Instead of using paper-based stock certificates that are laborious, time-intensive and expensive to administer, companies can issue electronic shares. To understand how electronic shares work, consider what happens when you directly purchase shares of stock in a public company today (if you purchase them through a brokerage, the brokerage is registered with the company as the owner of the shares, not you).
When you make a direct purchase of shares in a public company, you must register your shares using the Direct Registration System (DRS). DRS is an electronic database that tracks every share of company stock. It shows the current owner of stock shares and has historical records of how shares have been transferred, cancelled or reissued. When you purchase stock, a new entry is added to the database establishing you as the owner of specific shares. When you transfer stock, the record is modified to reflect the new owner. It’s a very standard, efficient and cost-effective way to record transactions in a bookkeeping system.
While the actual process that public companies use is much more complex because of the requirement to use a stock clearinghouse and the way shares are registered, the concept is the same for private companies. And one thing is clear -- electronic shares have many advantages for both the company and the shareholder compared to paper-based certificates.
ADVANTAGES TO COMPANIES
It's probably not too difficult to imagine how much easier an automated system is compared to a paper-based stock system, and how many human errors are avoided by using software specifically designed to manage an equity program. An electronic system is more accurate, more efficient and more cost-effective than a paper-based program. It requires fewer people and is less expensive to administer.
Since there are no longer any paper certificates to lose, all the work associated with tracking or replacing paper certificates disappears. Because the company doesn't have to physically have paper certificates in hand, stock sales and transfers can happen very quickly using email communication.
With all the share information stored in a single database, it's easy for companies to know who owns shares and how many shares they own. If some shares had voting or transfer restrictions, some shares haven't vested for an employee or some awards are stock options instead of restricted stock grants, the company knows and tracks that information, too. This makes it much easier to create reports that comply with government regulations and to communicate with shareholders about important events they might have forgotten, such as when stock shares change from being unvested to vested.
Because the company's ledger is the official record of who owns which shares of stock, the nature of electronic shares helps ensure that shares are properly transferred to their new owners. This enables the company to be its own transfer agent and retain control over shareholder communication and relationships. It also saves the expense of hiring a transfer agent.
It's typically very straightforward to provide shareholders with online access to their account information or to push a button and generate monthly statements that are sent by email or postal mail to shareholders.
In addition to being more efficient and convenient, an electronic share system also has strategic value, such as strengthening the role of stock in retaining employees. For example, suppose an employee gets an offer from an established competitor that can afford to pay a higher salary. With an electronic equity system, it's easy to show the employee the difference in earnings between a higher salary at the competitor today and the potential income from owning stock in a startup that goes public or is acquired. The number of unvested shares that the employee has is also an easy way to quantify what the employee would forfeit if she left the company.
ADVANTAGES TO SHAREHOLDERS
Some might remember years ago when companies handed every employee a paper paycheck on payday. Employees separated the check from the pay stub, cashed the check and put the paystub in a file in case they needed to refer to it later in the year. If an employee lost his check, the company had to stop payment on the old check and issue a new check. If an employee needed to review monthly paystubs, he had to fetch the file, get out his calculator and examine each month manually. When you compare that paper-based system to today's electronic system of direct deposit and online paystubs, it's immediately apparent how much more convenient and efficient electronic shares of stock might be.
Shareholders no longer have to keep track of paper stock certificates. There's no fear that certificates will get lost or stolen, and there's no expense or hassle of trying to have them replaced. Stock transactions are quick and efficient because shareholders no longer have to sign and mail paper certificates to the company.
A shareholder who wants to understand how many shares he owns, which shares will vest when and what options he holds can typically review his account over the Internet 24x7. Worst case, he can receive a monthly statement via email or postal mail that contains all the information about his account.
When you consider how laborious and time-consuming a paper-based stock certificate program is compared to a convenient and efficient electronic system of shares, it shouldn't be a difficult decision for any private company to choose the best option. Fortunately, even companies that started out issuing paper certificates can switch to an electronic system. It's up to the company to decide whether it wants to recall the outstanding paper certificates and reissue them as electronic shares or if they want to maintain a hybrid system and convert the paper shares as they are sold or transferred.