Certificate of Incorporation
Although some private placements involve the sale of common stock, many investments by sophisticated investors involve the purchase of preferred stock. The terms and conditions, and the rights and preferences related to preferred stock are found in a company's certificate of incorporation. It is common for companies to establish provisions in their original certificate of incorporation that permit the board of directors to negotiate preferred stock terms and then simply file the negotiated terms. This alternative is known as blank check preferred.
When a company does not have blank check preferred stock available, the company will negotiate the terms and conditions of the preferred stock security that it desires to issue, and then submit the proposed terms and conditions to the shareholders of the company. Submitting the terms and conditions to shareholders is required in order to amend the certificate of incorporation of a company that does not have blank check preferred. Most privately held companies have not made this election at the time of their incorporation, and as a result, this alternative is not available to them at the time of their investment closing.
In addition to traditional terms and conditions found in a company's certificate of incorporation, when an investor finalizes a preferred stock investment, the terms and conditions of the preferred stock will be included in a company's certificate of incorporation. There are several fundamental rights and privileges granted to the holders of preferred stock and these rights and privileges are described in detail in the certificate of incorporation. The rights and privileges include the following categories: dividends, liquidation preference, voting, conversion (including adjustments to the conversion price or antidilution protection), and redemption.
The dividends section of the certificate of incorporation may include provisions indicating that no dividends are contemplated to be paid, that dividends will be paid at a specified rate when and only when declared by the board of directors, or that dividends will accrue on the preferred stock at a specified rate whether or not declared by the board of directors. Dividends that accrue whether or not paid are known as cumulative dividends.
Where preferred stock is created with alternative dividend payment terms, a description of the alternative is contained in the certificate of incorporation. Alternative terms may involve dividend structures that permit the company to make dividend payments in kind (PIK payments). PIK payments ease the cash flow demands of a company and may be elected by a company under the terms of the certificate of incorporation. The contrast between a PIK dividend and a cumulative dividend is that in the PIK alternative, the company issues a note or share of stock based on the fair market value of the company's stock. If the issuer is public, the dividend recipient can then sell the security and receive liquidity for the dividend payment that is not available if the dividend is cumulative.
Preferred stock receives its senior financial attributes in the liquidation preference section. It is in this section that the preferred stock is designated straight preferred, convertible preferred, or participating preferred. In today's financial environment, a very high percentage of investments in early stage companies include participating preferred features. As the strength and maturity of a company increases, the percentage reduces and the primary vehicle for investment is convertible preferred.
Attributes of straight preferred are focused primarily on the holder receiving the original amount of the preferred plus accrued but unpaid dividends prior to the receipt of any return.
Although the section is labeled liquidation, the certificate of incorporation contains a section that obligates a company to treat mergers and acquisitions, and the sale or lease of all or substantially all of the assets of the company as a liquidation. In the event that the holders of preferred stock determine that liquidation treatment is not in their best interests, they can elect out of the treatment.
Convertible preferred permits an investor to view a liquidity event and to evaluate the investor's potential return under alternative financial scenarios. The alternatives permit the investor to compare returns generated by taking the original amount of investment plus accrued but unpaid dividends, and comparing this amount with the investor's pro rata amount of proceeds of the liquidity event assuming conversion of the preferred stock to common stock.
Participating preferred generates the highest return to an investor in that the investor takes both of the alternatives available to the holder of convertible preferred. These returns include an amount equal to the original investment plus accrued but unpaid interest, and an amount equal to the holder's pro rata share of proceeds on an as converted to common stock basis.
Preferred stock is granted voting rights in most early stage, venture capital, and private equity investments. In later stage companies, especially publicly traded companies, preferred stock voting rights are not granted.
The number of votes that a holder of preferred stock is entitled to cast is equal to the number of shares of common stock into which the preferred stock may be converted. The preferred stock may be granted separate rights to elect a designated number of directors to the board of directors of the company. These rights are negotiated frequently where the investor takes a minority position in the company. In the absence of a special certificate of incorporation provision, the investor would not be able to elect any director. After electing any designated board member, the preferred stock may vote with the remaining common stockholders for the election of the balance of the board of directors.
The voting section also contains a description of the protective provisions that the investor negotiated as part of the term sheet. These protective provisions are included in the certificate of incorporation to place the rest of the world on notice that the company may not take certain actions without the approval of the holders of preferred stock. The actions requiring preferred shareholder approval include: no liquidation of the business, no amendment to the articles of incorporation, no creation of a class of securities senior to the preferred stock, no redemption of shares, no dividends on shares, no borrowing in excess of specified amounts, and no increase or decrease in the size of the board of directors. The list of prohibited items is longer in some cases, but the actions just described are considered so fundamental to the financial interests of the preferred shareholder that they are almost always included in some form.
