Knowledge

Often times businesses that are rapidly growing (and fundraising) run into a key issue – they take on too many shareholders to remain a private company and breach (or will soon breach) the 50 shareholder (non-employee) limit.

Consequences of breaching the 50 shareholder limit on private companies

There are 2 key risks for a private company that breaches the 50 shareholder (non-employee) limit (Cap), these are:

1. Compulsory Conversion by ASIC;
2. Liability for Penalty Provisions.

Compulsory Conversion

If a private company exceeds the Cap ASIC may order that the company convert into a public company under section 165 of the Corporations Act 2001 (Cth). If a private company that breaches the Cap receives such a  notice from ASIC, it has just 2 months to bring itself back into compliance with the Cap or ASIC will order that the company convert into a public company (Compulsory Conversion).

While there are potential benefits to becoming a public company, an unplanned conversion entails significantly greater compliance costs and regulatory oversight, such as the obligation to:

1. Have at least three directors and one secretary, in contrast with private companies which can function with only one director who also serves as secretary;
2. Prepare and lodge with ASIC a financial report and directors’ report;
3. Hold an AGM within 18 months of registration and thereafter within 5 months of the end of its financial year;
4. Only pass resolutions in general meetings;
5. Have its directors removed by a general meeting; and
6. Appoint an independent auditor.

Also the burden of keeping updated company details will rest solely with the now public company, as ASIC no longer tracks company updates once the conversion into a public company occurs.

Penalty Provisions

There can be serious legal consequences for companies and their directors when the Cap is breached. Under the Corporations Act, exceeding the shareholder cap or failing to convert to a public company when ordered by ASIC are offences which both carry a penalty of up to 50 penalty units, 1 year imprisonment, or both, for individuals and an even greater penalty for companies.

In light of these heavy penalties, it can definitely pay to take a proactive approach when it comes to monitoring shareholder numbers and engaging the help of professional legal advisors when needed.

Solution – deploy a bare trust

One of the ways to avoid breaching the Cap is to have several shareholders (usually early stage minority shareholders) convert their existing direct shareholding in the company into a bare trust arrangement, where these “Select Shareholders” would have their shares held on bare trust for them by a trustee (usually a company acting as the trustee for the bare trust). A new bare trust arrangement would be created with each Select Shareholder and the trustee, and the Select Shareholders will each be the beneficiaries of that bare trust arrangement.

All of the Select Shareholders will be taken as one shareholder for the purpose of calculating the Cap and the trustee will be the only shareholder visible on the public share registries (instead of each of the Selected Shareholders appearing on the register) maintained by ASIC. The trustee will nonetheless need to maintain a registry of beneficiaries (via a fully diluted capitalisation table which will be kept up to date and will be disclosed to all current and prospective investors) where the Selected Shareholders shareholding will be appropriately reflected.

This structure has the dual benefit of:

1. Reducing the number of direct shareholders and thus avoid breaching the Cap;
2. Preserving space for future investors and key strategic partners.

The bare trust structure described above can also be deployed for parties who have invested in the company through Simple Agreements for Future Equity (SAFE’s) or Convertible Notes.

Please see below for a visual illustration of how this would work in practice.

What is a bare trust

A Bare Trust is generally the simplest form of a trust. A “Bare” Trust arises where the trustee (usually a corporate trustee) holds a particular item of property, eg, a parcel of shares, simply as a “nominee” for one or more specifically identified beneficiaries, being the Selected Shareholders in this scenario.

The trustee has no discretion and no active duties other than to transfer the property to the beneficiary when required. The trustee is merely the nominee of the beneficiaries. Additionally, any rights that attach to the shares held on bare trust can only be exercised by the trustee at the beneficiaries’ direction.

Importantly, the property held by the trustee on trust for each beneficiary will be kept separate and not comingled with the property of any of the other beneficiaries that are part of the bare trust structure. 

Tax Implications of holding shares in a bare trust

Under the existing Capital Gains Tax provisions, anything that occurs to the shares is treated as happening to the beneficiary, not to the trustee. The trustee is considered to be a “look-through” vehicle. Thus in the event of any disposal (ie, sale of shares), the beneficiary of the bare trust is required to report the disposal and account for any net capital gain or loss in their income tax return.  

Also, because the beneficiary has an absolute entitlement to the income of the trust, where, for example a dividend is paid in respect of the shares, the beneficiary, and not the trustee, will be taxed in respect of that income.

Therefore, there is usually no additional tax compliance required as a result of holding shares via a bare trust.

Avoiding Financial Licensing Pitfalls

Generally speaking if the company were to deploy the bare trust structure, under Australian financial services legislation, by holding shares in the company on trust for shareholders, the trustee would be considered to be providing a “custodial or depositary service” under section 766E of the Corporations Act and thus would require an Australian Financial Services Licence (AFSL).

However as long as the bare trust has less than 20 beneficiaries, the company would be able to leverage the 20 shareholder exemption (Limited Investor Exemption) as set out under Reg 7.1.40(1), and will not require an AFSL.

As the company takes on more investors in future capital raising rounds (and exceeds the Limited Investor Exemption), to ensure that the Company  with applicable Australian legislation, we would advise that the company then engage a provider of trustee or custodian services such as Perpetual  or Amal (who would have the requisite financial licensing to hold future investors above the Investor Cap), to act as its nominee to hold the shares on trust for investors instead of the existing trustee. 

Legal Documents Required

In order to properly implement a bare trust structure it is critical to document the structure appropriately. Some of the typical legal documents you would need are as follows:

Key takeaways

It's important to plan ahead to ensure your company does not inadvertently breach the cap. Also in order to avoid breaching financial services legislation and to ensure that the bare trust is set up properly. It's important that you seek professional advice.

Disclaimer

While Frank Law has used reasonable care and skill in compiling the content of this article. we make no warranty as to its accuracy or completeness. This article is only intended to provide a general guide to the subject matter and not intended to be specific to the reader’s circumstances. This article is not intended to be comprehensive, and it does not constitute and must not be relied on as legal advice and does not create a client-solicitor relationship between any user or reader and Frank Law. We accept no responsibility for any loss which may arise from reliance on the information contained in the article. You should undertake your own research and to seek professional advice before making any decisions or relying on the information provided.