Like any other field, the Corporate Hi-Tech world has its own jargon. For new players in this industry, we offer here a short explanation of some basic commonly-used legal and business terms. Check in every week for the new term.
Liquidation & Distribution Preference
The “Liquidation & Distribution Preference” provisions in a Company’s Articles of Association govern the order of distribution of dividends and other distributable proceeds, upon the occurrence of a Liquidation Event or a Deemed Liquidation Event (typically, a sale of all or a controlling block of the Company’s share capital, the sale of all or substantially all of the assets of the Company, a merger of the Company with an unaffiliated third party, the granting of an exclusive license to use all or substantially all of the Company’s IP or similar corporate combinations).
When a Company with more than one class of shares distributes to its shareholders dividends or other distributable proceeds, the amounts available for distribution will be paid to the shareholders in the order of priority, whereby the most senior class of shares is paid first, then the second most senior class, etc. and only once all of the preferred shares have been paid in full, do the holders of Ordinary Shares participate in the distribution. For example, when the share capital of a Company includes three classes of shares, Preferred B Shares, Preferred A Shares and Ordinary Shares, then, usually, the Articles will provide that the distributable proceeds will first be distributed among the holders of Preferred B Shares, until they recover their full investment (plus, in certain cases, annual interest accrued between the date of investment and the date of distribution); only then are the distributable proceeds distributed among the holders of Preferred A Shares, until they recover their full investment (plus, in certain cases, annual interest accrued between the date of investment and the date of distribution); and only thereafter do all of the classes of shares, i.e., the Preferred B Shares, the Preferred A Shares and the Ordinary Shares, share any additional funds still available for distribution, on a pro-rata and as converted basis.
In economic terms, this arrangement embodies two basic notions. The first is that the investors are first repaid their full investment (and often also a certain interest rate assured to them) and only then, once the investment is returned, are the remaining “profits” shared among all of the shareholders of the Company. The second is that if the “profits” are insufficient to repay the shareholders their investments in full, partial distribution is performed in the LIFO (last in first out) order.
In some cases, we find an exception to the first notion, whereby the Preferred Shares are defined as “Non-Participating” shares. This means that the holders of the Preferred Shares have priority in the distribution of an amount equal to their full investment plus the pre-approved annual interest (the “Preference Amount”), but do not participate in the distribution of the residual funds available for distribution after repayment of all Preference Amounts (i.e., they do not share in the distribution of the remaining amounts with the holders of Ordinary Shares). In such cases, the holders of the Non-Participating Preferred Shares can elect either to receive their Preference Amount or to convert their Preferred Shares into Ordinary Shares, immediately prior to the distribution, and then participate on a pro-rata basis with the Ordinary Shareholders, in the distribution of the residual amount. Obviously, such election is made whenever the amount due to the Preferred Shareholders on an as converted basis is higher than the return of their investment and the interest accrued thereon.
Dilution and Anti-Dilution
Dilution is a reduction in the percentage of ownership of the shareholders due to the issuance of new shares by the Company.
Dilution can also occur, for example, when a holder of options (such as a Company employee) exercises the options. In such event, the holder of the options is issued new shares, which effectively increases the total issued and outstanding share capital of the Company, therefore decreasing the percentage of shares owned by each of the other shareholders.
“Anti-dilution Rights” are often incorporated into a Company’s Articles of Association and are designed to protect the investors granted such right, against dilution of their ownership in the event of a future issuance by the Company of additional shares at a lower price per share (“PPS”), reflecting a lower valuation of the Company.
Typically, when Anti-Dilution rights are exercised, the protection is not implemented through the issuance of additional preferred shares to the original investor. Rather, the conversion rate of the preferred shares is adjusted, so that when the investor converts his preferred shares into ordinary shares, he receives more ordinary shares than he would otherwise have received.
There are two main methods of Anti-Dilution protection: Full Ratchet Protection; and Weighted Average Protection (which may be Broad Based or Narrow Based). The most common is Broad Based Weighted Average Protection.
Full Ratchet Protection:
“Full Ratchet” has the effect of reducing the PPS of the previous round to that of the later round. For example, if the original investor purchased 100 preferred shares, for which full ratchet protection is afforded, at a PPS of $1.00, and following such issuance, the Company issued new shares at a PPS of $0.80, then the economic effect is that the original investors will receive the value of additional shares, as if the original PPS of the preferred shares was $0.80. This is done by reducing the conversion rate for the original preferred shares, from 1:1 to 1:0.80, so that the original shareholders’ preferred shares will be convertible into 125 ordinary shares.
