Abstract
The veto right is a powerful legal tool that gives investors the ability to prevent material decisions being made in the company, including by appointing directors who represent the investor as a minority shareholder in the company. While the original purpose of the veto right is to protect the rights of investors and their investment, its use raises complex questions regarding the balance between investor protection and fiduciary duties towards the company. This issue also arises in the context of the voting of those investors in the company’s shareholder meetings.
The article examines the legal and practical consequences of using this right.
Background
In most investment agreements, sophisticated investors demand and receive effective control rights that exceed the proportion of their holdings in the company. The logic behind this requirement is clear: a party that invests significant capital wants to guarantee its investment and influence the conduct of the company. Alongside this, an essential part of the contribution of sophisticated investors, especially in young companies, is in improving management and the way decisions are made in the company.
In recent years, with the development of the private capital market and the proliferation of investments in technology companies, the right of veto has become a central tool in protecting the rights of investors. This right is anchored in the company’s articles of association or in the agreements between the shareholders and allows investors to influence material decisions even when they hold the minority of shares. At the same time, the legislation and rulings in Israel recognized the importance of balancing these rights and the benefit of the company, while establishing a legal framework that regulates their use.
Legal and practical aspects in exercising the right of veto
Officers in general, and directors in particular, owe diverse duties to the company and its shareholders. The fiduciary duty, anchored in Section 254 of the Companies Law, requires them to act in good faith and for the benefit of the company. A major issue arises when a director is appointed by a specific investor, since in this situation there is sometimes an inherent conflict of interest between the good of the company and the interests of the appointing investor. The case study of the company “Breath of Health” illustrates this complexity well: the company, which had developed a promising technology for diagnosing diseases through a breath test, was caught in a crisis when an investment fund that held 42% of its shares used its veto power to block potential investors, which ultimately led to the collapse of the company.[1]
It bears noting that similar duties also apply to the shareholders themselves within the framework of the general meeting. Sections 192 and 193 of the Companies Law require a shareholder to exercise his rights and fulfill his obligations towards the company and towards the other shareholders in good faith and in an acceptable manner, and to avoid abusing his power in the general meeting. These instructions supplement the normative framework applicable to the exercise of the right of veto in the board of directors and ensure proper conduct in all decision-making centers in the company.
Balancing mechanisms and practical recommendations
Accumulated experience shows that effective mechanisms must be developed to balance the use of the veto right. First, a precise definition of the circumstances under which this right is used is required, while limiting it to truly material decisions. Second, mechanisms must be established to resolve disputes, such as the obligation to propose a concrete alternative within a specified period of time when the veto right is used to block capital raising. In addition, strategic considerations beyond the financial aspect must be taken into account, especially when it comes to strategic investors whose contribution to the company goes beyond the purely financial aspect. The key to a balanced use of the veto right lies in creating mechanisms that enable the protection of investors’ rights on the one hand, while maintaining the company’s ability to develop and grow on the other.
Therefore, we recommend adding a condition to the veto right of a specific investor, according to which that investor has an obligation to invest the funds it needs in the company under the same terms of the investment that it seeks to reject at the board of directors. If the investor does not invest the same funds in the company, he will not be able to prevent the company from raising capital under the aforementioned conditions.
Thus, the company retains the right of veto for that investor, but on the other hand, it does not enter a spiral that could lead to its closure.
Summary
The veto right is a essential mechanism in investment transactions, but its use requires a delicate balance between the rights of investors and the good of the company. As the case of “Breath of Health” demonstrates, unwise use of this right may lead to disastrous results. Therefore, it is recommended to establish clear balancing mechanisms in advance, including the obligation to offer a concrete alternative when blocking capital raising and considering broad strategic considerations.
At the same time, those with the veto right must exercise careful judgment and remember that with power comes the responsibility to act in the best interests of the company as a whole. It is particularly important to understand that while the veto right is intended to protect investments, its unbalanced use may actually harm the value of the investment itself and the company’s stakeholders in general.
[1] https://www.themarker.com/technation/2025-01-10/ty-article/.premium/00000194-4ce7-d2ba-a5b5-cfefcef5000
For further information please contact:
Hanan Efraim, Adv. Ofer Inbar, Adv.
Office: 03-691-6600 Office: 03-691-6600
Email: hanan@ekw.co.il E-mail: ofer@ekw.co.il