on March 19, 2018 structuring

Why do businesses have multiple classes of shares?

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Does your business need more than one class of shares?

 

Full Disclosure. If you are reading this, you will need to speak to an accountant to answer specific questions for your personal tax or legal situation. This article is meant to give the reader an quick overview of why multiple classes of shares exist and the benefits they might offer.

First things first, what is a share? If you own a share, the share represents your claim to some portion of a business' equity. If a company was like a football stadium, then each seat would represent a claim to the profits that the business made. So if the company made $100,000 in a given year and the stadium had 50,000 Class A seats, then each seat (or shareholder) would be entitled to $2 of the profit for that year. 

Now it's common to pay different prices to sit in better seats in a football stadium. The same thing can happen in a company. For example, Mother Goose Co.  can issue Class A Common Shares and Class B Preferred Shares. Let's say Goose issued 40,000 Class A shares for $100 each. In return the Class A shareholders receive 100% of the equity. Now let's also say the company issued 10,000 Class B Preferred shares for $200 each. Since the claim to 100% of Goose's equity is held by Class A Shareholders, there is no equity left for Class B. But the company can have a clause that allows the Class B shareholders to receive $20 per share per year every year in exchange for the initial $200 investment. This would be paid to the Class B shareholders before a penny is paid out to the Class A shareholders.  So one reason for setting up different classes of shares is to allow the company to set different rights and obligations with each class of shares. This can help the company raise more equity.

By the same token, the principle is that all shareholders of a given class have to be treated the same. So if I own one share of Microsoft Class A, that share is treated no differently to a share owned by you or by Bill Gates himself. If Bill gets a twenty-five cent dividend, then I get a twenty-five cent dividend.

A company might have no reason to issue a Preferred Share but it does need to have two Classes of Common Shares. For example, Jack and Jill each own 50% of The Mother Goose Company. Jill works as the company's President and CEO. She oversees all the business operations. She draws a salary of $240k per year. Jack works for another company as a Safety Officer and earns $60k per year. He is not involved in the day-to-day operations of Goose. Goose makes $150k per year before tax. If Jack and Jill were planning ahead, they each purchased a different Class of shares at the beginning. This allows Goose to declare a dividend of $100k to the Class B shareholders and $0 to Class A shareholders. It so happens that Jack owns Class B shares. So his personal tax return now shows $160k (60+100) of income for the year. If J&J each owned Class A shares, then declaring a dividend would have created $50k (100÷2) of income for both Jack and Jill on the personal tax returns. So Jill would have been taxed on $290k (240+50) of income and Jack on $110k (60+50) of income. If you are taxed in a country where individuals pay a higher tax rate on higher levels of income, then having the ability to split income is potentially advantageous. Much needs to be checked to see if this could work for you because there are so many tax rules that can come into play in this example. Check with a great tax accountant before making any decisions on how to structure your business. 

There are a lot of details that I have left out to keep the examples as uncomplicated as possible. You should have an understanding of two possible ways to structure your company's ownership in order to give yourself flexibility around distributing income and capital to the shareholders. 

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Chris Yaren

Chris established Accountifi because he saw that small businesses needed help that they weren't getting from typical accountants. Accountifi's vision is that small businesses don't make preventable mistakes and have the best possible processes in place.

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