What Form Of Capital Structure Should Be Used?
The Founders will want the Company to have a capital structure that allows them flexibility in financing, recognizing that not all Investors will receive the same rights, and that different classes of Investors will have different investment expectations.
Early stage "friends and family" investors will typically receive common stock. "Angel investors" may be willing to accept common stock, but may choose to make their investment initially in the form of a loan to the Company evidenced by a promissory note, convertible upon the Company's successful completion of a first round of financing with Investors into common stock or preferred stock of the Company which enjoys parity with the rights given to those first round Investors. In addition, "angel investors" will often negotiate for warrants that entitle the Investor to acquire an agreed-upon number of shares of common stock from the Company at any time prior to a specified expiration date and at an agreed upon exercise price per share. Venture capital investors, however, will typically expect to receive preferred stock, convertible into common stock, that enjoys preferential treatment in any liquidation of the Company, and may enjoy other preferences, including as to the right to receive dividends. Venture capital investors will also expect to receive warrants. The warrant coverage on early stage investments could run between 50% and 100% (i.e., the number of shares subject to warrants is equal to the number of shares purchased).
Typical Preferred Stock Provisions
Preferred stock issued to venture capital investors will generally have some or all of the following features:
- The preferred stock will be convertible at any time, at the option of the holder, into common stock of the Company, at a specified price per share. The conversion ratio will generally be on a one-for-one basis, adjusted for stock splits, stock dividends, re-capitalizations and similar events. Also typically included would be anti-dilution rights discussed below.
- In addition, the preferred stock will automatically convert into shares of common stock, at the then applicable price per share, upon the completion of a "Qualified Public Offering" that meets certain specified criteria, which typically include a minimum of proceeds and a per share price which is a specified multiple of the original purchase price.
- The preferred stock will customarily vote with the common stock on an "as converted" basis (i.e., as if it has already been converted).
- The preferred stock will vote as a class (separately from the common stock) on certain issues of importance to the holders of the preferred stock, including (i) changes in the capital structure, (ii) the issuance of additional preferred stock which is pari passu with or senior to the existing preferred stock, (iii) mergers and business combinations, (iv) changes of control, (v) the adoption of any stock option plan and (vi) any IPO.
- Preferred stock will often carry a fixed dividend payable at regular intervals, which may or may not "cumulate" in favor of the holder if not declared for any reason. Cumulated dividends must be paid to holders of preferred stock before any dividend may be paid to holders of common stock. However, since start-up companies lack the cash with which to pay dividends, and are often in industries where the practice is generally to pay no dividends, holders of preferred stock issued by start-ups will customarily be entitled only to dividends and distributions equivalent to those paid on the shares of the common stock, based upon the number of shares of common stock into which the preferred stock could have been converted on the record date for the declaration of dividends.
- The preferred stock will enjoy a liquidation preference, so that upon any liquidation, dissolution or merger, the holders of preferred stock will be entitled to receive an amount equal to the purchase price, plus any declared but unpaid dividends, before any payment is made to holders of the common stock. The amount payable to holders of preferred stock upon liquidation may also include some form of return on invested capital or "participation" in the increased value of the Company. Often, a "liquidation" is deemed to occur upon a change of control entitling the preferred stockholders to a purchase price at least equal to the liquidation preference and, possibly, higher than the price paid to common stockholders.
In order to provide themselves with an exit strategy (which is discussed generally below), Investors receiving convertible preferred stock will often negotiate for a right of redemption at the option of the holder, which typically will be exercisable after the lapse of a specified period of time in which no initial public offering has been successfully implemented. Like the liquidation price, the redemption price will be the purchase price, plus any declared but unpaid dividends, and may include some form of return on invested capital.
Venture capital investors will typically expect to receive preferred stock, convertible into common stock, that enjoys preferential treatment in any liquidation of the Company, and may enjoy other preferences, including as to the right to receive dividends
As mentioned above, the Founders will expect to experience dilution as new Investors are brought in, but will nevertheless hope to retain control of the Company. The Founders may negotiate for pre-emptive rights, giving them the right to purchase their pro rata share of any new shares issued by the Company, before shares may be offered outside of the existing group of shareholders. However, since the Founders typically will lack the financial resources to exercise their pre-emptive rights, but will need additional capital, they will expect to be diluted.
