Introduction
Young startup companies wishing to raise funds in their initial stages contact, among others, professional investment funds. In most cases, in the framework of these investments, such investment funds become minority shareholders in the portfolio company, while requesting to receive effective rights to supervise and even to dominant the company’s conduct – again, despite them having a minority holding in the company.
In this article herein we will attempt to briefly discuss the process above, while understanding the difficulties involved in fundraising on the one hand, and recognizing the importance of formulating effective mechanisms on the other hand, through which rights of (limited) control are given to minority shareholders of a company.
The effect of a minority shareholder on a company’s conduct
The process of fundraising by young companies is a common and trivial process. In most of these fundraises, a shareholder invests capital in the company, and in exchange receives minority shares in the company. Whether it is a private, professional or institutional investor, the legitimate expectation of that investor is that despite him being a minority shareholder in the company, he will receive an effective capability of supervising and even influencing the company’s conduct and its decision-making process, namely: receiving effective control, although limited, of a minority shareholder in the company.
On the other hand, the majority shareholders will ask to minimize the effect of the minority on the company’s conduct, and the tension between the allegedly opposing interests of both parties leads to formulating complex mechanisms of control and supervision in the company, while maintaining the majority’s ability to navigate the company as it deems fit.
Corporate meaning of “control”
In the Israeli law, the term “control” has different meanings in various laws. Thus, the definition of the term Control in Article 1 of the Companies Act, 5759-1999, is not identical to the definition set forth in Article 1 of the Securities Act, 5728-1968. Furthermore, the definition of the term “control” may even differ between different articles of the same legislation, thus, for example, the definition of the term “holder of controlling interests” in Article 3(i) of the Income Tax Ordinance (New Version), compared to the definition of “control” in Article 9 or Article 88 of the same ordinance.
Furthermore, from a corporate aspect, the term “control” can be examined on a number of dimensions:
(1) Firstly, a differentiation between public, large companies and private companies. (2) A differentiation between companies (whether public or private) with a holder of controlling interests who holds more than 51% of the company, compared to companies where there is no dominant holder of controlling interests. (3) A differentiation between a company where there is active and dominant participation of shareholders in the management of the company, and a company where most of the shareholders are passive (this such companies are being managed by professional management).
It is important to note that the control mechanisms in a company change in light of each of the three dimensions as stated, starting with a trivial mechanism of control via an overwhelming majority in the meeting of shareholders and the company’s board of directors, and up to control via contractual and/or regulation mechanisms of different sorts.
This leads to a conclusion that apart from clear and easy cases where there is a dominant and conclusive holder of controlling interests in a certain company, in most cases it is not possible to determine unequivocally what “control” means, prior to delving into further details about the company and the way it is conducted, as well as understanding the procedural context in whose framework the need arises to determine how control is applied in a specific company.
Capital venture investments
Professional investors, inter alia in the form of professional capital venture funds, manage capital for passive investors who wish to maximize their yield. For this purpose, the legitimate expectation of those investors is that the fund managers (the GP) will invest funds in portfolio companies, and at the same time, formulate their rights of supervision and effective influence in those companies, even if the holdings of the fund are minority holdings in the company.
Needs to bear in mind that these are private companies, where in the framework of fundraising, new shareholders who invest in the company are joined in exchange for allocating shares which usually constitute minority holdings in the company (for the sake of discussion, there is no material difference between a minority holding of 49% and a more modest holding of 20%).
For this purpose, the investors’ representatives wish to receive effective rights in the company’s organs, namely the company’s shareholders assembly, and more than that in the company’s board of directors[1]. In the company’s board of directors, most of these rights are granted in the form of veto rights on certain matters where there is a legitimate expectation of the investor to receive the effective ability to supervise and manage risks.
In the framework of these subjects we can state, for example: a decision regarding future fundraising for the company, replacing the company’s senior management, a significant change to the company’s business plan, and additional matters which have a material effect on the company’s business, compared to the representations which were given to the investor, on whose basis he has decided to invest and join the company.
We will state again: despite minority holdings in the company, the representatives of the investor (who constitute a minority in the company’s board of directors) receive effective control over adopting material decisions in the company, inter alia in light of their experience and expertise in the relevant areas, in a way which damages the ability of the majority shareholders in the company to manage the company as they see fit.
It seems that in terms of a financial analysis of formulating the mechanism of control as stated there is great reason, since the company and its original shareholders, when raising an investment in the company while adding new professional shareholders, make an educated decision that apart from the financial consideration of the value of the shares, they recognize and accept the fact that these are professional investors whose contribution to the company will also be on managerial levels, hence the path to grant rights of control to holders of minority shares as well.
Summary
The Israeli law specifies different and varied mechanisms through which control in a company is examined. Control in company A is not necessarily similar to control in company B, and this changes in light of the nature of the company and its business, as well as in light of the needs and managerial capacities of the specific shareholders in that company.
The real challenge is formulating mechanisms with significant and effective content, on whose basis it is possible to grant minority shareholders rights of control in the company, in a way which will value and reflect their managerial contribution to the company, but will not nullify the control of majority shareholders in the company.
For further information please contact us:
Hanan Efraim, Adv. Tsippy Bengi, Adv.
Office: 03-691-6600 Office: 03-691-6600
Email: hanan@ekw.co.il Email: tsippy@ekw.co.il
[1] This article herein does not refer to additional rights of a financial nature, which investment funds receive in the company in which they invest (for example, liquidation preference, anti-dilution rights, preemptive right and such).