Pitfalls of Issuing Electronic Stock Certificates for Private Companies and How to Avoid Them

March 8, 2016 Shareworks Marketing

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: 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. So congratulations, you are joining an elite group of companies that are modernizing private-company equity management. 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 potential pitfalls:

  • Handling Legacy Paper Certificates
  • Investor Concerns
  • Auditor Issues
  • Tendering Shares

Basic Terminology

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 are typically a paper stock certificate.

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.

Handling Legacy Paper Certificates

We have spoken with hundreds of companies looking to migrate to uncertificated shares. One of the first questions is: “Can we 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. 

There is typically 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.

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.

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.

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.

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 can be difficult.

Also, it is potentially 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 Shareworks Startup Edition, this is as simple as entering an e-mail address and clicking a button.

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.

But 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 startup edition, 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 language to make the process fast and seamless. Most companies can make the transition relatively quickly.

Click below to get the guide and start moving your company toward electronic shares.

 

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