Investors will expect to be protected against dilution arising from the future issuance by the Company of shares at a price below the price which they paid for their shares. There are two common anti-dilution formulas: a "weighted average" anti-dilution formula, and a "full ratchet" anti-dilution provision. Under "full ratchet" provisions, the conversion price of existing convertible preferred stock automatically decreases if one share of stock is issued at a price lower than the existing conversion price. In that event, the conversion price of the preferred stock automatically "ratchets down" to the lower price, entitling the holders of the preferred stock to receive a higher (and possibly much higher) percentage of the common stock upon conversion, even though the Company may have only raised a nominal amount of additional financing. Obviously, this type of anti-dilution is much more Investor-friendly.
In contrast, a "weighted average" anti-dilution provision moderates the rate at which existing shareholders suffer dilution. Under this approach, where the Company issues new shares at a price below the conversion price of existing convertible preferred stock, the conversion price is reduced, but to a number that takes into account how many new shares are being issued by the Company. Thus, where only a limited number of new shares are issued by the Company at a price below the existing conversion price, the conversion price of the existing convertible preferred stock will be reduced (entitling the holders thereof to acquire more shares of common stock) only slightly.
Corporate Governance Rights
Set forth below is a description of the principal issues that will arise in any negotiation with potential Investors.
Board Representation and Observer Rights
Venture capital investors will expect representation on the Company's Board of Directors, typically at a level proportionate to their investment. Board representation allows an Investor to review all important managerial decisions relating to the Company and to participate in all decision-making that occurs at the board level. Typically, the board representative selected by an Investor will have experience in the industry in which the Company is involved, or will be experienced with companies at a similar stage of development. By having one or more appropriate representatives on the Board of Directors, together with veto rights referred to below, the Investor feels that it has the ability to influence the Company's business and to protect its investment. If a venture capital investor is unable to obtain a seat on the Company's board, it may request observer rights which give the Investor the right to receive all materials sent to the Board and to participate (though not vote) at board meetings.
Veto Rights of Minority Investors
Minority Investors will, dependent upon the level of their investment, generally expect to have a right of approval in relation to a variety of matters that are important to the capitalization, growth, financing and management of the Company. In the case of actions requiring shareholder approval, veto rights in favor of a minority Investor are created either by explicitly granting an Investor these rights in the organization documents of the Company (including by creating a separate class of securities held only by the Investor and requiring the approval of holders of that class of securities, voting as a separate class), or by requiring the approval of a supermajority of the stockholders that cannot be obtained without the participation of the Investor. If the organizational mechanisms are unavailable or impractical, the Investor may seek from the Company a covenant (to be contained in the shareholders' agreement) that such actions will not be taken without the prior consent of the Investor.
In development-stage companies, Investors generally seek approval of a broad segment of these issues. Issues requiring approval by a minority Investor are often divided between those actions that require approval at the level of the Board of Directors, and those actions requiring shareholder approval. However, while there is no prevailing convention for allocating in any particular fashion those actions that are taken at the board level and those actions that are taken by the shareholders, in practice these actions are often divided along certain logical lines.
Minority Investors will usually request that most fundamental changes of the Company, its business and direction, and its organic and capital structure, which normally require the approval of shareholders, be subject to a favorable vote by such Investors. These matters typically include the following:
- issuance of additional stock, bonds, debentures, shares or any options or warrants to purchase stock, the reclassification of stock, or an initial public offering;
- redemption of stock;
- amendments to the charter and bylaws of the Company;
- change of the corporate purpose of the Company;
- effecting a merger, spinoff, consolidation or business combination of the Company or a sale or conveyance of all or substantially all of the Company's assets;
- liquidation or dissolution of the Company or filing for bankruptcy or insolvency proceedings; and
- changing the number and composition of the board of directors or of any special committee of the board.
The issues that minority Investors typically identify as requiring their approval generally include changes to the capital structure of the Company, and particularly in the case of development-stage companies, changes in the management or operations of the Company's business. Board actions commonly requiring the Investor's approval include, among others, the following:
- appointment and removal of the CEO of the Company;
- approval and amendment of the Company's business plan;
- approval and amendment of the Company's annual operation and capital investment budgets;
- incurrence of debt;
- creation of liens and encumbrances;
- sale, lease, conveyance or purchase of assets outside the ordinary course of the Company's business;
- entering into any merger, consolidation or business combination;
- payment of dividends;
- appointment and removal of the Company's external auditors and statutory examiners;
- entering into agreements involving expenditures or commitments in excess of a determined amount or outside the ordinary course of business;
- approval of any agreement with related parties to the shareholders or directors or officers or their respective relatives;
- initiation of any litigation, or consent to the settlement or admission of liability with respect to any litigation;
- approval of employment contract and severance agreements with key management; and
- any of the above mentioned issues with respect to any of the Company's subsidiaries.
