How many entrepreneurs (shareholders) think about the importance of the share capital? This is a rhetorical question, and the answer is very few.
Usually, at the stage of setting up a business, its founders, when they come to the issue of share capital, pay attention only to the proportion of shares between them and hastily overlook the size of the share capital, because they do not consider it important.
There are many reasons for this state of affairs, the main one being that the size of the share capital is not obviously important at the start of a business, but this is a mistaken approach rooted in an incomplete understanding of the meaning of share capital.
“Fake” share capital
Before explaining how the share capital can be “fake”, we would like to quote an old well-known proverb: “Don’t judge a book by its cover”. Share capital is a public financial indicator that, similarly to book cover, is used to evaluate a company at the beginning of cooperation. However, this financial indicator can be misleading.
There are at least two simple ways for founders (participants/shareholder) to achieve an impressive number in the share capital column without making an equivalent investment:
Contribution to share capital for a period of eternity: in the most popular form of legal entity – LLC, the participants in the articles of association may deviate from the general rule of having to contribute within 6 months and specify a much longer period, for example, 5 years. In other words, the shareholders may set a large amount of the share capital, for example, UAH 10,000,000, but not actually contribute these funds.
In the public register, all your counterparties will see your share capital of UAH 10,000,000, which will have a positive reputational impact. Of course, this screen can be easily removed by requesting accounting documents or documents on contributions to the share capital, but in practice, counterparties rarely ask for this.
After this long period expires, the General Meeting simply decides to reduce the share capital by the amount of the unpaid share, i.e. to the amount actually contributed by the shareholders, so there are no negative consequences (Article 15 of the Law of Ukraine “On LLCs and ALCs”).
Overvalued in-kind contributions: in the previous method, we talked about a conditional increase in the share capital, i.e. if it is not made within a certain period, it is reduced by a decision of the General Meeting. In this case, the shareholders use the legal opportunity to independently assess their in-kind contributions through the General Meeting.
A shareholder may contribute certain property that has a small value, but asses it at a large amount of money through a unanimous vote at the General Meeting. In this case, you will achieve a large share capital ratio while having it fully funded, unlike the first option.
Such foul play can also be easily detected through the documents accompanying the contribution (Acceptance Act, etc.), as they will clearly show what property was contributed, and therefore, one can make assumptions about its real value.
The share capital is the financial basis of the company
The share capital of a company is formed from the contributions of all its participants. In fact, it is the financial basis of the company, which covers all expenses and liabilities.
Since there is no minimum amount of share capital for limited liability companies, it is not uncommon for entrepreneurs to contribute minimal funds when establishing a company. However, it should be understood that the share capital is the funds that ensure the start and development of the company’s activities.
If the share capital is too small, it can lead to unnecessary complications. Expenses such as rent, salaries, etc. can create an urgent need for additional funds that cannot come from anywhere.
As a result, you have to bring in funds by entering into service agreements, providing financial assistance, etc. However, all of these actions require time and resources, which can be avoided by taking care of the optimal size of the share capital in advance.
Share capital and sale of shares in a business entity
Do you like making a profit? Of course, everyone likes it. But no one likes to give away a significant part of it “because somebody said so”.
The fact is that when you sell a company or a part of it, you deduct investment income, which is subject to taxation at a total rate of 19.5%. Investment income = sale price of the company or part of it – amount of the share capital. Based on this formula, we conclude that the smaller the difference between the sale price and the amount of the share capital, the smaller the amount of tax to be paid.
In this case, the share capital will help to optimize tax expenses. By using such a tool as an increase in the share capital, we can significantly reduce investment income and, consequently, the amount of tax on it.
The entire procedure is described in the next section.
Increase of the share capital
According to the current legislation, a company’s share capital may be increased either by additional contributions from company shareholders or third parties or without additional contributions.
If you choose the more traditional method of increasing the share capital through additional contributions, such contributions may be:
-Funds, both in national and foreign currency;
-Movable and immovable property;
-Property rights, including property rights to intellectual property (e.g., trademarks).
Mark Twain said: “Money is the measure of everything that has value”. By the same principle, all property contributions must have a monetary value, which is determined by the General Meeting of Shareholders.
A less common method of increasing the share capital without additional contributions involves two options:
-increase in the share capital at the expense of retained profit;
-Offsetting claims (conversion of debt into capital).
The method of increasing the capital is chosen in each case individually, based on a thorough legal analysis.
The next step after choosing a method of increasing the share capital is to document it. The most basic procedure of all is provided for monetary contributions in national currency. Thus, to increase the share capital in this way, the company must take four steps:
- Make a Decision to increase the share capital through additional contributions.
- Shareholders and/or third parties actually make contributions.
- Approve the results of additional contributions by the company’s shareholders and/or third parties.
- State registration of changes to the information about the legal entity. The share capital of the company is considered to be increased from the moment an entry is made in the state register. It is important to note that the state registrar is not obliged to verify the actual deposit of funds to the company’s account, and therefore no documentation is required to confirm this.
A similar procedure is provided for increasing the share capital by contributing foreign currency, property and property rights, but some nuances should be taken into account.
When contributing property, an important point is the transfer of ownership of this property from the contributor to the company. This entails the need to conclude additional documents and perform registration actions.
To demonstrate this process, let’s take an increase in the share capital due to the contribution of movable property, namely a vehicle (car). In addition to the standard package of documents, the company is obliged to re-register the car (transfer it to its balance) at the service center of the Ministry of Internal Affairs. During the state of martial law, it is also necessary to take into account the military transport obligation, which obliges legal entities to register vehicles with the military register when contributing vehicles to their share capitals. This must be done before re-registering the car.
A popular trend in recent years is to increase the share capital by transferring rights to intellectual property. In this case, it is additionally necessary to conclude an agreement on the transfer of rights to the company, as well as to carry out their monetary assessment. It is important to remember that only property rights can be transferred, for example, the right to use an IP object, to allow or prohibit its use, etc.
The procedure for increasing the share capital without additional contributions is somewhat easier.
Firstly, it can be done at the expense of the company’s retained profit. As the name implies, the source of the share capital increase will be the company’s net profit, which was supposed to be distributed among its shareholders. In this case, the company’s shareholders must agree on such use of their finances. Since the funds are already at the disposal of the company, it is enough to make only one decision to increase the share capital.
The second method is the set-off of counterclaims. This method is quite convenient for working with creditors, since in this case the company actually repays the funds with a share in the share capital.
If the company has overdue debts to an individual creditor, they can be credited to the share capital under a procedure similar to the procedure for increasing the share capital by means of a monetary contribution. However, in this situation, the creditor acting as a depositor must be overdue in making the monetary contribution. This creates mutual obligations between the creditor-depositor and the company. After offsetting the counterclaims, a decision is made to approve the results of the additional contribution by the third party and state registration is performed.
Reduction of the share capital
In some cases, the share capital may need to be reduced. There are many situations that may require this, but the procedure is the same.
First, the General Meeting of the company makes a corresponding decision. 3/4 of the company’s shareholders must vote in favor.
Next comes the work with creditors. The company has an obligation to notify all its creditors of its intention to reduce the share capital, which makes the process quite time-consuming. After receiving such a notice, the creditor may make additional demands on the company or ignore it by giving tacit consent.
After working with the creditors, the company formalizes the reduction of the share capital by registering the changes with the state.
Amending the share capital is a useful tool that can help a company achieve its goals. However, it is a complex process that requires compliance with a large number of requirements. If you are considering increasing the share capital of your company, you should seek professional advice.