When a venture capital or private equity fund enters the share capital of a startup, it must negotiate with its founding partners the regulation of the relationships that arise as a result of the investment. Typically, this is achieved through a shareholders’ agreement and/or an investment agreement.
The Objective of the Venture Capital Fund
The principal purpose of the venture capital fund is to maximize the return on its investment and exit the project after a certain period. Negotiating and agreeing on certain preferred rights to ensure this goal is a common practice. Economically, this generally translates into priority in payments, ahead of other partners, when any liquidity event occurs in the startup, as well as a right to exit through a put option.
Mechanisms: Classes of shares
For these purposes, one of the most used mechanisms is the creation of different classes of shares. This mechanism allows investors and founders to align their incentives and protect their interests in the startup. In the Spanish legal system, this instrument is viable as the Capital Companies Act allows that shares of the same company may grant different rights.
According to Spanish regulation, the share capital of a company can be divided into classes, and a class can be, in turn, divided in series. Generally, the shares of a class and/or series have the same rights attributed to them. Therefore, this mechanism is ideal for recognizing preferred rights to specific shareholders, as may be sought when a venture capital fund enters the capital of a startup.
Preferred Rights
Economic Privileges
Firstly, economic privileges can be established. Funds usually ensure they are the first to cash in (or receive a minimum amount per share at the expense of other shareholders) when a liquidity event or profit distribution occurs. Similarly, in the event of the sale of shares or liquidation of the company, funds reserve the right to preferential payment ahead of other shareholders. Therefore, the latter will only receive a return if the investor’s preferred right has been satisfied beforehand.
Political Privileges
On the other hand, political privileges can also be established. Since a fund typically guides the business and strategic development of the company when it enters the capital of a startup, it is common for it to secure the possibility to control the decisions of the corporate bodies on specific issues. It can be established, for instance, that the vote in favour of the shares held by the fund will be necessary to adopt resolutions on concrete subjects at the general meeting.
Other Privileges
Finally, the future shareholders can also attach any prerogatives to a class of shares within the negotiations of the entry of the fund. It is usual to establish an information right whereby the fund, for example, can monitor the company’s progress and, consequently, its investment.
In summary, the creation of classes of shares in a company is a recommended method for structuring a fund’s investment in a startup, as it allows for the optimization of returns and protection of interests.
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