The Investor may require that certain changes be made in the management of the Company, and may seek involvement in the daytoday management of the Company, especially where the Investor has acquired at least a majority of the Company's voting securities. The resolution of this issue will depend on the financial situation of the Company, the level of the investment and the degree of expertise of the existing management to meet projected goals, among others.
Minority Investors will, dependent upon the level of their investment, generally expect to have a right of approval in relation to a variety of matters that are important to the capitalization, growth, financing and management of the Company
General Restrictions On The Company's Shares
Preemptive rights, which are discussed above, give shareholders the right to purchase, out of new securities to be issued by the Company, their pro rata share of such securities. This provides to each shareholder a right to maintain its proportionate interest in the Company and thereby avoid the dilution that will occur upon the Company's issuance of securities to other shareholders or third parties. Investors will typically insist on having preemptive rights, to protect themselves against any possible dilution.
Right of First Refusal
Shareholders' agreements typically include rights of first refusal, allowing certain shareholders (typically the venture capital investors) to purchase their pro rata portion of Shares that are offered by certain selling shareholders to a third party, at the price and on the terms that have been offered by the third party. If any shareholders elect not to purchase their ratable portion of shares to be sold, the remaining shareholders having rights will have a subsequent opportunity to acquire their pro rata portion of the un-purchased shares. Once the specified shareholders have exhausted their right of first refusal, the original selling shareholder is free to sell the remainder of its Shares to the third party, at the tendered price, for a specified period of time.
In the situation where the majority shareholders have successfully negotiated to sell their Shares to a third party, tagalong rights require, as a condition of the sale, that the other shareholders be permitted to sell their Shares to the purchaser (i.e. to "tag along" with majority shareholders) on the same terms and under the same conditions of the offer. This provision ensures that should a change occur in the majority ownership of the Company, the Investors will have available an exit strategy. Often, tagalong rights apply only to sales of a majority of the outstanding Shares, in which circumstance the tagalong prevents a third party from offering to purchase from the majority shareholders at a premium price only that number of Shares sufficient to obtain a majority of the board of directors.
Drag-along rights, which are common in shareholders' agreements, permit majority shareholders to negotiate the sale of the Company to a third party, and then compel (or "drag along") the minority shareholders to sell their Shares to the third party on the same terms and conditions that have been negotiated by the majority shareholders. Dragalong rights allow majority shareholders to force uncooperative or complacent minority shareholders to participate in an exit strategy. Dragalong rights can be very coercive to minority shareholders, compelling them to sell their shares in an entire sale of the Company in circumstances where they would prefer to remain as minority investors.
In limited circumstances, where the Founders have an urgent need for additional capital (giving the Investor great negotiating leverage over the Founders), the Founders and other earlystage investors have agreed (or were compelled to agree) to grant dragalong rights to a minority Investor, as a form of exit strategy. In that event, the Investor will be able to compel a sale of the Company to a third party, regardless of whether the Founders favor such a sale, and regardless of whether the Founders view such a sale as premature in relation to the growing value of the Company's business.
IPO Participation Rights
A venture capital investor may also negotiate the right to purchase a small portion of the shares to be publicly offered in the Company's IPO.
One of the most important issues to be negotiated between the Founders and any minority Investor(s) is the exit strategy. Investors in Internet start-ups do not expect to retain their investment for an indefinite period of time. As a result, exit strategies play a key role when an investment has matured (or the Investor believes the Company has achieved a sufficient level of growth or profitability) and the Investor wishes to "exit" the Company by selling its Shares. The exit procedure set forth in the shareholders' agreement will depend on, among other factors, the size of the Company and its business, as well as market conditions.
The shareholders' agreement will usually anticipate that the Company will be taken public through an IPO. However, it is possible that at the desired time the international markets may prove inaccessible for an IPO by a Latin American company, so an Investor is likely to require that an alternate exit mechanism is provided. An alternative would be for the Investor to be able to cause the Company to be sold to a strategic buyer, such as a larger local company wishing to expand or a foreign company interested in entering the local market. The shareholders' agreement may also provide the Investor with the option to "put" its Shares back to the Founders or to a third party (i.e., require that they purchase the Investor's Shares) that is acceptable to the Founders either at the then "market price" of the Company or at a price intended to provide the Investor with an acceptable rate of return on its investment.
If an exit provision such as a "put" has been triggered, the valuation procedures set forth in the shareholders' agreement will be of critical importance in determining the value of the Company. Therefore, a detailed procedure should be negotiated and documented in order to avoid any conflict or complications among the shareholders. This provision should be carefully structured so as to complement, and not conflict with, the exit strategies and dispute resolution measures also provided for in the shareholders' agreement.
