Legal risks of investing in startups of companies in the USA and Israel

By itself, investing in a startup is a high-risk investment, and if things go wrong, no legal documents will help. Also, if the idea turns out to be super successful, the income will be enough to get a bonus to all investors. Legal nuances are important for intermediate situations when the project is launched and it is necessary to raise new funds for development or move towards the exit, for example, through a sale to a strategic investor. If a startup generates income, the conditions for the participation of investors in income distribution become important.

The legal infrastructure of the United States and Israel is quite developed and helps protect the interests of investors, and therefore the startup market in these countries is booming. It should be noted that the founders of startups (founders) are not always attentive to the formation of legal documents, in connection with which legal expertise can delay transactions.

This article discusses some of the legal risks of a civil nature associated with investing in the purchase of preferred shares (preferred shares) in companies in the US and Israel. The following questions should be borne in mind both at the stage of signing an agreement on the basic terms of a contract (term sheet), and at the stage of signing documents on a transaction. Despite the fact that the term sheet is not a binding document (except for certain provisions, for example, on arbitration and confidentiality), there are rare cases when the conditions agreed in it are revised.
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In the overwhelming majority of cases, all the provisions discussed below are contained in the company's articles of association (Articles of Association) or in the Investors Rights Agreement, some are specified in the Share Purchase Agreement.

1. The risk of incorrect assessment of the percentage of the package received as a result of investments

Not only the amount of income is tied to the percentage of ownership of shares, but a number of essential rights, such as, for example, the preemptive right and the right to joint sale (disclosed below), and therefore the ownership percentage should be calculated as accurately as possible.

All information on the share capital before and after attracting investment should be contained in the documents to be signed (pre-money evaluation and post-money evaluation). At the same time, special attention should be paid not only directly to stocks, but also to other instruments that can be converted into stocks - loans (convertible loans), bonds (notes) and others, as well as reserved shares, for example, for transfer to staff as Bonus (pool), brokers, attracting funds for warranties issued and more. Optimally, all other instruments before investment would be converted into ordinary shares, thus avoiding confusion when calculating the percentage of ownership.

2. The risk of incorrect evaluation of the package after conversion

Understanding the percentage received in the conversion process is essential for estimating the possible income when the events are associated with the conversion, as well as for estimating the size of the package when voting on as converted basis (that is, as if the shares were converted by the time of voting) . In the latter case, for example, an incorrect assessment can lead to the impossibility of appointing a representative on the Board of Directors (Board). Also, an accurate understanding of the number of shares after conversion under certain conditions allows you to make a more accurate choice when exiting: stay in preferred shares or convert to ordinary shares.

3. Risk of share erosion

To protect the investor from dilution of his share, preemptive rights and anti-dilution provisions are used.

The preemptive rights give the investor the right to buy back shares of new issues primarily to new investors, which allows him to retain ownership in the authorized capital by participating in the subsequent investment. This right should not be confused with the right of preferential redemption (rights of first refusal) granted to the company and its founders - owners of ordinary shares and the company, which allows the redemption of shares sold by other shareholders to these persons.

As an alternative, anti-dilution provisions can be used, which provide the ability to automatically save a share upon a new issue of shares (full ratchet) or partial saving calculated by the formula (weighted average). There are also combined options that provide for both preemptive rights and anti-dilution provisions, and therefore these provisions should be studied in detail.

4. The risk of incorrect calculation of dividends

If the purpose of a startup is to receive dividends, then the order of their calculation and payment will be essential for the investor. The right to receive dividends on a priority basis is a distinctive feature of holders of preferred shares. In startups, the three most common dividend structuring options are: cumulative, non-cumulative, and paid after ordinary shares.

Cumulative dividends are paid upon the occurrence of a so-called. liquidation events (liquidation event), which includes both the sale of the company and its liquidation in the framework of a takeover. Dividends are accumulated during the implementation of the project and are paid priority to dividends on ordinary shares. Cumulative dividends may have a simple calculation linked to the stock price, and may also include in the calculation unpaid dividends for the previous period.

Non-cumulative dividends are paid only if the Board of Directors has decided to pay them, while payments are made priority over dividends on ordinary shares.

The third method of distributing dividends assumes that payment on preferred shares is made only after payments on ordinary shares. In this case, it is assumed that preferred shares are treated as converted to ordinary shares for the purpose of paying dividends. In its pure form, this method is used extremely rarely, since it is absolutely disadvantageous for owners of preferred shares. More often there is a truncated variant, when such a distribution of dividends is valid until a certain moment, for example, until the return of investments to the founders of the company.

5. The risk of non-participation in the sale of the company

In the course of the project, the company or its founders may receive an offer to purchase the company. In such a situation, owners of preferred shares should participate in the proceeds of such a sale. These relations are governed by the provisions on preferences for sale (distribution preference, liquidation preference) and on joint sale (co-sale).

Preferences during the sale allow to establish the conditions under which payments are made to holders of preferred shares during the liquidation or sale of a company within the framework of a takeover. The amount of payments is usually tied to the price of acquisition of one share, while the multiplier is set, allowing to determine the size of payments. The multiplier can be used simultaneously with the calculation of dividends. For example, a payment of double the value of a share plus 7 percent of the cumulative dividends of a simple calculation may be provided for.

There are two main types of preferences for sale: with participation (participation) and without participation (non-participating) in an additional distribution. Holders of preferred shares with participation in the additional distribution are entitled not only to receive the amount relying on them by calculation, but also the additional amount after all preferences are paid, as if the preferred shares were converted into ordinary shares.

Holders of preferred shares without participation in the additional distribution have no right to claim such additional payments. At the same time, it should be noted that preferred shares can be converted into ordinary shares, which allows the holder of preferred shares to choose which rights to use in the distribution: the holder of preferred shares or the owner of ordinary shares.

The co-sale provisions govern the investor’s participation in the sale of shares if the founders intend to sell their shares and the right of first refusal does not apply. Owners of preferred shares in this situation have the right to participate in the sale of shares in proportion to the redeemed package, and if as a result of the sale the founders lose a controlling stake, then in most cases it is considered as a liquidation event, entailing the use of the sale preferences.

6. The risk of the impossibility of transferring shares to an affiliated structure

Most documents contain a description of the permitted transferee, allowing the transfer of shares to associates. Special attention should be paid to the wording of these provisions, as well as to the presence of other restrictions (for example, the consent of the Board of Directors may be established as a mandatory condition for sale).

7. The risk of changing the documents establishing the rights of investors

The documents should clearly state that the provisions relating to investors cannot be changed without their consent (for example, changes to the relevant articles of the Charter and the investor rights agreement can be made only by the decision of the majority of holders of preferred shares).

8. Risk of loss of control over assets.

When evaluating the assets of the acquiree, if there are subsidiaries, it is necessary to pay special attention to the distribution of these assets within the group and to check whether corporate documents provide control over these assets. There are often situations when a parent company is offered for the purchase, which is only the owner of the working company’s shares and does not own any assets. In this case, it is required to verify whether these assets are at least controlled by the parent company’s board of directors.

Since when deciding to invest in a particular company, the investor is guided primarily by assessing the professionalism of key team members, the documents to be signed must include conditions for non-competition and non-solicitation, also relevant agreements should be concluded between the company and relevant key personnel.

Separate research deserves verification of the presence of intellectual property rights on objects necessary for the implementation of the project. This includes determining what license agreements are, as the company may be bound by obligations to grant rights to third parties or individual investors.