Navigating Venture Capital Agreements: Key Legal Considerations for Startups

In Short

• Key Equity Documents: Essential agreements include the Share Subscription Agreement (SSA), the Constitution, and the Shareholders’ Agreement.

• Share Types: Startups typically issue ordinary or preference shares, with preference shares offering additional rights like liquidation preferences and anti-dilution protection.

• Investor Protections: Provisions such as pre-emptive rights, drag-along and tag-along rights, and board appointment rights are commonly included to safeguard investor interests.

Tips for Businesses

When raising capital, ensure your startup’s equity financing documents clearly define share types, investor rights, and governance structures. Seek legal advice to tailor these documents to your specific needs and to comply with regulatory requirements. Properly structured agreements can attract investors and support long-term growth.

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Table of Contents

• Essential Equity Financing Documents
• Ordinary Shares or Preference Shares?
• Within the Company Constitution
• Within the Shareholders’ Agreement
• Key Takeaways
• Frequently Asked Questions

Securing funding is crucial for the survival and growth of start-ups, particularly those with business models that appeal to venture capital (VC) investors. 

When raising capital, companies must select an appropriate investment instrument. For start-ups, this choice depends on their development stage, investor profile, and financial status. Common options include:

1.       convertible notes;

2.       simple agreements for future equity (SAFE notes); and

3.       equity (typically convertible preference shares, occasionally ordinary shares).

This article will focus on equity financing documents and their typical construction.

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Essential Equity Financing Documents

When a start-up chooses to raise capital by selling equity, it can issue ordinary shares or preference shares. However, whatever shares a start-up is issuing, such a transaction will typically involve three main documents:

• the Share Subscription Agreement (SSA);
• the Constitution; and
• the Shareholders’ Agreement.

The table below provides an overview of the key features of these documents:

Ordinary Shares or Preference Shares?

Put simply, ordinary shares are shares with “basic” rights, and they are commonly issued to:

• founders;
• employee shareholders; and 
• very early stage investors who are not contributing a significant amount of money to the business. 

Generally, ordinary shareholders will have the right to:

1. vote on shareholder matters;
2. receive dividends, if and when declared by the board; and
3. receive their proportional share of the company’s remaining assets in the event of liquidation.

Preference shares, on the other hand, typically come with rights, privileges and protections that are not afforded to ordinary shareholders (as mentioned above). It is common for companies to issue preference shares as they mature and undertake major funding rounds or to an investor contributing a significant sum of money, primarily because those investors are taking on a larger degree of risk, and therefore, require additional rights and safeguards.

Below, we break down some of the standard terms associated with preference shares in Australian venture capital deals. 

Within the Company Constitution

Liquidation Preference

A liquidation preference refers to the order and manner in which the proceeds available for distribution are apportioned amongst the company’s shareholders if the company experiences a “liquidation event”. A liquidation event often refers to, among other similar events, a sale of all or substantially all of the company’s shares or assets, a liquidation or insolvency, a merger, or a listing of the company’s shares on a publicly recognised stock exchange.

The most common form of liquidation preference in the Australian venture capital market is a ‘1x non-participating liquidation preference’. That is, if a liquidation event occurs, investors holding these rights are usually entitled to receive an amount of money equal to the greater of:

• 1 x initial investment; or 
• their pro-rata proportion of the proceeds available for distribution.

The “non-participating” component means that the holder of the liquidation preference cannot “double-dip” by receiving both their initial investment back and then also a proportion of the remaining proceeds available for distribution. 

Anti-dilution Protection

Preference shares often have ‘anti-dilution’ rights, which aim to safeguard an investor’s ownership percentage if the company issues new shares at a lower price than the price paid by the investor who holds the anti-dilution right (known as a ‘down-round’). In Australian venture capital transactions, the most common form of anti-dilution right is a ‘broad-based weighted average anti-dilution right’, which requires calculation using a complex formula. 

If a “down round” occurs, the price at which the investor’s preference shares will eventually convert into ordinary shares (the “conversion price”) is adjusted downward, effectively giving them more shares. The new conversion price is typically situated between the down-round price and the price at which the investor initially purchased its shares. 

Within the Shareholders’ Agreement

A start-up will also reach a separate agreement with investors, commonly known as a shareholders’ agreement, that defines the relationship between the parties and typically contains provisions over and above what is in the company’s constitution by governing:

• financial information and inspection rights (which are frequently only given to investors above a certain share threshold);
• pre-emptive rights on the issue and transfer of shares;
• drag-along and tag-along rights; and
• board appointment rights and operational matters requiring the investor director’s approval.

Of course, the above list is not exhaustive. For the purposes of this article, pre-emptive rights and drag-along and tag-along rights warrant some discussion.

Pre-emptive Rights

Venture capital investors face a significant risk of dilution when companies conduct additional fundraising rounds. To mitigate this risk, investors typically secure pre-emptive rights, also known as rights of first offer (ROFO). These rights enable existing investors to maintain their proportional ownership in the company.

This mechanism allows investors to participate in subsequent funding rounds, thereby preserving their percentage ownership and avoiding dilution, subject to certain exceptions such as:

1.       the issuance by the company pursuant to its own ESOP rules;

2.       shares issued in an acquisition or other strategic transaction; and

3.       shares issued in an IPO.

In addition to these rights on new issues, investors typically secure another form of pre-emptive right known as the Right of First Refusal (ROFR). This applies when existing shareholders wish to sell their shares to third parties. The ROFR gives investors the opportunity to purchase these shares before they’re offered to external parties. This mechanism allows investors to potentially increase their stake in the company or prevent unwanted third parties from becoming shareholders.

Drag and Tag-along Rights

Shareholders’ agreements often include two important provisions: 

• Drag-along Rights: These allow the majority shareholders (usually the founders and major investors) to ‘drag along’ minority shareholders in a company sale. If most ordinary shareholders and preference shareholders agree to sell, they can require smaller shareholders to sell their shares too. This prevents minority shareholders from blocking or slowing down a potential sale of the company.
• Tag-along Rights: These protect minority shareholders. If a major shareholder decides to sell their shares and the company or other investors don’t exercise their right to buy these shares first, other investors can ‘tag along’. This means they can sell a proportional amount of their shares alongside the major shareholder, on the same terms. This ensures that smaller investors aren’t left behind if a good selling opportunity arises.

Key Takeaways

Start-ups typically don’t follow a straightforward, linear growth path. Their journey is often marked by unexpected turns and challenges. As a result, the most suitable financing instrument for a start-up can vary significantly depending on its current stage of development.

Given this complexity, it’s crucial for start-ups to seek legal advice before embarking on their capital raising efforts. If you have any questions, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.

Frequently Asked Questions

What is the difference between ordinary and preference shares?

Ordinary shares provide fundamental rights, such as voting and receiving dividends, while preference shares offer additional rights, including liquidation preferences and anti-dilution protection.

What are pre-emptive rights in venture capital agreements?

Pre-emptive rights allow investors to maintain their proportional ownership by purchasing new shares issued in future funding rounds, protecting them from dilution.