There can be many good reasons to invest in a company but what safeguards will you have? Will others, perhaps with more shares or a different class of shares to you, have disproportionate levels of control or receive greater dividends? In the absence of a shareholders’ agreement it is the articles of association that set out how a company should be run, governed and owned.
The articles of association will set out which decisions the directors can make and which are reserved for the shareholders. A prudent investor should therefore check the articles to ensure that, while directors may have general authority to make decisions relating to the “management of the company’s business”, they have not given themselves any extra powers. For example, directors do not normally have the right to determine their own remuneration, which is more properly a matter requiring shareholder approval.
In addition to checking that the directors do not have any excessive or unusual powers a prudent investor would also want comfort that the following areas have appropriate provisions:
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1 Voting rights
If a company is not being well run the shareholders (who after all own the company) will want to remove the deficient director or directors and replace them with someone more competent. Provided due process is followed, a director can be removed by a simple majority of votes at a general meeting. So it follows that if a director has more than 50% of the voting rights the other shareholders will not be able to remove them by a vote. This is not to say that you should never invest in a company where a director or the directors control more than 50% of the voting rights but if you are unsure about the directors do be alive to the fact that if they fail to perform you are unlikely to be able to replace them.
Also, when making an investment check which type of shares you are buying. If there is just one class of share and these shares carry the standard one vote per share it is quite easy to calculate how much you will be able to influence matters at a general meeting. It will be harder if there is more than one class of share since they could each have different voting rights. The different rights range from zero or restricted voting rights through to enhanced voting (multiple votes per share held). So, unless you know the rights and number of shares in issue for each class it is impossible to ascertain how valuable the voting rights attached to the shares you are buying will be.
The main reason an investor will buy shares in a company is in expectation of a return on their investment. The most usual form this return takes is right to receive a share of the profits paid out as dividends. The expectation would be that each share has an equal right to dividends i.e. dividends would be received in proportion to the holding in the company. However, be aware that if there are different share classes they sometimes have different entitlement to dividends.
Investors should check that each share has the same unrestricted right to dividends as all the other shares and the dividend entitlement of the shares being bought are not capped or limited in any way.
3 Proceeds on sale or winding up
When a company is sold (or wound up) it is often the moment a shareholder expects to realise a significant return (or loss) on their investment. The Articles of Association will usually provide that entitlement to any capital from a sale or winding up is in direct proportion to the shareholding in the company.
However, it is not uncommon, especially for early stage investors to seek to vary the usual position to ensure that they will get as much of their investment back as possible. Indeed, before investing they may have insisted on a ‘liquidation preference’ provision, i.e. a right to receive a sum equal to the amount of their initial investment before any of the other shareholders receive anything. What happens to the balance (if there is any) varies. Sometimes provisions will stipulate that any residual amount is then distributed pro rata to the other shareholders or even that the balance is distributed pro rata to all shareholders including those who had the benefit of a liquidity preference payment.
Before investing always consider whether any other investor has a liquidation preference which would place them ahead of you on a distribution or indeed whether this is something you should ask for.
4 New shares
Growing companies are in the habit of issuing new shares to fund their expansion. While this can be a good thing, a prudent investor should make sure there is an appropriate provision giving them a right of first refusal on any new shares being issued by the company. These provisions are usually referred to as pre-emption rights. The purpose of pre-emption rights is to give existing shareholders the ability to maintain their percentage interest in the company and avoid unwanted dilution.
The Articles of Association typically stipulate that the company will offer new shares first to the existing shareholders pro rata to their existing shareholdings. This means that if you have a 5% shareholding then provided you take up your rights (and purchase the new shares you are offered) you will retain a 5% interest in the company. However, if you do not take up all of your entitlement you can expect to be diluted. Where the Articles of Association contain pre-emption rights companies can seek to disapply them by special resolution.
5 To freely sell or transfer shares
It’s all very well making an investment but what if you subsequently want to sell or transfer some or all of your holding? Some companies will draft their articles of association giving their shareholders a completely unrestricted right to sell or transfer their shares to whomsoever they please. At the other end of the spectrum the shareholder may have almost no ability to sell or transfer their shares where the director(s) have an absolute right to ‘block’ any proposed change in the company’s ownership.
For most companies a middle course is struck by the inclusion of pre-emption rights on share transfers. These allow shareholders to sell their shares to a third party so long as they offer them to the other existing shareholders first. The entitlement of the other shareholders to purchase the shares being offered for sale is usually in proportion to their current holding.
6 Drag along rights
If a company is raising capital from a number of different investors – often the case in crowdfunding – then the majority shareholders will often reserve themselves a right to compel any minority shareholders to join in a sale of the company. This right is generally called ‘drag along’. The majority shareholder or shareholders who may well be the ones negotiating the sale of the company, will want to give comfort to the purchaser that they will be able to deliver – if wanted – 100% of the company. If minority shareholders are ‘dragged along’ these rights will ensure they receive exactly the same deal – in terms of consideration and any other payment terms – as all other sellers, including the majority shareholders.
7 Tag along rights
Where you find ‘drag along’ rights you will invariably also find ‘tag along’ rights. If a large shareholder sells his or her stake in a company, then minority shareholders may want a right to join the transaction (‘tag along’) and sell their minority stake. This is a protection that any minority investor should seek if they want to avoid the possibility of a number of shareholders selling their stake and then being left as a minority shareholder in a company that no longer has the same prospects.
A ‘tag along’ right is, however, not usually automatic. Generally, it will only apply if the shareholding, or combined shareholding if more than one shareholder has received an offer for their shares, exceed a certain threshold. If this is the case then the offer cannot proceed unless the same offer is made available to all the other shareholders on exactly the same terms. However, if the offer is for a number shares below the threshold then the tag along rights will not apply. Clearly, the matter of criticality is the threshold above which the tag along rights apply – often 50%.
These 7 items are things that every potential investor should consider checking in a company’s articles of association. There may also be others, especially when the company has very bespoke articles – it’s therefore worth checking through thoroughly and querying anything that you’re unsure about or uncomfortable with.
There will also be areas not covered by the articles that the prudent investor would want to investigate. We’ve already mentioned shareholder agreements. A further important example is the existence of share options or warrants. These give people the right to acquire new shares in a company, which if exercised would have the effect of diluting existing shareholdings. While we’ll look in detail at options in another article, when considering an investment in a company it’s worth checking the existing of any option schemes either already in existence or planned.
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