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Covid-19: what directors should look at when faced with an investment offer on onerous terms

Posted: 30/04/2020


Introduction

Covid-19 presents an economic environment which creates significant opportunities for venture capital and early stage investors. The need for cash creates better leverage to negotiate deal terms in their favour, which are often detrimental to existing founder shareholders and employees. Directors must balance the risks of safeguarding short term survival without jeopardising longer term health and effective management of their business.

This is not only relevant to an initial investment, but often to a second round of emergency funding and to an investor trying to force the company or the founders to accept onerous terms: does the company have a white knight or robber baron?

The key considerations for directors - typically founder shareholders - to bear in mind in these situations are:

Duties as a director/shareholder interests

Are they in conflict? They can be, and this may cause difficulties both for the company and the individuals. Existing investors seeking to impose their funding proposal may also be directors. How to avoid conflict? First, know the duties required of a director.

Duties as a director are codified in the Companies Act 2006. They are fiduciary duties owed to the company and are of paramount importance. Directors must never view their personal interests as shareholders to be more important than their duties as a director. If they do, they will not only risk a breach of directors’ duties but create the grounds for dispute with other shareholders and damage not only their personal interests, but the success of the company. For more guidance on directors’ duties, including potential liabilities for a breach of duty, see here.

How are shareholder interests regulated?

The rights of the shareholders will usually be set out in the articles of association of the company and in a formal agreement between shareholders and/or external investors, or both. This documentation is fundamental. Shareholders will not be subject to the same duties as directors and can act in their own interests separately from how an investor appointed director might need to act.

Documentation (articles and investment/shareholder agreements) - key terms

Get these right. You may be negotiating these first time around or referring back to them when discussing a second round of funding. An investor must have an appropriate level of information and control over their investment, but the directors must retain sufficient freedom to manage the day-to-day operations of the business effectively in its best interests and not end up with tied hands for key decisions. What you might expect:

  • Investor access to management accounts and key information.
  • Key decisions that will require the consent of the investor in order to be permitted.
  • Investor representation on the board of directors and/or observer rights. Does the investor have  weighted voting in certain situations?
  • Events that trigger increased voting capability or step in rights for an investor.
  • Drag along/tag along and good/bad leaver provisions that govern what happens if a shareholder director departs the business, and on what terms. This may include restrictive covenants and entitlement to retain shares or share options.

Insolvency backdrop

Where a company requires emergency investment, it may be insolvent or at risk of insolvency. This is critical and will be an important factor for directors in determining what can properly be done, how and at what speed. If a company has a reasonable prospect of avoiding insolvency, they must take every reasonable step to minimise potential losses to the creditors. Failure to do so can result in personal liability. For an in-depth look at insolvency, see our Guidance on Insolvency for Company Directors.

Is there a more favourable counter proposal or an alternative means of fundraising available?

Directors must not close off options prematurely, especially out of self-interest, but must properly evaluate all available options in the interests of the company with legal and accountancy advice and act in accordance with that advice. If a company and its shareholders are in dispute with each other or there are divergent interest and factions, a new area of risk may develop.

Risk factors may involve unfair prejudice to shareholders/derivative claims

If a minority shareholder considers the affairs of the company have been conducted in a way which unfairly prejudices them as a shareholder (or the shareholders generally), they may have grounds to petition the court. Alternatively, if the court agrees, a shareholder may bring a derivative claim in the name of the company against a director who is preventing the company pursuing its own claims against the director.

Administration

Where the board of directors is unable to agree with its shareholders to conclude a funding round while trading insolvent, it might be able to appoint an administrator who may be able to unlock a better future for the business. It may result in rival “interests” bidding for the business and this may lead to its own difficulties and the need for professional advice.

Conclusion

Where does all this leave a company and its directors/shareholders? When seeking new or further investment, the board will need to be ready to present its case on the sustainability of the business. Investors are likely to be more inquisitive and place the management of the business under increased scrutiny to leverage their position, using the Covid-19 outbreak. Founder directors should ensure that investment arrangements are not unnecessarily onerous; key to this will be obtaining timely and trusted legal advice to guide them through the process of securing viable investment while protecting the position of the founders, the company and its employees.


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Penningtons Manches Cooper LLP