Valuation of Shares & Dilution of Ownership
Convertible securities are financial instruments, such as convertible debentures or preference shares, that can convert into equity shares. They offer a blend of fixed income and the potential for equity participation, with conversion typically at the holder's discretion, triggered by specific events or milestones in the company's performance.
Fully diluted basis refers to a scenario where all convertible securities, such as bonds and stock options, are exercised and converted into equity, showing the total number of shares outstanding. It is crucial for understanding the potential dilution of ownership.
Anti-dilution protection is a key safeguard for investors, ensuring their investment's value remains intact even if new shares are issued at a lower price. There are two main types: full ratchet, which adjusts the conversion price to match the new lower price, and weighted average, which adjusts based on an average of prices for a more balanced approach.
Pre-emptive rights and super pro-rata rights: pre-emptive rights allow investors to maintain their ownership percentage by buying new shares before they are offered to others. Super pro-rata rights go further, letting investors increase their stake in subsequent funding rounds.
Clauses Impacting Decision-Making
Information and inspection rights: investors often require access to specific financial and operational information to stay informed about the company's performance, and inspection rights allow for on-site visits and thorough reviews of company records.
Investor directors and observers: investors may nominate directors to the board to represent their interests. These directors owe fiduciary duties to the company, not just to the investor. Observers, by contrast, can attend board meetings without voting rights or fiduciary obligations.
Non-executive status and indemnification of investor directors: non-executive directors are not involved in day-to-day management and are typically indemnified against personal liability arising from their role.
Affirmative voting matters: certain key decisions, such as amending charter documents or restructuring, require investor approval, ensuring major changes align with shareholder interests.
Share Selling & Transfer Provisions
Deed of adherence: when new shareholders join, they must sign this document to agree to the existing shareholders agreement, keeping the arrangement consistent across the board.
Founder lock-in and vesting: lock-in periods prevent founders from selling their shares too soon, ensuring their continued commitment to the company, while vesting schedules gradually unlock shares over time to incentivise long-term contribution.
ROFO and ROFR: the right of first offer and right of first refusal both give investors the chance to buy shares before they are sold to outsiders, with the right of first refusal being the more restrictive of the two.
Tag-along rights allow minority shareholders to join a sale initiated by majority shareholders, so they can exit the company on the same terms.
Exit Clauses
Exit strategies set out how investors can realise their investment, whether through an IPO, a merger or a third-party sale, and an accelerated exit can be triggered by specific events for a quicker route out.
Drag-along rights enable majority shareholders to compel minority shareholders to sell their shares, facilitating a complete sale of the company.
Liquidation preference determines the order and amount paid to shareholders on liquidation, ensuring preferred shareholders recover their investment first.
Miscellaneous Clauses
ABAC compliance: anti-bribery and anti-corruption compliance matters especially for companies with foreign investors, ensuring adherence to global anti-corruption laws.
Options and clawback provisions: call and put options allow shareholders to buy or sell shares under specific conditions, while clawback provisions require founders or employees to return shares if they fail to meet performance milestones or leave prematurely.
Understanding these terms matters for founders navigating the landscape of a shareholders agreement. Getting them right helps ensure that founders and investors are both protected, and that the company's interests stay aligned with long-term growth. For any specific transaction, always seek professional legal advice before signing.
Disclaimer: The content of this article is intended to provide general guidance on the subject matter. Specialist advice should be sought about your specific circumstances.