Initial Public Offering and Demand Registration Rights
To many Investors, registration rights are an important issue in making their initial investment decision. A Company can engage in a public offering only with the support of the Company's board of directors and its management, meaning that a minority Investor in a non-public company is effectively subject to decisions made by the majority shareholders. Therefore, negotiating in advance the circumstances under which the Company will co-operate in a public offering of its shares is critical to a minority Investor.3
In order to insure their ability to sell their shares publicly, minority Investors secure in advance the consent of the Company to co-operate in the preparation and filing of a registration statement (referred to as "registration rights") and to pay associated expenses (other than underwriting discounts and commissions). As a practical matter, an IPO is only likely to be successful where the Company itself is issuing shares, although at the discretion of the underwriters the IPO may also include all, or some portion, of shareholders' shares among those shares that are to be registered with the SEC. Accordingly, minority Investors will negotiate for registration rights that will permit them to include their shares in any future public offering by the Company.
There are two types of registration rights: "demand" rights and "piggyback" rights. "Piggyback" registration rights allow shareholders to have their shares included in any suitable registration statement that the Company is planning to prepare and file with the SEC on behalf of itself or other shareholders. "Demand" registration rights, on the other hand, require that the Company initiate and follow through with a registered offering (and pay the costs associated with preparing and filing a registration statement) and include in that offering shares held by the Investor making the demand. Typically, Investors will seek the right to make up to a negotiated number of demand registration rights within an agreed-upon period.
Amendments to the Company's Charter and Bylaws
In most circumstances, the Company's charter and bylaws will have to be amended to reflect the terms and conditions agreed to by the Investors, the Company and the Founders. The most significant changes affecting these documents will probably involve changes to the description of the economic and voting rights appurtenant to the Shares being purchased, the structure of the board of directors, the procedures for appointing and removing directors, key management and auditors, and the voting requirements for the board of directors and general and special shareholders' meetings.
Minority Investors will negotiate for registration rights that will permit them to include their shares in any future public offering by the Company
Stock Purchase Agreement
In addition to negotiating a shareholders' agreement, the parties will also negotiate a detailed stock purchase agreement, which is generally prepared by counsel for the Investor. This agreement will, in addition to containing the terms regarding the purchase of the Shares, include extensive and detailed representations and warranties concerning the business, assets, liabilities and financial condition of the Company and its subsidiaries, their compliance with all applicable laws and regulations, and their possession of all required governmental permits, authorizations and licenses and may also include representations about the selling shareholders.
It will also include covenants applicable to the Company and, in many cases, the selling shareholders, conditions to closing (including receipt of any required governmental authorizations or approvals), provisions allowing for termination of the agreement, and a broad indemnification in favor of the Investor for any damages, losses or claims (including fees and expenses) arising from any breach by the Company or the selling shareholders of any representation or warranty or covenant contained in the stock purchase agreement.
In order to ensure adequate disclosure to the Investor concerning the condition of the business of the Company, the stock purchase agreement will typically include numerous disclosure schedules that require management of the Company and its counsel to furnish detailed, itemized information concerning all of the Company's assets, liabilities, material contracts, real estate owned and leased, information systems, insurance coverage, licenses and similar information. Inaccuracy of the representations and warranties by the Company will allow the Investor to assert a claim for postclosing indemnification against the Company (and typically the selling shareholders), and obtain a downward adjustment in the price paid by the Investor for the investment.
For Internet start-ups, venture capital is a critical step toward achieving financial viability. As the discussion above makes clear, there are a number of important considerations that require careful review and negotiation by the Founders in connection with any venture capital financing. The discussion set forth above relating to these issues is not intended to be comprehensive, but rather is designed to highlight certain issues to which Latin American Internet start-ups need to be sensitive when negotiating venture capital financing.
1. High Tech Start Up, John L. Neisham, The Free Press (2000)..
2. In lieu of incorporating a company, the Founders may organize a partnership or a limited liability company. However, corporations are the most common form of Internet start-up company, and therefore we are not including a discussion of the U.S. tax issues related to partnerships or limited liability companies.
3. For a useful discussion of registration rights, see Equity Finance Venture Capital, Buyouts, Restructurings and Reorganizations, Joseph W. Bartlett (John Wiley & Sons, Inc., Second Edition, 1995).
Copyright © 2000 Mayer, Brown & Platt. This Mayer, Brown & Platt publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.