- Have a lawyer work with the bank to draft a custom contract that pledges the shares
- Transfer the shares on the records of your company to the pledgee and then transfer them back to the pledgor if and when they are no longer collateral
If you want to move to completely uncertificated environment, you will need to implement one of these solutions.
Using a solution like Capshare can make this easy but keep in mind this is only a problem in extremely infrequent cases. Most of the time, your company will never have a problem with this. Also, over time, it is likely that state laws will evolve to make this an even smaller problem.
#7 Tendering Shares
The last area of concern around uncertificated shares involves concerns around tendering processes.
Tendering shares occurs when a shareholder exchanges his or her shares in return for some consideration (typically cash). Most often this occurs when a company sells to a larger company or when a new investor wants to buy out some of the existing shareholders. The process involves giving up ownership rights to shares in exchange for consideration which is most often cash.
Again, this is an area of false concern. Tendering uncertificated shares is actually much easier than tendering certificated shares–even digitally signed certificated shares.
Tendering uncertificated shares can be done via e-mail and a simple change to a shareholder register. If you are using a system like Capshare, making the ownership change is a click of a button.
By contrast, tendering certificated shares means that you have to collect and verify the physical stock certificates of each shareholder that wants to tender shares. If a shareholder wants to tender only a portion of their shares, you will need to cut several new certificates.
Often shareholders have lost or misplaced their certificates which leads to additional delay and legal costs which typically come right in the middle of a time-sensitive deal.
You are much better off moving over to uncertificated shares when it comes to tendering.
Making the Jump to Uncertificated Shares
Ready to make the jump?
Great news, you are becoming part of what we believe is the obvious future of equity.
To help make your transition as smooth as easy as possible, we have created a step-by-step guide to moving over to electronic shares.
In the guide, you will get specific instructions, steps, and even sample legal language to make the process fast and seamless. Most companies can make the transition with an hour of work. But there are a few gotchas with some differences in state laws. So we included some information that will help you avoid any specific state pitfalls.
The guide covers the following topics:
- Board actions required to amend the company’s by-laws
- Important considerations if you are converting to electronic stock from paper
- State-by-state considerations and regulations
Click below to get the guide and start moving your company toward electronic shares.
References [ + ]
|1.||↑||Delaware Code, Section 8, § 151f|
|2.||↑||Delaware Code, Section 8, § 151f|
|3.||↑||Texas Busines Organizations Code, TItle 2, Sec. 21.213. Delware’s is very similar. You can find it here: Delaware Code, Section 7, § 218a|