Customary clauses in a Shareholders Agreement with a Venture Capital

August 2008

Introduction

Financing with venture capital may be a perfect fit for a growing company that does not want or cannot add debt to its balance sheet. On the other hand, the managers of companies considering this solution should first find out about the usual requirements of venture capitalists (or "venture capitalists") before seeking such financing.

These requirements may obviously vary considerably from one country to another or even from one venture capital company to another. We wanted to highlight herein the main contractual clauses that we often find in shareholder agreements (or shareholders' pact) with venture capitalists in the main industrialized countries and aimed at unlisted companies.

Management rights of the venture capital company

As the venture capitalist generally does not benefit from a guarantee on the assets of the company to be financed, he in turn requires sufficient management rights to properly monitor the business of the financed enterprise. This is why the venture capitalist normally requires:

• controlled management rights, or veto rights, over important decisions of the company;
• as well as representation on the Board of Directors of the company.

The veto rights require the company to obtain the approval of the venture capital provider before putting forward a business decision on a specific point part of a pre-established list. For example, here are some business decisions that are often subject to a veto:

• change in the nature of the business activities;
• relocation of the head office;
• acquisitions, mergers or sales of the business or a significant part of its assets;
• significant overrun of the company's operating budget;
• issue of shares;
• declaration of dividends;
• significant increase of company’s liabilities
•  

Right of preemption

The venture capitalist will also want to protect his percentage of ownership of the company's capital stock. For this, he will require a clause allowing him to avoid dilution in the event of issuance of new shares by the company. This clause is called the right of preemption. It generally allows the venture capitalist to subscribe to any new issue of shares in proportion to its current holding, with the remainder of the new shares being offered to other existing shareholders. Sometimes this clause also allows the venture capitalist to subscribe for any shares that are not subscribed by the current shareholders of the company

Right of first refusal

The venture capitalist will very often request a right of first refusal on any sale of shares by another shareholder of the company. This right is generally for the benefit of all shareholders and proportional to the ownership of each.

Call option

There is often a clause allowing the venture capitalist to also sell his shares to a third party in the event of a sale by another shareholder of the company. The logic of this clause is often the following one: the venture capitalist relies on the talent of a management team in which he believes. But if one of the members of this management team decides to sell its shares in the company in question to a third party, the venture capitalist may also want to withdraw from the company under the same conditions.

Piggy-back option

The venture capitalist obviously has a performance objective and must one day be able to sell his equity portfolio. Therefore, in the case of an unlisted company, he must be able to enjoy a certain level of liquidity of his shares. One way to increase this liquidity is for the venture capitalist to benefit from a training right of the other shareholders in the event of an offer to purchase. Often, this clause allows shareholders who have accepted an offer to purchase from a third party to force other shareholders to sell their shares of the company.

In general, the purchase offer must have been accepted by a certain minimum percentage of the shareholders so that the piggy-back right may be exercised.

Put option

Taking care to ensure the liquidity of his investment, the venture capitalist will often request an put option clause that will allow him to withdraw on a given date. This clause can appear with many variables. For example, the venture capitalist may be entitled to require his co-shareholders to purchase his shares at a fixed price in accordance with a pre-established formula. If the co-shareholders are unable to meet this commitment, the venture capitalist may often have the option of selling the entire business to a third party.

Non-compete clause

The non-competition clause will normally prevent the shareholder-managers of the company from engaging in activities that compete with the company's operations. It should be noted that the jurisprudence of most industrialized countries has considerably restricted the scope of these clauses in terms of the activities concerned, their duration and their geographical extent. But it is quite logical that a venture capitalist will want to avoid that his associates of today compete with him tomorrow.

Conclusion

The clauses mentioned in this article are only a brief summary of the traditional requirements of venture capitalists. There is no single recipe and every venture capital company has its specific requirements. It is better to be well represented by a lawyer specialized in this type of agreement before starting negotiations with these investors.