Early stage companies issue shares to raise money to offset startup costs, including attorney fees, rent, security deposits, insurance, marketing, product purchases, business travel, equipment and furniture. Typically companies incur extensive startup expenses well before they begin generating revenue.
An increase in the share capital may seem bad for existing investors of a company, because it represents the issuance of additional shares, which dilute the ownership value of existing members’ shareholding. However, the increase in share capital may, in the long run, benefit shareholders in the form of increased return on equity through capital gains, an increase in dividend payouts or both. The additional capital helps the company expand business and avoid unnecessary interest costs on associated borrowings.
The increase in capital due to the issue of additional shares typically finances company growth. If the company invests the additional capital successfully, then the ultimate gains in stock price and dividend payouts realized by investors may be more than sufficient to compensate for the dilution of their shares.
When a board of directors has to make a decision with respect to an issue of shares, it must, at all times, consider carefully the duty imposed on directors by the Mauritius Companies Act 2001, namely to act ‘honestly in good faith in the best interests of the company’ and exercise a degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.
The Companies Act 2001 further requires a director who makes a business judgment to do so in good faith for a proper purpose and he/she must reasonably believe that the judgment is in the best interests of the company. The test to be applied by the courts would seem to be whether the share issue was made for a proper purpose or not. As of now, it does not seem that our Mauritius courts have made a comprehensive ruling on the above matter and in the circumstances, our courts will in principle be guided by the decisions of the courts of Commonwealth having similar laws.
Upon a reading of the decision in the English case of Howard Smith Ltd v Ampol Petroleum Ltd 1974 AC 821, it would seem that, in a gist, the court will need to (a) determine on the facts, for what purpose the power was exercised, and (b) ascertain whether the purpose was in all circumstances a proper one.
In that regard, Lord Wilberforce stated in the above-mentioned case: In their Lordships’ opinion it is necessary to start with a consideration of the power whose exercise is in question, in this case a power to issue shares. Having ascertained, on a fair view, the nature of this power, and having defined as can best be done in the light of modern conditions the, or some, limits within which it may be exercised, it is then necessary for the court, if a particular exercise of it is challenged, to examine the substantial purpose for which it was exercised, and to reach a conclusion whether that purpose was proper or not. In doing so it will necessarily give credit to the bona fide opinion of the directors, if such is found to exist, and will respect their judgment as to matters of management; having done this, the ultimate conclusion has to be as to the side of a fairly broad line on which the case falls.
Lord Wilberforce further ruled that if the purpose of issuing shares was solely to alter the voting power, the issue would be invalid.
Raising capital is usually the major purpose of an issue. In the English case of Winthrop Investments Ltd v Winns Ltd , other purposes which have been regarded as ‘proper’ include the fostering of desirable business connections, the maintenance of the minimum necessary membership in the company and improvement of the company’s financial position.
If for example, a board needs cash to fund various company expenses, if it is questioned, it should be prepared to provide evidence of application of monies obtained from cash calls to show that the directors were indeed not motivated by self-interest in making these calls.
One must not forget that the ambit of section 56 of the Companies Act which inter alia requires shares to be issued on a “fair and reasonable” basis. This hurdle is normally satisfied when the board has arranged for an independent expert valuation to determine the “fair and reasonable” value of relevant shares to be issued at the material time. The conclusion from the above is that the board of directors must always be in a position to justify and substantiate the basis for accepting an increase of share capital to the extent that it may involve a serious decrease in shareholding of existing investors who may quiz the directors for the rationale of same.