Weighted Average Anti-Dilution Protection:
Weighted Average Anti-Dilution Protection is based on a formula that adjusts the conversion rate of each preferred share, but takes into account the relative impact that the dilutive financing round had on the original investor. This means that if the original number of shares issued at the higher PPS was large, and the later issuance, triggering the anti-dilution protection, was small, the effect on the conversion rate will be relatively minor.
Accordingly, when applying the Weighted Average formula, each Preferred Share is convertible into a certain number of Ordinary Shares, based upon the amount of money previously raised by the Company and the PPS in the previous rounds, as well as the amount of money being raised by the Company in the subsequent dilutive financing and the PPS at which such new money is being raised.
The difference between the Broad Based protection and the Narrow Based protection depends on the way the number of Ordinary Shares is calculated in the adjusting formula.
The typical adjusting formula is as follows:
(N x P) + (N’ x P’)
CP = ————————-
N + N’
CP = the new Conversion Price of the applicable Preferred Shares
N = the number of Ordinary Shares prior to the current financing round (on an as converted basis)
P = the Conversion Price applicable to such Preferred Shares in effect immediately prior to such issuance (originally the Conversion Price will be equal to the PPS, i.e., a conversion rate of 1)
N’ = the number of Ordinary Shares issued in the new financing round (on an as converted basis)
P’ = the price per share of the New Securities
The Broad Based Weighted Average takes into account all the Ordinary Shares and the Preferred Shares (on an as converted basis), and all of the options, warrants or other securities, which are convertible into ordinary shares. Therefore “N” will be the total fully diluted share capital of the Company prior to the dilutive transaction.
The Narrow Based Weighted Average takes into account only the Ordinary Shares issuable upon conversion of the issued and outstanding Preferred Shares, while excluding all of the Ordinary Shares, options, warrants or other securities, which are convertible into Ordinary Shares.
Let’s look at the following example of a Broad Based Weighted Average Anti-Dilution Protection:
Assume that the pre-financing capitalization of the Company is:
1,000,000 Ordinary shares
2,000,000 Preferred A shares (issued at $1 PPS)
1,000,000 Options__________
Total share capital – 4,000,000
The Company now issues 2,000,000 Preferred B shares at a PPS of $0.50, for a total consideration of $1,000,000.
Preferred A adjustment
The Preferred A Conversion Price will be adjusted as follows:
Original Preferred A Conversion Price = $1
[4,000,000*$1] + [2,000,000*$0.5]
———————————————- = (5/6) = $0.833 (New Conversion Price)
4,000,000 + 2,000,000
Hence, the number of Ordinary shares issuable upon conversion of Series A is:
(2,000,000) x ($1.00 / 0.833) = 2,400,960, reflecting a Preferred A Conversion Rate of 1:1.20.
Using the same formula we used above, the narrow-based formula will be as follows:
[2,000,000*$1] + [2,000,000*$0.5]
——————————————– = (3/4) = $0.75 (New Conversion Price)
2,000,000 + 2,000,000
Hence, the number of Ordinary Shares issuable upon conversation of Preferred A Shares =
(2,000,000) x ($1.00/$0.75) = 2,666,666, reflecting a Preferred A Conversion Rate of 1: 1.33.
One important factor to keep in mind is that most Anti-Dilution Protection provisions do not apply, and therefore will not be exercised, in certain events in which new shares are issued at a lower PPS. These events typically include: (i) any issuances of shares or options under an employee stock option plan (“ESOP”); (ii) issuances of shares upon stock splits, stock dividend, reclassification and similar recapitalization events; (iii) issuances of shares to strategic investors (i.e., where the price per share is not the sole factor for obtaining such investment), such as credit arrangements, equipment financings or similar transactions; (iv) issuance of Preferred Shares upon conversion of any loan under a convertible loan agreement; (vi) issuance of Ordinary Shares upon the conversion of any Preferred Shares into Ordinary Shares; and (vii) issuance of shares upon a merger or acquisition event.
Term Sheet
Most investment transactions require the creation of a relatively complex set of documents (the “Transaction Documents”), which typically include three major documents: the Share Purchase Agreement (the “SPA”); the Amended Articles of Association (the “Amended AOA”); and the Investors’ Rights Agreement (the “IRA”). In addition, a typical set of investment documents also includes a handful of other agreements and undertakings, which are usually referred to as Ancillary Agreements or Ancillary Documents.