Conversion rights are normally divided into two categories - voluntary and mandatory conversion. Voluntary conversion may be elected by the holder of preferred stock at any time. Mandatory conversion is triggered by two primary actions - either a company's initial public offering (IPO) or a vote of the majority of the holders of preferred stock to convert. An IPO triggers mandatory conversion because investment bankers taking the company public do not want the company's capital structure complicated by the rights negotiated by the holders of preferred. These rights are viewed by public shareholders and institutions as concentrating too much power in too few hands. Consequently, access to the public markets and their liquidity is normally sufficient to convince preferred stock investors that mandatory conversion at the time of an IPO is consideration commensurate with the loss of preferred stock rights.
Conversion is the process by which an investor moves from the debtlike preferred instrument into the common stock category in order to take advantage of the participating features of common stock. The factor that determines the number of shares that an investor is entitled to receive is called the conversion price. The calculation of common shares is simple arithmetic. The aggregate investment amount is divided by the conversion price to determine the number of common shares to be received by the preferred stockholder. In the calculation, one variable that can dramatically change the calculation is the manner in which accrued but unpaid dividends are treated. In early stage or venture capital-backed deals, although the dividends are stated as being cumulative, they are hardly ever declared. As such, the typical early stage conversion section would take the original purchase price and divide by the conversion price with no other adjustments. As companies mature and the investor groups begin to include private equity investors or the companies are publicly traded, the calculation of the number of common shares does include accrued but unpaid dividends. Where the preferred stock has been outstanding for several years, the initial percentage ownership of the preferred stock holders creeps up quickly.
In most instances involving privately held companies, the conversion price is fixed and it is only adjusted in the event that the company issues shares at a price less than the price paid for the preferred stock. If the company does issue shares at a lower price, then an adjustment mechanism is triggered and the number of shares into which the preferred stock may be converted is increased. There are two basic mechanisms for adjusting the conversion price - weighted average-based and ratchet-based antidilution. These mechanisms are illustrated previously in the section describing the negotiation of the term sheet.
When a small-cap public company issues preferred stock in a private placement, the conversion price in many cases is not fixed. These equity issuances, otherwise known as private investment in public equities (PIPE) investments, have conversion prices that float based on the price of the company's registered shares on the date that an investor converts. For companies with undercapitalized balance sheets, the attraction of a PIPE investment is significant. The funds may be raised quickly, and there are thousands of investors with funds willing to make an investment in large or bulk purchases where the investment can be liquidated quickly. In order for the investment to be liquidated, the underlying shares of common stock must be registered; this is normally a process that must be initiated by the company immediately after the investment is finalized, and the registration process must be completed within a limited period of time in order to avoid penalties.
In the context of a public company, a situation arises frequently that is known as the death spiral. In this situation, the preferred stock is issued and in unrelated transactions, investors begin to short the public shares. The shorting process places significant downward pressure on the company's share price and as the price falls, the number of shares into which the preferred stock may be converted increases directly in proportion to the fall in share price. As the number of shares that could potentially be outstanding in connection with the conversion of the preferred stock increases, the market responds by reducing the value of each share. Now with downward general market forces applying downward pressure in connection with the shorting process, the share price spirals downward. In order to reverse the spiral, the issuing company must be able to use the proceeds of the preferred stock offering to bolster sales and revenue; however, in most cases, the investment proceeds for these smaller companies is used to satisfy existing obligations and not for growth opportunities.
As a result, the companies are permanently relegated to penny stock status, and due to the reduced share price are unable to raise additional capital. The only solution for many of these small-cap stocks is a formal insolvency.
Redemption provisions provide moderate protection for investors involved in investments that are going sideways. These provisions are included in the certificate of incorporation in order to provide investors with a potential exit strategy where the company is not qualified for an IPO, and the performance of the company precludes a merger or acquisition at an attractive price. Pricing of the redemption is based on either the original investment plus accrued but unpaid dividends, or an amount equal to the fair market value of the common stock into which the preferred stock may be converted. The investor selects which valuation method to use, and the company is obligated to purchase the stock in cash if available, or if not, in installments over typically a three-year period.
Investors' Rights Agreement
The investors' rights agreement covers four primary rights granted to investors in connection with preferred stock investments. These rights may not be amended or reduced without the approval of a majority of the preferred stockholders. The primary rights include securities registration rights, information rights, preemptive rights to acquire new securities issued by the company, and a grouping of affirmative and negative covenants to which the company must adhere.
The registration rights section of the investors' rights agreement includes three types of rights granted to investors. These rights include demand registration rights, incidental or piggyback registration rights, and short-form registration rights. Shares covered by these registration rights are known as registrable shares. Investor expenses incurred in connection with these offerings are paid for by the company, but any underwriting discounts or commissions are deducted from the proceeds otherwise payable to the investor. The company agrees to maintain all of its SEC filings and reports at any time that it is publicly traded and there are registrable shares held by investors.
Demand registration rights are granted to investors at the time of purchase of the preferred stock, but the rights do not vest until the earlier one of two specified periods of time have lapsed. It is customary for an investor to receive two such demand rights. The vesting periods are stated as either a fixed amount of time such as five years, or the passage of 180 days after the effective date of a company's initial public offering. Both rights are coupled with minimum dollar amounts of shares that must be offered for sale in order to trigger the registration right, and most minimums are at least $5,000,000, with $10,000,000 being a typical trigger in early stage venture financings. Demand rights generally terminate in the event that the investor can sell all remaining shares within one 90-day period under Rule 144 without restriction.
