Preferential Rights For Start-up Investors (No. 5)

Sooner or later, start-up founders have to face the fact that investors demand not only a proportional share in the company's equity in return for their financing, but also additional preferential treatment. Such preferential rights are enshrined in contractual and/or statutory rules. In most cases, a specific class of so-called preferred shares is created in the course of a capital increase, which are allocated to the respective preferred investors in return for their investment. Preferential rights can generally be divided into economic rights, such as a preferential right to sales proceeds, and qualified participation rights.

For founders, every preferential right weakens their position in the company beyond the mere transfer of a proportional share in equity. The higher the company valuation accepted by the investor, the more likely founders are to agree to preferential treatment for such investor. Economic preferential rights in particular are therefore directly related to the company valuation: the higher the valuation, the more likely it is that extensive preferential rights will be acceptable. The lower the valuation, the less willing founders are to grant investors additional rights.

However, preferential rights do not only burden the founders. The more financing rounds a start-up goes through, the more likely it is that new preferential rights will also affect earlier investors who themselves have preferential rights but are downgraded in seniority.

Qualified participation of investors at the board of directors and general meeting level

An important preferential right for investors are qualified participation rights at the board of directors and general meeting level. These rules can be achieved by introducing qualified quorums and/or by representation of the investor on the board of directors.

Qualified quorum

Qualified quorum rules distinguish between attendance quorum requirements and decision-making quorum requirements. Attendance quorums are rules that stipulate that certain persons (shareholders at the general meeting level or board members at board meetings) or groups of persons must be present in order for the general meeting/board of directors to be quorate and validly take decisions. Such attendance quorums are often mitigated by a provision whereby, if the quorum is not reached, the same items are placed on the agenda of a second meeting which can be held within a pre-defined period of time and where attendance quorums no longer apply. This prevents a company from being paralyzed through one person or a group of persons simply by not showing up.

Voting quorums are qualified majority rules whereby certain persons or a certain number of members of a group of persons must agree to a resolution for it to be valid.

When several investors invest in a particular class of preferred shares, they usually agree on certain qualified majorities (e.g., for shareholder decisions, a majority of all shares and at least 50% of the preferred shares). At the board level, such qualified majorities can be achieved in various ways, e.g., by a group of investors agreeing on the nomination of a board member or by several investors of the same class being represented by several board members, whereby not all of these board members having to agree to a decision (e.g., 2 out of 3 investor directors). If there are several classes of investors, these rules are negotiated not only between the company and new investors, but also between the investor groups, which can lead to different representation rules between the individual share classes. For example, Series A investors must agree on one board member, while two Series B investors may each appoint one board member. However, in addition to a simple majority on the board of directors, a qualified majority also requires a majority of all investor representatives (2 out of 3 Series A and Series B representatives).

Veto rights

A regularly raised demand by investors is a veto right, either on all or certain decisions in the board of directors or the general meeting. Veto rights for certain groups (e.g., founders, individual share classes) are now standard. These groups are thus given preferential treatment on certain issues, but must first come together as a group in order to exercise these veto rights. If an individual shareholder (e.g., a large new main investor) wants a veto right, this should be avoided at all costs. Veto rights for individual shareholders inevitably lead to disputes, even if the shareholder in question exercises their right to the best of their knowledge and belief, because the mere accusation of abuse can lead to disagreements within the shareholder body or with potential new investors. 

Economic rights

Dividends

In its early years, a start-up often does not generate sufficient income to pay dividends. A preferential dividend right for investors is therefore usually a purely mathematical entitlement that only applies in the case of predefined transactions with proceeds paid out to shareholders. In concrete terms, this means that a certain percentage is calculated for the years of an investor's participation and taken into account when determining the liquidation proceeds. Such dividend rights can significantly shift the distribution of liquidation proceeds in favor of newer investors and at the expense of earlier shareholders.

A distinction is made between the cumulative dividend, which is added up as an annual calculated number, and the non-cumulative dividend, which is paid out once with the liquidation proceeds. Cumulative dividends in particular can lead to a considerable advance skimming in the distribution of liquidation proceeds for everybody else, thereby disadvantaging founders and early investors compared to later investors with preferential dividend rights.

Liquidation proceeds

Preferential rights to liquidation proceeds refer to the right to receive proceeds from company sales or comparable transactions (e.g. sale of important assets or licensing of key intellectual property rights) in a specific order. This means that preferred shares with seniority over other shares are paid out first, and depending on the amount of the proceeds, this can even result in individual share classes receiving no proceeds at all. With liquidation proceeds preference rights, a general distinction is made between "non-participating" and "participating" rights. With non-participating rights, investors either receive only the amount they invested (or a multiple thereof, e.g., 1.5×) or they must waive their preference right and then receive only the share of the proceeds corresponding to their capital participation. With participating rights, investors receive their investment amount back and participate proportionally in the proceeds remaining after all preferential rights have been satisfied.

Anti-dilution protection

Another economic preferential right that is often demanded by investors is the anti-dilution protection. Compared to dividend rights or rights to liquidation proceeds, antidilution protection is not aimed at the end of an investment, but is primarily a preferential right in the event that future financing rounds have to be closed at a lower valuation. In such cases, investors want to secure the right to subscribe for additional shares at a low price (usually nominal value) and be treated, in whole or in part, as if they had also invested at the lower price.

For founders and early investors in particular, subsequent rounds with lower valuations that trigger anti-dilution protection are burdensome, as they do not benefit from these additional subscription rights and are therefore unable to maintain their ownership structure to the same extent and at the same prices.

Information rights

In addition to participation and economic preferential rights, it is understandably also important for investors to be given certain preferential information about the company's business performance. Information rights are intended to ensure the timely delivery of quarterly, half-yearly, and annual financial statements and to enable investors to address specific questions on specific issues to the company. Professional investors in particular rely on this information to prepare their internal and external reports.

How are preferential rights regulated?

Preferential rights are usually regulated in shareholders' agreements. Investors are interested in seeing their negotiated preferential rights reflected not only in the shareholders' agreement, but also, if possible, in the company's articles of association. If preferential rights are only included in the shareholders' agreement, they are purely contractual agreements between the parties to the shareholders' agreement. The parties promise each other to take the necessary actions to realize the preferential rights. If such preferential rights are registrable and are also reflected in the articles of association, they become obligations under company law and the company is also obliged to realize them.

When structuring preferential rights in the shareholders' agreement, the parties have considerable freedom in formulating the outcome of the negotiations. However, if the preferential rights are also to be reflected in the articles of association, this is often only done in simplified form. In practice, the commercial registers only enter a few rights and usually only in a very superficial form (qualified majority at shareholder level, dividend and liquidation privileges (in the event of liquidation, not in the event of a sale of shares), anti-dilution protection). If a new investor attaches great importance to a specific wording in the shareholder agreement and in the articles of association, we therefore strongly recommend a preliminary check with the relevant commercial register.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.