In view of their complexity, Transaction Documents are only prepared after the investor and the Company have reached an agreement on the basic terms of the investment. These terms and conditions are summarized in the Term Sheet, which can be a 5 – 10 page document in itself.
A typical Term Sheet will include: the name of the investor, the amount to be invested by him or her, the agreed valuation of the Company for the investment (pre-money and post-money), and as a consequence thereof – the number of shares to be issued to the investor in consideration for the investment and the price per share (the “PPS”).
The Term Sheet will also describe the type or class of shares to be issued to the investor and the rights and preferences attached to them, in terms of voting power and the distribution of dividends and proceeds upon the sale of the Company or another exit event.
The Term Sheet will further describe the agreed composition of the Board of Directors following the completion of the investment (the “Closing“), and usually includes a long list of veto rights granted to the investor or to the director appointed by him or her following the Closing.
In addition to a description of the said basic terms of the investment, the Term Sheet also sets forth the actions to be taken by the parties to facilitate the transaction and the time frame for their performance. In this respect, the Term Sheet will contain reference to the investor’s right to conduct a due diligence review of the Company and its business, the time frame for its completion and for the Closing, the parties’ mutual undertaking to negotiate exclusively with each other during the said period (the “No Shop Period”) and the obligation to keep the negotiations confidential (the “Confidentiality Undertaking”).
Typically, other than the No Shop and Confidentiality Undertakings, which are legally binding upon the parties (meaning that a breach of such undertakings could lead to a law suit), most of the provisions of the Term Sheet are not legally binding, and serve as a road map for the parties and their lawyers to follow in drafting the Transaction Documents. This means that if the due diligence review reveals findings which are non-satisfactory to the investor, he or she may withdraw from the transaction or demand an amendment of its financial or other terms as a condition to making the investment.
The bottom line is that receiving an investment proposal in the form of a draft Term Sheet, and reaching an agreement on its terms, is a crucial step towards the Closing of an investment transaction. However, it does not ensure that the investment will actually close.
“No Shop”
No Shop is an undertaking by a Company to a potential investor not to negotiate with any other party, so long as the investor and the Company are engaged in serious negotiations for an investment.
One of the major concerns of a potential investor is that while he or she are spending significant resources in negotiating an investment transaction (both in terms of management attention and actual costs of lawyers and other consultants), the Company will attempt to raise capital from other investors on better terms, perhaps even leveraging on the negotiations with the potential investor.
In view of this concern, a potential investor will typically demand that the Company enter into a binding No Shop agreement, prior to the commencement of the due diligence review and the negotiations for the complex set of deal documents.
On the other hand, the Company also has a legitimate concern that if it is off the market for too long, and the negotiations with the potential investor do not yield an investment, it shall have lost other investments, which may have otherwise materialized. Moreover, since start-up companies usually attempt to raise investments only when they are very short on cash, any delay created by restricting the ability to negotiate with several potential investors simultaneously, may lead to a cash crisis, which could risk the very existence of the Company.
In an attempt to balance the two conflicting concerns, the No Shop undertaking is usually granted only after the signing of a Term Sheet for the investment (at which point in time the likelihood of closing the deal is relatively high), and is limited to a short period of time, usually 30-45 days.
Interested Party Transactions
The Directors, the CEO and any person directly reporting to the CEO (such as the CFO, CTO, COO and other VPs), are considered the officers of the Company (the “Officers”).
Due to the potential for conflict of interest between the Company and its Officers, the Companies Law, 5759-1999, includes a special mandatory mechanism for the approval of any transaction between the Company on the one hand and any Officer or any entity in which an Officer has a personal interest, on the other hand (an “Interested-Party Transaction”).
Each Officer who knows that he or she has a personal interest in an existing or proposed transaction with the Company, is required by law to disclose to the Company his or her personal interest in the transaction and any relevant material fact or document. A Company may approve only such Interested-Party Transactions which the Board of Directors (the “Board”) or the General Meeting of Shareholders (the “General Meeting”) affirmatively determine to be in the best interest of the Company.
The Companies Law provides that if the Interested-Party Transaction is in the ordinary course of the Company’s business, the transaction is subject to the approval of the Board (unless a different approval mechanism has been set forth in the Company’s Articles of Association).
