An investment transaction is a complex transaction which includes two structured tensions: the relationship between the investor and the target company and the relationship between the investor as a future shareholder and the current shareholders of the company (in this article, we will not review an additional tension which exists in companies between the shareholders and the creditors of the company).
During negotiations towards the formation of the transaction, the parties wish to try and reduce risks by conducting mechanisms that will assist them in managing the company in the best optimal way and maximizing their interests as shareholders. Most of the agreed upon legal mechanisms relate to the method of management of the company and part of them relate to the rights and obligations associated directly to the shares allocated to the investor and their marketability.
Memorandum of Understanding, Investment Agreement, Shareholders Agreement or Articles of Association?
From the outset, we will state that many a times there is confusion between Term Sheets (or TS) to the comprehensive investment agreement, which is the Share Purchase Agreement (or SPA) and also between the Shareholders Agreement and the Company’s Articles of Association.
Due to time constraints, we will briefly state that in every complex investment transaction, it is customary to finalize the transaction details in summary under the framework of a (relatively) short document, which is the TS that defines the agreed upon period of time for the investor to conduct a comprehensive Due Diligence process with regard to the target company. Concurrently, the Definitive Agreements relating to the execution of the investment, are formulated, the main agreement being- the Share Purchase Agreement. Thus, all the legal mechanisms to be agreed upon in the framework of the TS shall be extensively detailed under the SPA and some legal mechanisms will also be detailed in the Shareholders Agreement and in the target company’s Articles of Association.
Among the legal mechanisms discussed under the framework of negotiations towards formation of the investment transaction, we will specify the main and most common ones herein:
Right of first refusal– a right which provides the shareholder with the option to purchase shares of other shareholders seeking to sell their shares to third parties. There are a few exceptions to this right, including transfer between affiliates.
Preemptive Right– a right which provides the shareholder with the option to participate in a future allotment of shares, in order to maintain its holding rates in the company. There are a few exceptions to this right, including allotting securities to employees of the company and issuance to a strategic investor.
Bring along– the right of most of the shareholders to compel the minority shareholders to join a transaction for purchasing all of the company’s shares. It is important to state that this right also exists, with certain reservations, in the Companies Law relating to private and public companies.
Co sale / Tag along– the minority shareholder’s right to join a transaction of selling a substantial part of the company’s shares, to a third party under the same terms. This is an interesting right which gross up a premium of control core also to minority shareholders (subject of a separate article to be published later on).
Anti-Dilution– a dramatic right by which a shareholder which purchased shares in the company at a certain price shall be entitled to receive additional shares in the company with no additional payment on its behalf in the event that the company will allot new shares in the future in a lower price than the price paid by the investor. This right has a few variations, the main being Full Ratchet, which does not take into consideration the investment amounts in each round, together with a more moderate variation called Weighted Average Ratchet.
Restrictive provisions– in the event that after formation and completion of the transaction, the holdings of the investor constitute a minority in the company, this will, no doubt, also be manifested in its ability to affect resolutions in the board of directors in the company. In such cases, the investor requests to determine that in substantial issues, the company’s board of directors will not be able to resolve any resolution unless the representative (representatives) of that investor supported the resolution (although they constitute a minority in the board of directors). Examples of substantial issues: a material change in the company’s field of business, a material deviation from a business plan or an agreed budget, a material change in the company’s Articles of Association and more.
Buy Me Buy You: BMBY– in the event of material disputes between main shareholders, there is a substantial fear of paralyzing the company. According to this mechanism, given certain terms, a main shareholder may offer other shareholders in the company to purchase their shares. The other shareholders may accept the offer or suggest an improved offer to the first shareholder, all in accordance with the terms of the BMBY.
Expiry of rights
Before concluding, we will note that in most cases, the above rights are not provided to a certain shareholder for an unlimited period of time, and the company defines the period in which these rights continue to apply. The main example for expiration of these rights is a public offering of the company’s securities, along other examples such as a dramatic decrease in the rate of holdings of a specific shareholder, the company’s completion of certain business milestones, etc.
Under the framework of negotiations for a corporate investment, it is important to understand the interests of each party in order to consolidate a balanced transaction which will allow each of the parties to maximize their benefits.
Recognizing the legal mechanisms is vital for creating a productive relationship between the joining shareholders of the company and senior shareholders, and concurrently for building a corporate texture in which the target company may be conducted in an efficient and practical manner for promoting the business of the company, even though, at times, these can be different from the interests of its shareholders.
 In this article we will not relate to additional ancillary documents such as: Investors’ Rights Agreement, “Straight” or convertible Promissory Notes, etc.