Key terms of the Articles of Association
The articles of association are a contract between the company and each shareholder and between the shareholders themselves. Every shareholder subscribes for shares in accordance with the rights and restrictions set out in the articles of association and therefore the articles will contain detailed provisions about, amongst other things, how shares are to be dealt with, what rights attach to the shares and how the directors may call and hold meetings.
Classes of shares
It is common in life sciences investments for the founders and other (non-investor) shareholders to hold ordinary shares and for the investors to hold preferred shares which have preferential rights over the shares held by the founders and other shareholders. We have set out below typical preferential rights that the shares held by investors may have.
As life sciences companies usually always have more than one class of shares, separate class consents may be required if the rights of a class of share are being varied or abrogated.
Liquidation and sale preference
If the articles of association are silent, on a distribution of net proceeds of a company on a liquidation or sale, such proceeds are distributed to shareholders pro rata to their shareholding in the company. It is usual in investments for life sciences companies for the investors to seek provisions to ensure that they get as much of their investment monies back as possible. An investor may therefore insist on a 'liquidation preference', i.e. the right to be paid a sum equal to (or in some cases (though less common nowadays) a multiple of) the subscription amount paid by it before any of the other shareholders are paid. This may also apply on a listing.
The investors can seek a non-participating or a participating preference depending on the commercial circumstances. A non-participating preference means that the investors receive their liquidation preference payment amount in priority to other shareholders and the remaining proceeds are distributed to the other shareholders pro rata their shareholding. A participating preference means that, after the investors receive their liquidation preference payment amount, the remaining proceeds are distributed to all shareholders, including the investors, pro rata to their shareholding. Generally, a participating preference in investments for life sciences companies is more common than a non-participating preference.
Dividends
It is not uncommon for life sciences investors to insist upon a dividend on their preferred shares which ranks ahead of any dividend payable to any other shareholders. However under English law, dividends cannot be paid to shareholders unless the company has distributable profits, so there is no guarantee that any such investors will receive their preferred dividend. The investment documentation may state that the dividend may become payable on a quarterly or annual basis, at the time of an exit or conversion and can be cumulative or non-cumulative.
Voting
It is typical for the holders of ordinary and preferred shares to have one vote for each share.
Conversion
It is usual for the investors to have the right to convert their preferred shares into ordinary shares at any time. However, on certain events it is usual to see a provision made for the automatic conversion of the preferred shares into ordinary shares, for example on the listing of a company. An investor may insist that an automatic conversion on a listing of the company only happens if the shares are listed at a price which is at least the same price per share as the subscription price paid by the investor.
Redemption
The intention of any investor (in a life sciences company or otherwise) is almost always to exit by a sale of the company or a listing. However, the investor may set a target date by which the realisation must be achieved and if this has not happened it may require the company to redeem its preferred shares at a price equal to the subscription amount. This is another mechanism for protecting the investment money put in by the investor. However, the company must have distributable profits to redeem such shares. Moreover, due to accounting rules redeemable shares may impact the balance sheet of the company as being treated as debt as opposed to equity and can be undesirable.
Anti-dilution
On the assumption that a company continues to grow and to enhance its value, all parties would expect future share issues to be at higher subscription levels. However, should the business (and accordingly value) decline then a company may need to issue further equity at a lower price. It is not uncommon for an investor in life sciences companies to look to protect its stake by having the right to have further shares issued, at no cost, but which are credited as fully paid, to bring its cost per share in line with the lower issue price. Such adjustment could be based solely on the new issue price (otherwise known as a full ratchet) or could take account of the amount of new monies being raised and shares in issue (otherwise known as a weighted average).
The articles of association can also contain "pay to play" provisions so that if the investor does not participate in the future issue, it loses its right to such anti-dilution protection.
