Equity Financing

Equity Financing

A company can be financed by issuing new shares. The applicable procedures for share allotment are discussed in detail in [link to the previous article]. The biggest disadvantage of equity financing is that you surrender a certain degree of control of your company to the person to whom the new shares are allotted. In addition to having a system with multiple classes of shares (discussed in [link]), this article will discuss different measures that can be used in shareholder agreements to mitigate the problem. In particular, these measures guard against the risk that the new investor has complete freedom to transfer his shares unless restrictions have been agreed upon prior to the allotment.

Business Vision and Control

Both the founder and the investors share the same business vision, which is the core value to incubate the start-up business. They want to see the business develop and grow along its original business plan so that they can reap the rewards. Since the control of a business’ operation is steered day to day by its management (which will be the board of directors in a small company) and directors are appointed by shareholders of the company, it is important to lay down rules for shareholders and directors to run the start-up business effectively and to minimise disturbance from changes in shareholders’ interest.

There are four areas generally adopted in shareholder agreement by founder and investors to achieve this goal.

A.    Decisions Making

The law and the articles of association provide collective decision-making rules so that shareholders can agree on various corporate matters to avoid arguments and fights that can paralyze daily operations. These rules include procedures for shareholders’ meetings and board meetings (e.g., quorum, notice period, voting and specific resolution requirement), any nomination limits for directors (and alternate directors) by each shareholder and directors’ terms of service and authority. Moreover, funding requirement and dividend policy should be consistent with prudent commercial principles (profitability & cash resources maintenance).

B.    Restriction on Transfer of Shares

A general restriction that none of the shareholders shall dispose of their respective interests in the shares and that any such disposal of shares shall be null and void can preserve the business vision by a steadfast shareholding structure. However, a permanent restriction may give rise to shareholder deadlock which is not desirable for the healthy growth of a business, and would probably be struck down by a Hong Kong court. Below are two methods which seek to maintain a balance between flexibility and stability in the shareholding of a company.

Lock in Period

Parties may agree to a lock in period which should run from the date of investment and not be too short. A desirable lock in period may range from 18 months to a couple of years depending on the lifespan of a product or the investment payback timetable. During the lock-in period, shareholders would be disallowed from transferring their shares to third parties. After the expiry of the lock-in period, it can be agreed that each shareholder shall grant to the other shareholder (i) a right of first offer/refusal, (ii) a tag-along right.

Right of First Offer/Refusal

This is an effective measure to prevent shares from being transferred to third parties. A right of first offer clause makes it mandatory for a shareholder who wishes to dispose of his shares to first make an offer to other existing shareholders before selling to third parties. This gives the other shareholders an option to preserve the investor consortium among themselves.

So for example, it can be agreed that the transferring shareholder who wishes to dispose of its interest must give prior written transfer notice to the other shareholders setting out (i) the identity of the buyer; and (ii) the price and terms proposed by the buyer. This piece of information is crucial for the existing shareholders to appraise the ability of their potential co-investor and the valuation of the interest by an outside third party, by means of which, the existing shareholder may evaluate if the potential investor shares the same business vision as they do.

If an existing shareholder elects to exercise its priority right to purchase the shares at a price that is not bettered by the third party buyer, then the shareholder seeking to dispose of his shares will be prevented from selling to the third party.

If they refuse to exercise the right, the transferring shareholder may sell its interest to the buyer within a period with an obligation to procure the buyer to sign a new shareholder agreement. This will bind the newcomers to core values of the business and ensure the continuity of the undertaking and obligation of the outgoing shareholder.

Tag along

When a shareholder’s shares are to be bought by a third party, a tag along clause would entitle the other shareholders to elect to have their shares to be sold to the same third party and at the same terms.

If the existing shareholders do not exercise their right of first offer/refusal, these shareholders may give written tag along notice to the transferring shareholder of its intention to dispose of their shares and shall have the right to sell their shares on the same terms and conditions as specified in the transfer notice. Then, the transferring shareholder shall not be entitled to dispose of its interests to the buyer unless the buyer agrees to purchase the interest of the transferring shareholder together with the interests of the other existing shareholders.   

C.    Events of Default

The success of the business depends much on shareholders honouring their obligations as well as their well-being. There are occasions that a shareholder is unable or fails or neglects to pay its due portion of shareholder’s loans (provision of security)required to be contributed, shareholder commits any material breach of or omits to observe any of its material undertakings or obligations, inability of shareholder ( a court order against the shareholder, insolvent, bankrupt, winding-up, liquidation or dissolution of the shareholder), the shareholder suspends,  ceases or disposes the whole or a substantial part of its business.

It should be agreed that in such cases, the rights of the defaulting party (nomination to board, vacation of board nominee, entitlement to dividend etc.) should be suspended and the defaulting party should be allowed to remedy within a prescribed period, if it fails, there should be procedures allowing dilution by non-defaulting party to buy out the shareholding of the defaulting party at a valuation determined according to a predetermined formula.

D.    Dispute Resolution

Shareholders must co-operate to resolve any differences. Voting majorities are designed to facilitate this. Nevertheless, parties may agree beforehand to a predetermined recourse for dispute settlement, such as mediation or arbitration.

Checklist – You should know: The meaning of equity financing and its mechanism, namely financing by issuing of shares;The different goals of founders and investors in equity financing and how can they can be entertained through legal devices;The decision-making power attached to shares;The common restrictions placed on transfer of shares; andThe disputes that commonly arise in relation to equity financing and how they can be tackled.
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