As public companies are increasingly opting out of providing paper certificates to shareholders in favor of providing electronic registration (a movement known as “dematerialization”), most private companies and their shareholders have yet to follow suit. Issuing uncertificated shares is allowed under most states’ laws, and, as many on the public company side can attest, numerous cost and time efficiencies can be gained by going paperless with shares. As we accept electronic statements to represent our public company holdings and exhibits to Operating Agreements to note our LLC ownership interests, do we really still need as evidence of our private company ownership a hokey, bordered piece of paper with an eagle on it?
Disadvantages of Issuing Paper Stock Certificates
Consider the inefficiency and chances for errors in the typical cumbersome process to issue paper stock certificates:
- Law firm staff orders special certificate paper
- Attorney gives legal staff information needed to complete the certificates
- Law firm staff keys in information on a blank Word document in calculated places on the page to line up with the paper form (or pulls out the old typewriter)
- Law firm staff puts special certificate paper in the shared printer
- Law firm staff reprints each certificate until the text lines up in the blanks
- Law firm staff flips over the certificate (hopefully correct side up) and puts it back in the printer and prints the restrictive legend on the back side
- Attorney reviews certificates for accuracy
- Law firm staff sends or delivers the certificate to the company
- The company obtains two busy officers’ signatures
- The company sends the signed certificates back to the law firm to send out
- Law firm staff prepares cover letters and overnight envelopes (or arranges for messenger service) to the investors
- If the delivery was set for “do not release without signature,” the investor can be frustrated with having to be available for the package
- The investor is then instructed to sign the stock receipt and return it in the envelope
- Law firm staff follows up with investors who have failed to return the signed stock receipt, and sends another one
In addition to the inefficiency and error prone nature of issuing paper stock certificates, replacing lost stock certificates can be administratively burdensome for private companies. Private companies typically require an affidavit of lost stock certificate and could (but usually do not) also require an indemnity bond to replace a lost certificate. If a shareholder fails to replace a lost stock certificate while the company is private and it goes public, replacement can be quite expensive for the shareholder. The transfer agent will pass through to the shareholder a fee charged by its indemnity carrier to insure replacement of the certificate, typically 2 – 3% of the fair market value on the date of replacement. This could easily be tens of thousands of dollars! What’s more, when delivering the certificates to the company or transfer agent for the IPO, most courier services will not insure a legal document delivery worth more than about $50,000. I have seen a situation where a paralegal from the firm representing the selling shareholders in a follow-on offering, flew to the transfer agent’s office with shares worth millions in hand.
As rapidly growing emerging companies can go through one or more stock splits before an exit event, the disadvantages of issuing paper certificates multiply – more certificates for shareholders to safeguard, more chances for errors, and more costs associated with printing, proofing, and delivery.
Written Statement Instead of Paper Stock Certificates
The laws of Delaware, Wisconsin, Illinois and 42 other states/territories (all but Louisiana, Missouri, New Hampshire, New Jersey, North Dakota, Oklahoma, West Virginia and certain territories), with limited exceptions, provide that the board of directors of a company may approve the issuance of shares without certificates as long as the shareholder is provided with a written statement containing applicable information within a reasonable time after the issuance or transfer. The written statement, which in most situations can be transmitted by email, typically must include the following:
- Name of the corporation and what state organized under
- Name of the shareholder
- Number and class of shares and the designation of the series
- If a corporation is authorized to issue different classes or series of shares, include (i) a summary of the designations, relative rights, preferences and limitations applicable to each class and for each series, and the board’s authority to determine variations for future series and (ii) a conspicuous statement that the corporation will furnish the shareholder the information described in item (i) on request, in writing and without charge
- Transfer restrictions, if any
Usually, the board of directors can authorize the creation of uncertificated shares either by the first issuance or as replacement for shares previously represented by certificates. The board also typically has the discretion to issue stock certificates for some classes and series of shares and not others. Generally, there are no differences between certificated and uncertificated shares, except for the process to transfer them and to perfect security interests in them.
Resistance to Uncertificated Shares
Despite the legality of uncertificated shares in most states, most private companies still issue paper stock certificates and most shareholders still expect them. Shareholders sometimes prefer to have tangible evidence of their company ownership even though they do not appear to have the same expectation for partnership or LLC interests. Some people want stock certificates for historic preservation and pride. That may make sense in the context of long-standing businesses, but makes less sense with emerging companies funded by angel and venture capital investors. With most technology start-ups, the company sells, merges, dissolves, or goes public within several years, in which case the stock certificates typically must be tendered for replacement shares or cash; shareholders cannot keep them for historic sake, unless of course the certificates become worthless. On the public company side, many brokers have been discouraging shareholders from requesting paper certificates in their name by passing through a $500 fee that the Depository Trust Company (DTC) started charging on July 1, 2009.
Changing the Tide from Paper Stock Certificates to Uncertificated Shares
DTC’s change in fees and procedures last year led to declining public company shareholder demand for physical stock certificates. Just as stock certificates are becoming a thing of the past for public companies, it is time for privately held emerging companies to consider issuing uncertificated shares.