How to efficiently advise our clients – pan-European lean investment documents

Tom Ensink
Ploum, Rotterdam
t.ensink@ploum.nl

A report on the joint session of the Closely Held and Growing Business Enterprises Committee and the M&A Law Committee, with support from the European Regional Forum, the Securities Law Committee, the Healthcare and Life Sciences Committee and the Technology Committee at the From Start-Up to IPO Conference in Paris

Monday 18 October 2021

Moderators
Marco Rizzi Bratschi, Zürich; Chair, IBA Closely Held and Growing Business Enterprises Committee
Antonia Verna Portolano Cavallo, Rome; Vice Chair, Diversity and Inclusion Group; IBA European Regional Forum
Jens Wenzel Hengeler Mueller, Berlin

Speakers
Emma Dansbo Cirio, Stockholm
Grzegorz Pobożniak Kubas Kos Gałkowski, Kraków
Luís Roquette Geraldes Morais Leitão Galvão Teles Soares da Silva & Asso, Lisbon

Introduction

Marco Rizzi and Antonia Verna kicked off the session, and explained the background of the lean documents initiative. At the Start-Up Conference in London in 2017, a discussion ensued over the need to achieve lean and internationally standardised documentation for investment documentation. The first stage was reported the next year at the Start-Up Conference in Berlin. In 2019 at the London Start-Up Conference, seven clauses were presented. Since then, the journey has continued, and meanwhile a group of more than 40 lawyers from different countries are working on this project. Since 2019 the group has been separated into multijurisdictional groups, with each group covering a sample clause.

The group is working on, and perfecting, the main seven clauses that they started with:

• warranties;
• board composition and reserved matters/shareholder rights;
• lock up provision and pre-emptive rights;
• exit;
• tag along/drag along;
• liquidation preference; and
• anti-dilution

with the aim of making the sample clauses as simple as they can be.

At this Paris session, the aim was to focus on the last three clauses, on which the speakers briefly touched. The audience was invited to share their views during the session.

The chairs further stressed that anyone who would like to join the group was more than welcome to do so, and could get in touch with any members of the committee. The materials can be found in the conference materials on the IBA website at www.ibanet.org/session-details/se_84017.

Jens Wenzel then went on to explain the scope of the project, and first started making some observations. Standard model documents can substantially contribute to making venture investments in start-ups more efficient if they are sufficiently accepted in the market. The aim, as stated, is to make the documentation leaner, crisp and easily identifiable (also for non-lawyers). This aim presents a challenge, because lawyers – by nature – tend to come with new insights that make the contracts only more complex. The second observation is that the documentation should be ‘jurisdiction agnostic’, so no references should be made to law sources. Thirdly, it is not always easy to strike a commercial balance – a clause tends to be either more founder-friendly, or more investor-friendly. An example is the question of whether a founder should personally give warranties or not. The fourth observation is that sometimes you come to the conclusion that some things simply cannot be written shorter. Then it might be better to come up with a simpler concept, for example,  as the committee has done with the liquidation preference.

Tag along/drag along

Luís Roquette Geraldes briefly explained the content of the tag along and drag along. Because of the agnostic approach, and despite the lawyers’ quest for perfection, the committee has come up with a very short principle for the tag along (or put more nicely, the bring along right): investors are entitled to demand from a transferring shareholder the pro rata co-sale of their shares, provided certain conditions are met (in short: no permitted transfer, ROFR not exercised in full, same terms and conditions as in notification). There is then a short explanation of the procedure.

Same for the drag along. The committee has chosen wording that simply states that all parties are obliged to dispose of all of their shares or pro rata part if certain conditions are met (qualified investor majority to disposal and offer, certain minimal consideration and a time limit).

The committee asked the audience if tag along rights should only be assigned to investors (such as in the NVCA in the US), or to all parties. The response varied. The committee then asked whether the clause should allow for a drag of less than 100 per cent of the shares or is 100 per cent always the case. The response from the audience seemed to indicate by majority that 100 per cent was still the case. According to one audience member 100 per cent was only in the old days. The issue is or should be whether you have control or not.

A question came from the audience about whether tags and drags should be in the agreement only or also in the corporate documentation. The committee has chosen agreement only, because of the agnostic approach.

Other remarks from the audience:

• in India you see that a minority can also drag a portion of the founders shares; and
• did the committee consider the duties of the board in relation to the drag and tag? (This was considered too complicated and dependent on local jurisdictions to include in the lean document.)

The chair then closed the subject because of the limited time.

Liquidation preference

Emma Dansbo described in brief the content of the clause drafted on liquidation preference, and explained the difference between non-participating preference shares vs participating preference shares. The committee has opted for a sample with non-participating preference shares but with a ‘higher of’ wording which does not require the preferred shares to be converted into common shares upon a liquidity event.

The committee has opted not to include conversion rights in the draft lean documents, because there may be differences between jurisdictions, and this would have become too technical for a lean document. Furthermore, the definition of Liquidity Event in the sample includes an asset sale, change of control merger, share sale and other dissolution or winding up but the committee has opted not to include the IPO in the liquidity event.

A short discussion with the audience ensued. One person said that in the UK it was practice and necessary to include conversion, because conversion was necessary to come to an IPO, and to work with the concept of a qualifying IPO (minimum amount of proceeds to be listed).

The chair then moved on to the next subject.

Anti-dilution

Grzegorz Pobożniak explained in brief the content of the clause that has been drafted on anti-dilution. An anti-dilution provision is a mechanism that serves to mitigate the dilutive effect of future stock issuances at a lower price (‘down round’) on certain stockholders having preferred shares. It is triggered when there is a new series of shares issued and typically an issue price per share is lower than the price paid for the issuance of the preferred shares. There are two types of price-based anti-dilution protection: weighted average and full ratchet.

Weighted average gives the preferred shares’ holder an entitlement to new shares issued in the down round in the amount intended to offset the dilution caused by the down round. Anti-dilution adjustment is applied based on the defined mathematical formula. The formula takes into consideration the preferred shares price, the amount of shares before down round, the amount issued in the down round and the number of shares held by the entitled shareholder. The purpose is to define what shall be the broad based weighted average price for the entitled holder of the preferred shares and how many shares shall be allotted to the entitled shareholder.

Full ratchet gives the holder of preferred stock rights to convert preferred stock into a number of shares of common stock equal to the amount invested by the preferred stockholder divided by the price per share in the current round. As a result, holders of the preferred shares effectively get a price adjustment to the price paid in the down round.

Grzegorz Pobożniak explained that the committee had considered all interests and opted for broad-based anti-dilution. Full ratchet will result in a larger conversion rate adjustment than the weighted average provision, and for that reason, is more detrimental to common stockholders than the weighted average. Full ratchet is something from the old days, and is often considered to be too aggressive in the present day. He furthermore explained that weighted average may not provide the only solution. You can also negotiate other investor friendly solutions.

Pobożniak finally noted that the committee has opted to give the benefit of the anti-dilution only to the investor.

A discussion ensued on broad-based average in general. One audience member asked if the committee has considered the ‘pay to play principle’ (requiring the shareholder to participate in future stock offerings in order to benefit from anti-dilution protection). The committee has opted not to include this in the sample. The audience member stressed that if the company was in a crisis, you could only get a combined interest if the price could not be pushed down too much by one group only.

Conclusion

Rizzi concluded the session there because of time constraints. He thanked everybody and repeated that anyone who would like to join the group was more than welcome to do so, and could reach out to any members of the committee. Also, he said, general comments were more than welcome.
 

The group will consider all comments from the audience and direct comments and the results will be presented at the next session.