A share premium is the amount of money that a company receives for its shares over and above their nominal value. Thus, the ‘premium’ is the difference between the nominal value assigned by the company and the actual market value that a shareholder pays for the shares.
It may sound a little confusing but, in reality, it is a relatively simple concept. To give you a better understanding of a share premium, we explore the topic in detail below.
We discuss the most common reasons to issue shares at a premium, why you need to create a share premium account, and the limitations on using funds reserved in this separate account.
Understanding the share premium
To understand the share premium, you must first understand the meaning of the ‘nominal value’ and ‘market value’ of shares.
When a limited by shares company issues shares, it assigns a fixed nominal value to those shares. This is sometimes referred to as the ‘par value’ ‘face value’, ’book cost’ or ‘subscription price’.
The nominal value is often £1 per share, but it can be any sum. It is the absolute minimum that a company can sell its shares for. It also reflects the ‘limited liability’ of members (shareholders), i.e. the maximum sum of money the members risk losing if the company becomes insolvent and can’t pay its debts.
However, the nominal value is an arbitrary figure that has little (if any) relevance to the market value (real value) of the shares.
The market value is the amount that a shareholder actually pays for their shares when the company offers them for sale. It is a fluctuating figure that is based on a range of variables, including market interest rates and the current valuation of the company.
The share premium is the difference between the nominal value and the market value. That is, the sum of money that a company actually receives for newly issued shares above the assigned nominal value.
Consider this example
A company issues 100 shares with a nominal value of £1 per share.
If the company sells the shares for only £1 each, it will receive a total of £100 in share capital. In this scenario, there is no share premium.
However, if the company sells the shares at a premium of £10 each, it will receive a total of £1,000 equity.
In this scenario, the share premium is £9 (£10 market value minus £1 nominal value), or £900 in total (£1,000 minus £100). The other £100 is share capital.
What is a share premium account?
In accordance with the Companies Act 2006, any premiums on shares must be transferred to a separate account called the ‘share premium account’. These funds must not be mixed with the company’s share capital.
Despite the name, it is not a separate bank account – the share premium account is simply an accounting entry. Typically, it is listed under the capital and reserves section on a company’s balance sheet.
The funds held in a share premium account are non-distributable reserves, meaning that the money cannot be treated as profit to be used for general purposes, such as paying dividends to shareholders.
Instead, share premium funds can only be used for a very limited range of transactions, such as paying expenses related to the issuing of shares (e.g. underwriting costs) and issuing fully paid bonus shares to existing shareholders.
That being said, the Companies Act allows private companies to transfer reserves from the share premium account to their profit and loss reserves, enabling them to distribute these funds as dividend payments.
To do this, the company will need to complete a reduction of share capital. Some companies go down this route when they have insufficient funds in their profit and loss reserves to pay out dividends. Any such reduction of capital must be permissible under the company’s articles of association and approved by a majority of the shareholders.
Accounting for non-cash payments for shares issued at a premium
Some companies accept non-cash considerations as payment for shares, including shares issued at a premium.
Non-cash considerations include property, machinery, shares in another company, expertise, time spent, intellectual property (IP) rights, or any other form of tangible or intangible asset.
If a company accepts any type of payment for shares other than cash, the assets in consideration should be valued by an independent valuer. This is to ensure that they are at least equal to the market value of the issued shares.
The company must then transfer a sum equal to the monetary value of the assets to its share premium account, minus the nominal value of the share(s).
Selling new shares for more than the nominal value
Companies often sell shares for more than their nominal value.
This may happen at the time of company formation, whereby the founding members agree to pay more per share as a way to inject capital into their new business venture.
As the company grows and becomes more successful, the value of the business will increase. Consequently, the market value of its shares will also increase above the assigned nominal value.
If the company decides to issue more shares, it will offer them for sale at a premium price to reflect the current market value of the business.
This is common practice for established companies with a good track record and strong financial position.
Why would a company issue new shares at a premium?
By issuing shares at a premium, an established, successful company can ensure that the selling price reflects the real market value of those shares.
