Constitutions for Start-up Companies
A small start-up company with just one owner does not need anything but the bare essentials when setting up in business. With no other shareholders there is no point in having a constitution.
The main reasons for having a constitution are:
- to create pre-emptive rights on the sale of shares
- to allow the company to buy back its own shares
- to allow the company to indemnify and insure its directors
- to remove or modify the application of section 45 of the Companies Act (which requires new shares to be offered pro rata to existing shareholders first)
- to allow directors appointed by a majority corporate shareholder to vote in the interests of the shareholder instead of the company.
- to provide for different ways of appointing directors.
When a company has two or more shareholders, the need for a constitution becomes greater, but really only to address points 1, 4 and 6 above. I personally have never seen any merit in point 5, least of all with a start-up company that needs everyone to focus on what is in the best interests of the company itself rather than one of its shareholders.
As for point 4 (section 45 of the Companies Act), capital raising is an essential part of a start-up company’s ability to survive. A start-up usually goes through several financing rounds and needs the speed and flexibility to bring in funds without any unnecessary obstruction from shareholders.
If the company is happy to allow existing shareholders to have the right of first refusal on new share issues, the only suggestion I would make is to ensure that the offer period is short, so that existing shareholders do not drag things out, as this can often cause a loss of momentum with new investors.
Where shareholders are represented on the board of directors, there is no need to have a formal requirement to go to existing shareholders first. This is not to say that existing shareholders should be excluded from fund-raising rounds; quite the opposite in fact – the shareholder/directors will of course discuss the need for capital and where to get it from, including themselves.
Most difficulty with section 45 comes with minority shareholders, especially when a number of other shareholders are actively involved in the company. The “silent” minority shareholders tend to be the ones who object to the capital raising, more often than not out of a fear of having their shareholdings diluted. They also tend to use up all of the time frames and delay the introduction of new money.
Where these circumstances exist, my recommendation is to remove the application of section 45.
The fear of dilution is overrated. Percentages have nothing to do with the value of a shareholding. If a shareholder paid $10 for 10 shares representing 10% of a company and a new shareholder buys 20 shares for $20, the capital of the company will increase to $120 and the number of shares will increase to 120. The first shareholder still has 10 shares worth $10. The only thing that has changed is that his percentage has gone from 10% to 8.3%. While that will affect his voting power a little, the company has grown bigger and he has not otherwise suffered.
The only situation where a minority shareholder can suffer is where new shares are issued at less than the price paid by the minority shareholder. However, even in this scenario there are two answers: (1) the minority shareholder can participate in the share issue at the lower value; (2) if the share issue is below the fair market value, the minority shareholder may have recourse to the company under the Companies Act for unfair or prejudicial conduct.
As the number of shareholders increases without board representation, there may be more merit in retaining the pre-emptive rights on new share issues, provided that the response time for accepting a rights issue offer is short.
An alternative to pre-emptive rights is co-emptive rights: if existing shareholders insist on the right to participate in new share issues, the easiest way of satisfying this is to allow them to participate in the share issue on the same terms and at the same time as shares are offered to outsiders.
Having said all this, start-up companies need to remember not to spend too much time arguing about the finer details of pre-emptive rights, or other provisions of the constitution. When the company wants to raise serious capital from new investors, it can be assured that the new investors (especially angel and private equity investors) will want to review the constitution (if there is one) and change it or enforce the adoption of a constitution of its choosing.
At this point the start-up company is likely to face additional demands from investors, including restrictions on the number of directors, the investor’s right to appoint directors, the requirement for “independent” directors, drag-along and tag-long rights and the enforced sale of shares by departing employees.
While most of these issues are normally addressed in an investment agreement, my view is that, if they are agreed to and are intended to apply regardless of shareholding changes, the better place to put these provisions is in the constitution. Leaving them in the investment agreement requires vigilance to ensure that new shareholders are similarly bound the agreement. And, of course a new investor is likely to want changes made to the existing agreement as a condition of putting his money in, which results in more legal work and legal fees, without any benefit to the start-up company.
If, on the other hand, the agreed provisions are inserted into the constitution, they will automatically apply to each new shareholder, without the need for an amending or accession agreement.
As for the merits of the provisions themselves, my views are as follows.
- Drag-along rights: These rights allow a significant majority of shareholders to force all other shareholders to sell to a third-party buyer on the same terms. Sometimes the drag-along rights bypass the company’s standard pre-emptive rights; in other cases they apply only after the pre-emptive rights procedure has been exhausted. In general arguing over such provisions is a waste of drafting time and legal fees. In my 30+ years of legal practice I saw these clauses used only twice, once to overcome a technical error with two sister companies, and the other where just one shareholder thought the price offered by the third-party buyer was too low.
Are such provisions necessary? They add nothing but tension to a start-up business. They assume that one group of shareholders has the right to dictate the fortune of everyone else. If they are used, it is likely to be because the smaller shareholders have not been properly consulted. If the start-up company is operated on the basis of full disclosure and openness amongst all shareholders, the use of drag-along provisions should be unnecessary. If there is a good deal on offer, it should not be hard to persuade all shareholders to accept the deal.
If, despite these comments, a company agrees to include drag-along rights, the clauses should contain a provision that the rights cannot be exercised unless the sale price is higher than the price originally paid by the sellers or the last price at which shares were traded on an arm’s length basis.
- Tag-along rights: These rights apply where a significant number of shareholders has agreed to sell down some but not all of their shares. If this happens, they must allow all other shareholders to participate in the sell-down on a pro rata basis. I have never seen these rights exercised and I suspect that they came into being as a token trade-off by investors who insisted on the more draconian drag-along rights.
- Investor’s right of appointment: The right of an investor to appoint a director is a pretty normal provision. But normal does not necessarily mean that it is always the right thing to do. If it is allowed, all shareholders with a similar percentage shareholding should have a similar right of appointment. In fact it is easier in situations like this to provide in the constitution that a certain percentage carries the right to appoint a director. In any case, beware the investor who insists on a right of appointment that is disproportionate to his shareholding.
- Independent Director: Having an independent director can be a good idea, if there are many divergent interests represented on the board. However, care needs to be taken in the selection of the independent director as, too often, it is the investor who comes up with the name of a proposed director. The natural assumption in this case is that the director will not be truly independent and will have an investor-oriented bias. Of course an independent director is only needed if there is an equal number of directors already. And he needs to be agreed on by all existing shareholders and directors.
- Enforced sale of shares by employees: Sometimes investors insist that departing shareholders sell their shares. This attitude confuses share ownership with employment-related issues: the two are and should remain separate issues. If an employee shareholder (who will usually be a founder) leaves, my view is that he should have the choice of whether to sell his shares or not. However, if an investor insists on enforced sale, the employee should not be forced to sell at any less than the fair market value of his shares and there must be a buyer for those shares.
There are other issues that arise with the introduction of new investors but these are normally dealt with in the investment agreement.