How to Get the Balance Right for Investors and Shareholders
One issue we often face is when a company has identified an investor but the existing shareholders agree excessively generous terms with the investor resulting in those shareholders giving away too much control and too many rights to the investor.
The investor will go through a due diligence process by which they seek to understand the nature of the liabilities and issues of the company. As part of this relevant shareholders, typically majority shareholders/the directors, will give warranties to the investor about the state and condition of the target company. These warranties cover the investor in relation to unknown risks. Those giving the warranties should ensure, at that very least, that any claims for breach of warranty have financial caps applying to them and also require claims to have a specified minimum value before and limit the period in which the investor can claim under them.
The investor will want to ensure that pre-emption rights apply on the transfer of shares. These provide that if any shareholder (including the investor) wishes to sell their shares, the remaining shareholders have the first option to buy them. The investor will want to include exceptions to this pre-emption right procedure so, depending on the nature of the investor, the investor can transfer the shares in the company to other companies in which they are a shareholder. The existing shareholders, if they are individuals, should seek to include provisions which permit them to transfer their shares to family members and family trusts and permit the trustees of those family trusts to transfer to new trustees or beneficiaries of those trusts.
Key shareholders/directors in the company will be expected to remain in the company for an agreed period and so the investor will want them to be subject to “good leaver/bad leaver” provisions. They will define the meaning of these terms and the investor will want to ensure that the bad leaver provisions are drafted widely and the good leaver definition drafted narrowly. The former, for example, may cover any situations such as resignation within a certain period or dismissal. The latter may cover situations such as leaving for ill health. Whether a person is a good or bad leaver will result in a difference in the price paid for that departing shareholder’s shares, with a lower price paid to a bad leaver than for a good leaver.
You will need to think what will happen if a third party is interested in buying the existing shareholders’ shares. If they hold the majority of the existing share capital before investment, then those shareholders will want to sell their shares and ensure the buyer can also buy the shares of the other shareholders. This can be achieved by including a “drag along” right which can allow the majority shareholders to force the minority shareholders to sell their shares. If the investor is to be a minority shareholder they will want to include a “tag along” right which will prevent the majority shareholders from selling their shares to a buyer without the buyer also offering to buy the investor’s shares.
Investors will normally want the right to appoint at least one non-executive director to the board of the company. The investor director will help the investor in monitoring the performance of the company. Certain investors prefer not to take up their right to appoint directors, relying instead on rights to attend and observe board meetings and receive board papers. This is usually because they prefer not to take on onerous director’s duties, particularly if the company underperforms. The existing directors should also ensure that they also have the right to appoint a director.
The investor will also want to build in some minority protection rights which will ensure that the company cannot do certain things without the investor, or their director, agreeing to them. These will typically relate to the company taking on liabilities or reducing its value. For example, the investor will want to first agree to the taking on of new employees, perhaps those receiving remuneration over a specified sum and the company from disposing of any assets. These investor consents are normally listed and the existing shareholders should ensure the list is as narrowly worded and as brief as possible so that the company’s operation is not excessively limited.
The above is just a brief overview of some of the key terms when considering investment and much will depend on the level of investment and percentage of shares in the company the investor will take. If you need advice about investments please contact Michael Budd, Partner and Head of Company Commercial.
Please note the contents of this blog are given for information only and must not be relied upon. Legal advice should always be sought in relation to specific circumstances.