Most other Interested-Party Transactions (including the making or the amendment of an employment agreement between the Company and a director, and if the Company has not appointed an Audit Committee – also an employment agreement with an Officer who is not a director) require the approval of both the Board and the General Meeting of the Company. The General Meeting may only grant its approval after the transaction was duly approved by the Board.
To the extent the Interested-Party Transaction involves a director, he or she may neither be present nor vote in the Board meeting in which such transaction is discussed, unless a majority of the directors of the Company have a personal interest in the transaction, in which case, all of the directors are entitled to participate and vote in the meeting, but the transaction is also subject to the approval of the General Meeting.
If the Company does not duly approve an Interested-Party Transaction, such transaction will be null and void vis-à-vis such Officer, and if the transaction is with a third party, then the transaction is also null and void vis-à-vis such third party, if such party knew about the Officer’s personal interest, and knew or ought to have known that it had not been duly approved. An Officer who fails to disclose his or her personal interest to the Company is deemed to have breached their duty of loyalty to the Company.
The Chief Executive Officer
The Chief Executive Officer (the “CEO”) or General Manager, is the third of the three major organs of the Company, the other two being the General Meeting of Shareholders (the “General Meeting”) and the Board of Directors (the “Board”).
The Companies Law, 5759-1999, provides that a private Company may (but is not required to) appoint one or more CEOs. In the absence of such appointment, the powers assigned to the CEO vest with the Board. The CEO is appointed and removed from office by the Board.
The CEO (if appointed) is responsible for the day-to-day management of the Company’s affairs, based on the policies outlined by the Board and subject to its instructions. The CEO is required by law to report to the Chairman of Board of any irregular matter which is material to the Company, and otherwise to provide the Board with such reports, at such times, as shall be determined by the Board.
With the Board’s approval, the CEO may delegate some of his or her powers to other persons who report directly to the CEO (the “Officers”). Typically, such Officers include the Chief Financial Officer (the “CFO”); the Chief Technology Officer (the “CTO”); the Chief Operating Officer (the “COO”); and other Vice Presidents (“VPs”) such as VP Marketing; VP Business Development, etc.
Preemptive Right
A Preemptive Right is a privilege granted to a Shareholder to maintain his or her proportionate share of ownership in the Company’s share capital, in the event the Company issues new shares. A shareholder who has been granted a Preemptive Right will be notified by the Company on the issuance of new shares, the number of shares he or she is entitled to purchase and the price per share (“PPS”) quoted by the Company in connection with such offering. The Shareholder will typically have a limited period of time in which to notify the Company of his or her intention to exercise the Preemptive Right and purchase such shares.
Under the default rule of the Israeli Companies Law, 5759-1999 a Preemptive Right is only granted in Companies who have a single class of shares (i.e., Ordinary Shares). However, it is very common to include in start-up companies’ Articles of Associations (“AOAs”) Preemptive Right provisions which entitle either the shareholders of all classes or only the holders of Preferred Shares to participate in such offerings. The AOAs of start up companies typically also exclude Preemptive Rights in various cases of issuances of shares or equity securities, such as upon conversion of Preferred Shares into Ordinary Shares; the issuance of additional shares as a result of anti-dilution rights; the granting of Options to Company employees and the exercise of such Options by such employees; share issuances to strategic investors; and issuances for which a majority of the Preferred Shares have resolved to waive such right.
General Meeting of Shareholders
The General Meeting of Shareholders (the “General Meeting”) is one of the three major organs of the Company, the other two being the Company’s Board of Directors (“Board”) and the Chief Executive Officer (“CEO”).
The Israeli Companies Law, 5759-1999, assigns certain statutory powers and duties to the General Meeting, among them: amending the Company’s Articles of Association (the AOA”) and its authorized share capital; electing the Company’s Board (unless a different election mechanism is set in the Company’s AOA); appointing the Company’s independent auditor and determining his or her terms of engagement; authorizing certain acts and transactions of the Company (such as mergers, certain interested party transaction, etc.); and deciding on the Company’s dissolution.
Unless otherwise specified in the Company’s AOA, in each General Meeting all classes of shares vote together and each share, be it an ordinary share or a preferred share, has one vote. The Companies Law requires however to conduct a separate vote of the relevant class of shares, if the rights of such class are about to be specifically adversely affected by such resolution.
AOAs of start-up companies typically grant a specific class of Preferred Shares or the Preferred Shares as a whole, veto rights with respect to the adoption of material resolutions brought before the General Meeting. This means that such resolutions may not be adopted unless approved by a majority (or supermajority) vote of the shareholders of the classes who were granted such veto rights.