Given that their market value is likely significantly higher than their fixed nominal value, selling new shares at a premium creates a fair and balanced position between new members and existing members.
It would be unjust if new shareholders were able to acquire high-value shares at the nominal price, reaping the same rewards as the existing shareholders who founded and developed the business.
Companies also issue shares at a premium because it allows them to sell fewer shares whilst still generating significant reserves. This minimises the dilution of existing shares and ensures that the controlling interest and dividend entitlement of all shares remains high.
Another common reason is to fund a bonus issue of shares to existing members on a pro-rata basis (i.e. in the same proportion as their current percentage of shareholdings).
Companies can use the reserves in their share premium account to issue fully paid bonus shares to their members (and staff, as part of an employee share scheme) as an alternative to paying dividends.
This enables the company to reward shareholders whilst retaining profits in the business – profits that would have otherwise been used to pay dividends.
Private companies can also issue fully paid bonus shares to increase their issued share capital to £50,000 in order to re-register as a public limited company (PLC).
Transferring existing shares for more than the nominal value
The situation is different if a shareholder decides to sell their existing shares to someone else for more than the nominal value, or transfer shares for free as a ‘gift’.
Any difference between the original purchase price and the new sale price is classed as profit for the selling shareholder. It is not a share premium, because the money is not being paid to the company.
Can a company sell shares for less than they are worth?
Companies can assign any nominal value they want to the shares they issue (even as little as £0.01), but they cannot issue fully paid shares at a discount, i.e. any amount below the nominal value.
However, they can issue shares as unpaid or partly paid. In these types of situations, the amount unpaid remains due and must be paid to the company when requested.
When it comes to market value, companies do not have to issue shares at a premium. Provided there are no restrictions in the articles of association or shareholders’ agreement, they can sell shares for less than their market value.
Companies can also issue partly paid or fully paid shares funded by their own reserves. This enables a company to issue shares at a discount or for free. For example, as bonus shares for existing members, or to set up an employee share scheme.
Existing shareholders, however, can transfer their own shares for below market value. They can even give them away for free, for example, to their spouse or children. In such instances, the market value of the shares will usually be taken into consideration when working out any tax liability associated with the transfer, e.g. Capital Gains Tax, Inheritance Tax.
How to work out the market value of shares
Working out the market value of shares can be incredibly complex, particularly in private limited companies. It will depend on a variety of factors, including:
- the company’s assets and liabilities
- turnover, profits, and cash flow
- future profitability forecasts
- current economical climate and market interest rates
- performance of similar-sized businesses in the same industry
- the company’s reputation
In many cases, the company will need to appoint an independent valuer, like a forensic accountant, to determine the market value of shares.
Often, a company’s articles of association and shareholders’ agreement will specify the way in which shares must be valued.
Difference between share capital and share premium
Share capital is money generated from issuing shares at their nominal value. A company’s share capital is equal to the total nominal value of all of its issued shares.
For example, if a company issues 10 shares with a nominal value of £1 per share, the resulting share capital will be £10.
However, the market value of those 10 shares may be worth much more than the nominal value and, thus, greater than the company’s total share capital.
The share premium is the difference between the nominal value and the market value of those shares. It is equal to the total amount of equity that a company receives for shares in excess of the nominal value.
Therefore, when a company sells shares for more than the nominal value, it is issuing them at a premium.
Share capital and share premium funds must be kept separate under different entries on a company’s balance sheet.
We hope this post has left you with a better understanding of the share premium, including why companies issue shares at a premium, the importance of transferring the correct funds to a share premium account, and how these funds may be used.
Whilst the topic is relatively straightforward in theory, issuing shares at a premium is often complex in practice. Therefore, we always advise seeking professional advice from an accountant before taking any such steps.
You should also refer to your company’s articles of association and shareholders’ agreement for any restrictions on issuing new shares in a limited company.
If you have any questions about this post – or issuing shares, in general – please leave a comment below or contact our company formation specialists for advice.