Founder shares
It is commonly the case that investors in life sciences companies will insist that the shares issued to the founders be subject to a `vesting schedule'. This means that, although the shares are issued to the founders from the outset, the holding of such shares is conditional on the founders continuing to be employed by the company for a certain period of time following completion of the investment. If the founders do cease to be employed, then all or a proportion of a relevant founder's shares (depending on when the founder leaves) will automatically either be converted into worthless deferred shares (discussed below) or offered for sale, usually at a nominal value per share, first to the investors and thereafter to other shareholders (in the event that the investors do not want to acquire any such shares). Typically the investors will not be involved in the day to day management of the company and will rely on the founders' skill and knowledge of its particular market to maximise the success of the venture. The investors (in particular for higher levels of investment) therefore wants to ensure that the founders stay with the company for a significant period of time (usually three or four years) and the vesting process enables this by ensuring the founders effectively earn their shares.
If the principle of vesting is accepted, typically the articles of association will include provisions so that the founder shares vest on a monthly or quarterly basis over a defined period. The circumstances of departure (for example due to misconduct or poor health) may vary the vesting or whether such vesting applies and if so at what price the shares must be offered for sale.
As stated above, in respect of unvested shares of a departing founder, it is not unusual for such shares to become converted into deferred shares. Deferred shares are a class of shares which have minimal rights. Deferred shares will almost certainly be non-voting shares with only minimal rights to dividends and capital once the ordinary and preferred shareholders have been paid.
Pre-emption rights on new issue of shares
When a company issues new shares, the articles of association typically stipulate (unless dis-applied by special resolution) that the company is required to offer such shares first to the existing shareholders pro-rata to their shareholdings (or a particular class of shares). The main purpose of the pre-emption rights is to give existing shareholders a right to maintain their percentage interest in the company. There are typically carve-outs including the grant of options under the share option plan and shares issued for an acquisition.
Pre-emption rights on transfers of shares
Unless the transfer falls within the list of permitted transfers (discussed below), it is common for the articles to provide detailed pre-emption rights setting out the process that must be followed where shares in a company are proposed to be transferred. In life sciences companies, usually this right is drafted so that either (a) the holders of the same class of shares have a first right of refusal on any transfer of shares of the same class, following which the shares must be offered to the holders of other classes of shares or (b) for an investor to push for it to have a first right of refusal over any shares proposed to be sold, irrespective of class.
Permitted transfers are exemptions to the pre-emption rights and may include transfers to family members and trusts as well as intra-group transfers amongst group companies or members of an investment fund.
The investors may require that their prior consent is required before a founder can transfer his shares, in particular unvested shares, to any other party (even permitted transferees).
Compulsory transfers
The articles of association may specify on the occurrence of certain circumstances a shareholder is compelled to sell his shares. These typically include bankruptcy or insolvency events, change of control of a company or the cessation of employment.
Drag along rights
"Drag along" is another situation where a shareholder may be compelled to sell its shares. The drag-along provision compels minority shareholders to sell their shares if shareholders holding a specified percentage of the shares of the company (always almost at least a majority of the shares) decide to sell their shares. This mechanism enables the sale of the entire company to a purchaser. However, it is important to note that a purchaser may be reluctant to rely such provision to effect the share transfers, for a variety of reasons. It is important that the drag along also applies to existing options that are exercised at the time of a sale.
Tag along rights
Shareholders may want to negotiate “tag along” rights so that if an offer for shares in the company is received by a number of shareholders holding a specified number of shares (so that for example the purchaser will acquire a majority of shares in the company), and those shareholders wish to accept the offer, that offer cannot proceed unless it is made available to other (or perhaps all other) shareholders at the same price. This protects minority shareholders so that they can participate in any offer.
Additionally, "tag along" rights or "co-sale" rights can be put in place to ensure that, if the founders receive an acceptable offer from a third party, they are obliged to procure that the third party also makes an offer to the investors or the other shareholders on the same terms for the requisite percentage of their shares.
Additional issues
The articles of association will also deal with the following issues: director appointments and conduct of board meetings, conduct of shareholder meetings, conflicts of interest of directors and insurance and indemnity of officers of the company. Where relevant, they should reflect the terms of the investment agreement.
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