Under the Companies Law, a Company is required to hold an Annual General Meeting at least once a year and not more than 15 months after the last Annual General Meeting. In addition, and unless otherwise specified in the Company’s AOA, the Board must convene a Special General Meeting upon the demand of one or more of the Company’s directors or the demand of shareholders holding together 10% or more of the voting rights in the Company.
Board of Directors:
A Company’s Board of Directors (“Board”) is one of the three major organs of the Company, the other two being the Chief Executive Officer (“CEO”) and the General Meeting of Shareholders (the “General Meeting”).
The Israeli Companies Law, 5759-1999, assigns certain statutory powers and duties to the Board, among them: determining the Company’s policies (including in terms of executive compensation); supervising the CEO; declaring distribution of dividends; approving the Company’s budget any debt taking; appointing the signatories of the Company; preparing and approving the Company’s financial statements; and pre-approving any interested party transactions (between the Company and its shareholders or executives). Unless otherwise specified in the Company’s Articles of Association (the “AOA”), the Board has the residual powers which are not specifically assigned to the two other organs. Moreover, if a Company does not appoint a CEO, his or her powers and authorities vest with the Board.
In private companies, the Board may be elected by a majority vote of the General Meeting or appointed by specific shareholders or classes of shareholders. In start-up companies, the Founders typically get to elect several directors and the holders of each class of shares (typically, each round of investors) are assigned a right to nominate one representative to serve as a director on their behalf. The composition and procedures of the Board are set forth in the Company’s AOA.
Controlling the Board is equal to controlling the Company. Therefore, in most cases, a shareholder who holds a controlling interest in the Company’s share capital (typically 50.1%) will appoint the majority of the directors.
Most resolutions are adopted by the Board through a simple majority vote of the directors. Yet, it is common (especially in start-up companies) that either the director appointed by the investors of the last round of investment or a majority of the directors appointed by the investors in several rounds of investments, have veto rights with respect to certain material matters which are under the responsibility and authority of the Board.
Each director owes the Company fiduciary duties and must act in the best interests of the Company. Accordingly, a director must disclose to the Company any conflict of interests he or she may have and refrain from participating in any vote on such matter.
Articles of Association:
Articles of Association (“AOA”) is the Company’s charter, and serves as a binding contract between the Company and its shareholders and among the shareholders themselves. As such, the AOA contains both informative details and governing rules and provisions pertaining to the Company, including: the name of the Company; its objects; whether the Company is private or public; its authorized share capital and the exact rights of each class of shares; the rights and duties of the shareholders; the structure of the Board of Directors and the manner in which it is required to conduct its business; the conduct of the General Meetings of Shareholders; anti-dilution provisions; and any other matter the Company may deem fit to include in connection with its corporate governance.
The AOA can be a very simple document of one page (in which case the Company will be subject to many of the default rules of the Israeli Companies Law, 5759–1999), or a very long, complicated and detailed document (which is typical for startup companies having completed one or more material rounds of investment).
The AOA is a statutory document filed with the Registrar of Companies, and any action or transaction by the Company in clear contradiction to its provisions may result in such action being null and void vis-à-vis the shareholders and third parties who are aware or deemed to be aware of the Articles.
Cap Table:
A Cap Table is a detailed spreadsheet representing the share and option holdings in the Company. Details of the Cap Table usually include: the various classes of shares; each investment round; prices paid per share (“PPS”) in current round; and each shareholder’s percentage of the issued and outstanding share capital of the Company and of the Company’s share capital on an as-converted and fully diluted basis (i.e., including options and warrants reserved or granted by the Company which have not yet been exercised for shares).
The Cap Table provides a good insight into the Company’s share capital and the ownership thereof and together with the Company’s Articles of Association (the “AOA”), it enables the viewer to fully understand the ownership structure and rights in the Company.
Shenkar-Lax Law Office (www.SL-adv.co.il) is a leading boutique law firm specializing in corporate and business law. We provide our clients with high-quality, closely-involved service, combining professionalism and personal dedication. We support and advise our corporate and individual clients in domestic and international transactions in the fields of high-tech, real estate and “old economy”. In the context of these transactions, we represent both investors (including venture capital funds and private investors) and public and private companies. We also provide ongoing legal advice to our clients on most corporate and commercial aspects of their business activities. Our Mission is to make business happen.