Share vesting agreements – could compulsory acquisition be a penalty?

In the Australian start-up community, we appear to have adopted most of the terminology from the United States, notwithstanding that the laws in relation to shares, options, loans (Securities) are completely different.   One such “imported term” is the “Vesting Schedule” which is commonly utilised in a Share Vesting Agreement.   The principle is simple enough, individuals contribute to a start-up (Startup) work to build a product or service and are given equity in the business (Company) in exchange for their efforts (Sweat for Equity Deal).  A Share Vesting Agreement will usually contains a Vesting Schedule which describes the rights and obligations of the participants by which their Securities vest, or are cancelled if the person fails to achieve certain milestones.  Whilst Securities is a broader term, generally in the case of start-ups we refer to various classes of shares in a proprietary limited company incorporated under Australian law.

What issues need to be considered in Share Vesting Agreements?

Broadly speaking, a Vesting Schedule provides a schedule by which a Sweat for Equity Deal is manifested.  It is up to the person who applies to the Australian Securities and Investments Commission (ASIC) to incorporate the Company (Promoter), to document the commercial terms of such an arrangement including the terms and conditions and any events of default.  Generally, Promoters need to consider the following in preparing a Vesting Schedule:

  • the amount of securities that vest in exchange for what effort and over what period of time;
  • assignment of copyright in any literary or artistic works which needs to be assigned in writing pursuant to the terms of the Copyright Act 1968 (Cth);
  • whether the shares are all issued and if so on what basis can they be cancelled;
  • the terms and conditions by which the shares can be cancelled or transferred;
  • are the shares fully issued and if so, on default, will they be:
  • transferred at a price (and how is this price determined); or
  • cancelled (and how can cancellation be achieved);
  • the class of shares that are to be issued;
  • any taxation consequences of the share issue;
  • whether the terms and conditions of the Share Vesting Agreement congruent with the Shareholders Agreement and Constitution of the Company; and
  • the likelihood that there will be an event of default by the Sweat for Equity participant.

Can shares vest incrementally?

In Australia, if a Startup vests shares over time on the achievement of milestone then this would, subject to the terms and conditions of the contract, mean that multiple resolutions would have to be passed by the Director(s) and subsequently, ASIC would have to be notified of the issue of securities each time.  It is also likely that section 708 of the Corporations Act 2001 (Cth) (Act) will need to be considered to ensure that the entity does not breach the 12/20 Rule.

Vesting incrementally is an administrative and financial burden.  Each time a Startup wants to do an issue of shares they will have to engage professional advisers.  There may also be taxation consequences depending on the circumstances.  Another issue of vesting incrementally is determining the price that shares will be issued given that there may be investors who have paid cash in exchange for their shares and that it is likely that the value of the business has increased.

Fully Vested Shares which may be cancelled or transferred subject to an event of default

One (1) alternative to vesting incrementally on the achievement of milestones is to issue all the shares to the participants and then cancel or transfer the securities subject to the occurrence of certain events of default.  We have reviewed several standard form vesting contracts which provide for:

  • the cancellation of all the defaulting parties securities on the occurrence of an event of default; and
  • the transfer of the defaulting parties securities for nominal consideration on the occurrence of a forfeiture or default event.

The underlying issue is determining the true value of the Securities.  In the context of a Startup, the valuation may be very little today, and tomorrow millions!  This creates various legal difficulties.

Given that a person working for their share may have been working for years, and the securities underlying the business may have acquired significant value, then the legal question which must be asked (and appears to have been overlooked) is whether the event of default is actually a penalty or an invalid forfeiture and prima facie void under the penalty doctrine as recently determined by the High Court in Paciocco v Australian and New Zealand Banking Group Limited [2014] FCA 35.

What are Redeemable Preference Shares?

According to section 9 of the Act a Redeemable Preference Shares is

a preference share in a body corporate that is, or at the body’s option is to be, liable to be redeemed”.

It is generally considered that Redeemable Preference Shares (REDP) are hybrid securities because they have characteristics akin to both debt and equity.  REDP are also known as Convertible Preference Shares.

Standard share class codes

ASIC lists “REDP” as the standard share code for Redeemable Preference Shares in addition to defining a range of other Standard Share Codes which can be used to describe the various different classes of shares.

What is important to understand is that the rights and entitlements associated with those shares are not generic, but can be defined by the members passing a special resolution of the Company or by amending the Constitution to include the rights and obligations associated with those shares.  Therefore the codes may be standard, but the rights and obligations may not be.

Power to issue

Section 254A of the Act provides for the issue of bonus, partly paid, preference and Redeemable Preference Shares.

In particular section 254A(3) provides that:

“Redeemable preference shares are preference shares that are issued on the terms that they are liable to be redeemed. They may be redeemable

  • at a fixed time or on the happening of a particular event; or
  • at the company’s option; or
  • at the shareholders option”.

General requirements for issue and redemption

Further requirements for Redeemable Preference Shares are provided in sections 254J 254L of the Act.

  • the redemption of shares can only be in accordance with the terms of their issue -section 254J;
  • a company can only redeem Redeemable Preference Shares if the shares are fully paid up and out of profits of the proceeds of a new issue of shares made for the purpose of redemption –  section 254K; and
  • section 254L describes the consequences of contravening the provisions dealing with Redeemable Preference Shares.

Could the answer be Redeemable Vesting Preference Shares?

Section 254G of the Act provides that a company may,

  • convert an ordinary share into a preference share; and
  • convert a preference share into an ordinary share.

Redeemable Vesting Preference Shares allow for conversion or cancellation, avoiding the need for a share buy-back in the event that shares are fully issued to the holder in the case of an event of default.

Cancellation of forfeited shares

Section 258D of the Act provides that a Company may, by resolution passed at General Meeting, cancel shares that have been forfeited under the terms on which the shares are on issue.

Could cancellation of securities be oppressive?

One further complication is whether the cancellation of securities following a “deemed Event of Default” may be oppressive pursuant to section 232 of the Act to a minority shareholder.  See our commentary on shareholder oppression and shareholder disputes.  Boards really should consider their actions in the context of oppression.

Practical issues in transferring or cancelling shares

One way of addressing the potential consequences for promoters is to issue redeemable shares which on satisfaction of all the conditions, convert to fully paid ordinary shares.  Conversely in the case of and Event of Default, the shares may convert to non-voting ordinary shares on a pro-rata basis, which will be harder to classify as a penalty or forfeiture.  Care needs to be taken to precisely draft the clauses which relate to the Events of Default or Forfeiture so that the clauses are not a penalty or prima facie void.

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

Links and further references

Related articles by Dundas Lawyers

Shareholders’ Agreements and Inconsistency clauses

Capital Raising without disclosure

Drag Along Rights Enforceable

Top 7 Mistakes in Shareholders’ Agreements

What do shareholders agreements protect against

Legislation

Corporations Act 2001 (Cth)

Corporations Regulations 2001 (Cth)

Relevant cases

Paciocco v Australia and New Zealand Banking Group Limited [2014] FCA 35.

Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30 (6 September 2012).

Further information

If you need advice on how to put together a sweat for equity deal or a Share Vesting Agreement that includes securities which vest over a period of time, please contact us for an obligation free and confidential discussion.

Malcolm-BurrowsMalcolm Burrows B.Bus.,MBA.,LL.B.,LL.M.,MQLS.

Legal Practice Director

Telephone: (07) 3221 0013

Mobile: 0419 726 535

e: mburrows@dundaslawyers.com.au

Dundas Lawyers
Street Address Suite 12, Level 9, 320 Adelaide Street Brisbane QLD 4001

Tel: 07 3221 0013

Send this to friend