Background
The difficulty in raising funds for technological ventures that are in various stages, both in the initial stages (Pre Seed) and in later stages, is known and complex.
In advanced capital raisings, there are various considerations and changing circumstances that influence the company’s decision whether to turn to external investors or to raise capital internally within the company. Take for example a case in which the company is in difficulties and does not have enough cash to survive without further investment. In such a predicament, the company may prefer to quickly raise a relatively small amount of capital internally from its existing shareholders (either through borrowing or selling stock) rather than to raise capital from external investors, which may take longer and result in the existing shareholders relinquishing a significant part of their holdings in the company for a relatively small, lower value investment (Down round).
Judicial review of internal capital raising
A company which wishes to raise capital internally directs its request at all its current shareholders (without prejudicing the preferential rights of specific shareholders in the company and subject to other contractual constraints).
The existing shareholders will naturally seek to invest additional sums in the company in exchange for a lower value. The difficulty arises when some of the shareholders decline to join in an internal investment which effectively both dilutes and depreciates their holdings. These situations raise for discussion many issues relating to the relationship between the shareholders themselves (majority versus minority, etc.), as well as between the shareholders and the company’s lenders/creditors.
A similar issue arose in Civil Case 44736-03-19 (Tel Aviv District Court) Maimon v. Unavoo Food Technologies Ltd et al. (hereinafter: “the Unavoo case”), in which the court held that given the personal interest of the shareholders in the investment, where a company raises capital internally its decision to do so shall be subject to stringent review.
It should be noted that while, provided that they were taken on the basis of relevant considerations, in good faith and for the benefit of the company, the courts are usually disinclined to interfere in a business decision of the company’s institutions (its shareholders and board of directors) (Business Judgment Rule), but where those taking that decision have a conflict of interest, the court applies a stringent standard of review.
Thus, a decision to raise capital within the company, which was taken and endorsed by shareholders or directors who have a conflict of interest, is necessarily tantamount to a transaction in which the decision makers have a personal interest, since after all, the same shareholders are those who are investing in the company and determining the amount of the investment and the value of the company on which their investment will be based upon.
In the Unavoo case, a minority shareholder petitioned for annulment of the company’s decision to raise capital internally on the grounds that since it was based on a company value which was significantly lower than its true value, according to him raising the capital caused a massive dilution of his holdings in the company.
Since, as aforesaid, approval to raise the capital internally had been given by shareholders who had a conflict of interest, the court decided that its interference in and rigorous review of the company’s decision were warranted.
Her Honor Judge Ruth Ronen therefore held that in light of the fact that a move to raise capital internally may harm the holdings of shareholders who do not participate in the investment, it must first be examined whether or not that investment is urgently needed by the company, and should no such necessity be found, then due to the harm which may be done to those shareholders who are not participating in the investment, it shall be precluded. It should be noted that provided it is made according to real value, then even though the shareholder’s stock shall be diluted, the investment shall not harm or reduce the actual value of his holdings in the company.
For example, suppose a shareholder (who does not participate in the internal raising) holds 30% of the company’s capital on the eve of the investment. If the value of the amount raised was real or even exaggerated, then even if the shareholder’s stock is diluted to 20%, this still reflects the real value of his holdings in the company. Conversely, in the case of an investment where the prescribed value is lower than the real value, the shareholder’s stock in the company shall be diluted more than necessary, because it is being simultaneously both diluted and devalued.
Returning to the Unavoo case, there, contrary to past decisions of the courts regarding the raising of capital within a company in times of crisis, Her Honor Judge Ronen ruled that due to the consequences of the internal enlistment, the personal profit being made from the low valuation by the investing shareholders, and in contrast thereto, the unnecessary damage being caused to the non-investing shareholders as aforesaid, the shareholders participating in the raising of capital bore the burden of proving that the proposed valuation reflected the true value of the company.
In the end, the court decided to approve the internal raising, although based upon a company valuation which the parties would determine later on during the legal proceeding.
Conclusion
Raising capital is a complex process. As with any business process, before the process begins it is important to try and define what the desired outcome should be, on several levels, including the amount which must be raised, the value of the company, and whether the funds should come from external investors or be raised internally. In the latter case, following the Unavoo ruling, decision makers must give serious consideration as to whether capital should be raised internally and the terms upon which the investment shall be made, especially when there is a concern that shareholders not participating in the investment may be detrimentally affected by it.
Finally, we would point out that a classic solution to similar problems has been given by providing capital to the company in the form of a convertible loan, in which the actual valuation of the company is postponed to a later stage.
For further details, contact:
Hanan Efraim, Partner Tsippy Bengi, Senior Attorney
Tel: 03-691-6600 Tel: 03-691-6600
Email: hanan@ekw.co.il Email: tsippy@ekw.co.il