Although the public markets ditched paper certificates a long time ago, they didn’t just replace them with “electronic certificates.” Rather, public companies now rely on a much better solution, and there’s no reason why private companies can’t follow their example.
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.
For too long, the dynamics of private stock ownership have remained relatively unchanged and rudimentary. Private companies issue some sort of stock certificate that serves as an official record of ownership, and lawyers handle the mechanics of sales, transfers, etc. Lately, things have progressed a little for private companies with the introduction of e-certificates, but public markets have already come up with an even better solution.
So rather than just moving paper stock certificates to the cloud, why not build a solution modeled after the most efficient market system in the world?
The Public Market’s Solution: Get Rid of Stock Certificates Entirely
As it is, most companies rely on an outdated system of issuing stock certificates as the official record of stock ownership. But do you really need something that looks like this to certify your ownership of stock?
Turns out you don’t. The requirements for issuing legally recognized stock aren’t actually that hard to satisfy, and it shouldn’t really cost anything.
Direct Registration: The Replacement for Certificates
The public markets mostly abandoned certificates decades ago in favor of the Direct Registration System (DRS), which “allows you to have your security registered in your name on the books of the issuer without the need for a physical certificate to serve as evidence of your ownership.” (SEC). In other words, the DRS is basically just a ledger of who owns what that is maintained by the issuing company or by the company’s transfer agent.
What a concept! No fancy certificates needed – digital or otherwise. It’s just basic bookkeeping.
If you sell your shares in IBM, the transfer agent’s electronic ledger simply gets updated to reflect the fact that you sold some number of shares to a buyer, who is now the recorded owner on the transfer agent’s books. (In reality, the mechanics of a sale are complicated by brokers, custodians, clearing houses, regulators, etc. But the point is that everything is done electronically and with precision.)
Can Private Companies Do the Same?
Can’t private companies do something similar? Instead of issuing certificates to everyone, can’t they just record everything in a ledger?
The answer is yes.
Every state has their own laws, but in Delaware (where most startups are incorporated) the law provides for something called “uncertificated” shares:
The shares of a corporation shall be represented by certificates, provided that the board of directors of the corporation may provide by resolution or resolutions that some or all of any […] of its stock shall be uncertificated shares.
– Delaware Code – Section 158: Stock Certificates; Uncertificated Shares
So essentially, the board just has to make a resolution that all shares going forward will be uncertificated. Any shares previously issued as certificates can become uncertificated by simply handing them back over to the company and issuing uncertificated shares in their place. As we mentioned in another recent article, every state in the United States (and most other countries) support uncertificated shares.
The Benefits of Uncertificated Shares
But what exactly does it mean for a company to issue “uncertificated” shares? And what are the benefits?
1) No More Certificate Hassle
First of all, you can ditch all forms of stock certificates along with the need to get signatures from the recipients for proof of receipt. Instead, you can simply email the shareholder a written notice that contains all the relevant info pertaining to the issuance and the company, as well as a clearly conspicuous way for the shareholder to request more information if desired. Then all you need is an accurate way to keep track of all the shares that have been issued.
Really? You don’t need to send around certificates and get signatures from every single shareholder? And you can have all official records of ownership organized and accessible from one source?
As an aside, even though you technically don’t need to get formal signatures from shareholders, it’s probably still a good idea to at least get some form of acknowledgement from each person. That way you cover all your bases and greatly reduce the probability of disputes. This process can be drastically simplified through an online platform.
2) Switching Over is Easy
What’s also great is that you can change to uncertificated shares going forward without having to do any additional work for existing certificates. While it may be worthwhile to have everyone turn in their old certificates in exchange for uncertificated shares, it’s not a requirement. So if you don’t want to track everyone down, you don’t have to. You can just keep track of existing certificates alongside uncertificated shares within the same system.
3) Empowers Companies to Act As Their Own Transfer Agent
Shareholders can no longer just sell or transfer their certificates without the company’s knowledge. Because there are no physical certificates, the company’s ledger is the official representation of all shares outstanding, so in order to execute a legal transaction, shareholders are forced to engage the company in a formal process that can be executed and recorded properly.
This makes it easy for companies to act as their own transfer agents. There’s no need to pay fees for someone else to handle this.
4) Manage With Software
With uncertificated shares, every transaction can be easily recorded, documented, and verified in an electronic and indisputable manner. And every shareholder can have access to this information according to their information rights.
Theoretically this could all be accomplished with a spreadsheet, but that’s a terrible practice. Public companies could just use spreadsheets too, but obviously that would not meet standards for security, accuracy, speed, accessibility and so forth. You’re better off using a system designed specifically for tracking stock issuances in a ledger-based form.
How to Make the Switch
Given the simplicity and ease of this approach, why doesn’t every private company use it? We did some research, and we couldn’t find any good reason not to.
Think about your bank account – it is not a safety deposit box with physical dollar bills in it. And you don’t ever request ornate PDF copies of dollar bills. Your account’s balance is simply represented by a number on an electronic ledger. Most people even opt out of monthly paper statements to help save the environment.
Private companies need to make a similar paradigm shift. It’s time to do away with certificates completely! So how does a company go about issuing uncertificated shares? It’s actually pretty easy.
We strongly advise you to consult an attorney before taking any legal action since laws and requirements may differ depending on your state of incorporation. This article is written for general informational purposes only. Providing this information does not constitute advertising, a solicitation or legal advice.
Issuing uncertificated shares generally involves three steps:
- Make a board resolution that the company is authorized to issue uncertificated shares.
- Next, you might need to amend the company’s by-laws to the same effect.
- Lastly, start issuing shares by recording them on the company’s official stock ledger.
And that’s about all you need to do. Orrick has provided a library of sample legal documents that contains all the language you’d need to start issuing uncertificated shares. But again, consult an attorney before taking any legal action.
Are there situations where you might want a physical certificate? In rare circumstances, yes. But in any situation where a physical certificate is needed, the shareholder can simply request one from the company. Also, most sophisticated online equity systems offer other simple solutions to this problem and many other potential pitfalls of going all electronic. A few institutions, like banks and some VCs, will be late adopters. But we don’t need to set the standard based on these edge cases. The uncertificated system is more efficient while still offering provisions for other modes of ownership representation.
We no longer need a fancy looking physical or electronic document that represents ownership. What we need is an efficient way to issue and keep track of shares so that all shareholders have access to the right information about their holdings at any time.
The public markets have been doing this for a while. It’s about time that private companies adopt a similar approach.
If you are ready to move over, we have prepared a step-by-step implementation guide that will walk you through the process of getting ready to issue electronic stock in your company. Click on the link below to get the guide.