Each of the terms incidental, piggyback , or company registration describes the same right granted to investors under the investors' rights agreement. This right permits a holder of registrable shares to add shares to any offering of securities for cash that is proposed by the company, with certain exceptions. Generally excluded from this right are registrations for company combinations in connection with mergers and acquisitions under SEC Rule 145 transactions and registrations related to securities underlying convertible debt instruments. The company is obligated to give the holder of registrable securities advance notice of any company registration, and the holder a reasonable amount of time to decide whether to participate in the offering. If the holder decides to register shares, the shares will be liquidated in connection with the offering. Investors are typically granted an unlimited number of company registration rights.
Short-form registrations provide an opportunity for investors to take advantage of SEC rules permitting streamlined registration guidelines on the use of SEC Form S-3 for companies that have been public for more than a year. Because the restrictions on the use of Form S-3 other than the one year requirement and timely filing of all periodic reports are related to issuances by the company, using SEC Form S-3 for registration of investor shares is efficient and available for many smaller companies. Investors will normally be subjected to aggregate dollar minimums of $1,000,000 to $5,000,000 per filing and a maximum of one or two registrations per year.
Conditions applicable to an IPO registration include so-called lockup agreements, in which investors agree not to sell stock within 180 days of the effective date of an offering. With respect to company registrations and short-form registrations, all investor rights are subject to blackout periods during which the company may suspend a registration statement if the board of directors determines in good faith that it would be detrimental to the company to continue with the registration. This option is exercised when a company believes that a material event may occur during the registration period, and the company determines that it is not ready to disclose the event because disclosure could jeopardize the event such as an acquisition or because the disclosure is premature and there is a reasonable business purpose served by maintaining the confidentiality of the information in the short term.
Because many investors take a minority position in their portfolio companies, they do not have the voting power or board power to force a company to provide them with ongoing information unless the obligation is negotiated in connection with the closing of the investment. Information rights fall within this category of rights, and included within this negotiated right will be an obligation on the part of the company to provide monthly and quarterly unaudited financials, annual audited financial statements, and annual budgets delivered 30 days before the beginning of any fiscal year. All statements are required to be prepared in accordance with GAAP, applied on a consistent basis throughout all periods covered, with the only exception being that the monthly and quarterly statements may be subject to normal year-end adjustments and the statements may not contain all footnotes otherwise required to comply with GAAP.
Investors' rights agreements normally contain provisions that provide an investor with the right to protect the investor's pro rata percentage ownership of the company. The right is called by a variety of names including first right of refusal, right of first offer, option to purchase, or preemptive right. In each case, the company must provide notice to an investor of any issuance of securities. The investor has a predetermined number of days to elect to purchase the offered securities. If the offer is declined, a company may then sell the offered securities to a third party on the same terms within a set period of time, normally not more than 90 days. If the proposed sale has not been consummated within the designated time period, or in the event that the company changes the terms of the proposed sale, then the company must again permit the investor an opportunity to purchase the securities offered. Standard exceptions to the right include issuances under a preapproved option plan, shares issued in connection with an IPO, and securities issued in connection with mergers and acquisitions.
Affirmative covenants negotiated by an investor include an obligation on the part of the company to obtain standard confidentiality, noncompete, and nonsolicitation agreements from all employees. In addition, the company normally agrees that it will not grant employee options unless the grants have predetermined vesting schedules.
Negative covenants typically require the approval of a majority of the holders of preferred stock before the company can engage in specified activities. The activities include prohibitions on loans to third parties, guarantees of third party debt, investments in third parties, borrowings in excess of agreed-upon and budgeted amounts, transactions with affiliates, setting or changing compensation to senior executive officers, or selling, transferring, or encumbering the intellectual property of the company.
The shareholders' agreement contains two categories of agreements. The first agreement grants investors and the company the right to purchase shares of stock that owners desire to sell. In addition, this agreement covers the situation where owners have identified purchasers for their shares, and in this case, the owners are obligated to permit the investors to sell shares to an identified purchaser on a pro rata basis.
The second type of agreement relates to voting matters. In a voting agreement, all of the owners and investors will agree to vote their shares in accordance with the terms of the agreement. These terms include voting for a specified board size and specified board members, as well as a requirement on the part of owners to vote with investors in the event of an acquisition approved by a majority of the shareholders of the company. This vote requirement that is associated with an acquisition is known as a drag-along right. Investors negotiate a drag-along right in order to avoid conflicts with minority owners who may not want to sell the company at this time or on the terms as negotiated. The drag-along right precludes minority shareholders from exercising dissenters' rights. Dissenters' rights provide minority shareholders a mechanism for challenging the value of an acquisition through a third party valuation. Signing a drag-along right eliminates this dispute resolution mechanism, because if exercised, dissenters' rights proceedings are disruptive to the closing of a transaction.