exam Start Up law Flashcards
What is the difference between a convertible non-participating preferred stock and a participating one?
Non-Participating: Investors choose between their liquidation preference or converting to common stock, whichever is more profitable. Participating: Investors get their liquidation preference and share in the remaining proceeds with common stockholders.
Pollman’s article points out that a set of governance issues affecting startups are horizontal and concern the conflicts that arise between shareholders (preferred vs common, preferred vs preferred, common vs common): Please discuss these issues.
- Preferred vs. Common: Conflicts arise because common shareholders may prioritize long-term growth over early liquidity.
- Preferred vs. Preferred: Different series of preferred stock may have different terms, leading to conflicts between earlier and later investors over exit strategies.
- Common vs. Common: Founders may prioritize control or strategic goals, while employees holding stock options may want liquidity faster.
What is a cumulative dividend?
A cumulative dividend is a guaranteed dividend that accrues over time if unpaid. Preferred shareholders with this right must be paid any accumulated dividends before common shareholders receive dividends.
The function and mechanics of anti-dilution clauses
Function: To protect investors from ownership dilution in a “down round.”
Mechanics: Adjust the conversion price of preferred shares using methods like full ratchet (price adjusts to match new round) or weighted average (adjusts based on new share price and quantity issued).
The board composition and functioning in VC-financed startups (consider the Synthesia example).
The board is structured to balance founder control with investor oversight, focusing on strategic growth and protecting VC investments.
In venture capital (VC) investments, the board is typically divided among founders, investors, and independent directors.
INVESTORS negotiate board seats to protect their interests. FOUNDERS hold seats but may have reduced control. INDEPENDENT DIRECTORS may be appointed for neutrality.
Function:
The board makes major decisions regarding fundraising, hiring, M&A, IPOs, and financial strategy. The board structure influences company strategy and exit scenarios
Drag-along: How it works and why is it used in the articles of association of VC-financed startups?
Drag-along rights allow majority shareholders (often VCs) to force minority shareholders (founders, early investors) to sell their shares in an acquisition or liquidity event.
VC decides to sell the startup, minority shareholders must also sell at the same terms.
Prevents founders or small investors from blocking a sale.
- Ensures a clean exit for VCs.
- Avoids holdout problems (where small investors refuse to sell).
- Gives acquirers full control over the startup without minority resistance.
How anti-dilution clauses work in the articles of association of Italian startups?
Antidilution clauses are starting to be implemented and represent something truly new in Italian charters; accordingly, an instrument that was almost never used in Italian corporate law before the emergence of venture capital financing. However, since Italian charters do not use convertible preferred shares, antidilution clauses are not focused on the conversion ratio, but on the attribution of adjunctive shares to the investors protected by them.
Antidilution clauses in Italy differ because they do not rely on conversion ratios but instead grant additional shares to protected investors.
Why do startups pursue an IPO instead of private financing or crowdfunding?
Creates a Secondary Market → Investors can buy/sell shares anytime.
Gives VCs an Exit Opportunity → Best way for venture capitalists to cash out.
Provides More Capital for Growth → Unlike crowdfunding, IPOs raise significant capital.
Improves Company Reputation & Creditworthiness → Public companies attract better business partnerships.
Downsides:
Expensive & Complex (legal fees, prospectus requirements).
Regulatory Scrutiny (more compliance rules).
Loss of Control (founders dilute their ownership).
Why do VCs require preferred shares instead of common shares when investing in startups?
Preferred shares provide investors with advantages not available to common shareholders, such as:
Liquidation preference → Ensures VCs get paid first if the company is sold or liquidated.
Anti-dilution protection → Protects investors if the startup raises funds at a lower valuation (down round).
Dividend preference → VCs get dividends before common shareholders (if applicable).
Control mechanisms → Preferred shares often grant voting rights on key decisions.
All this for to minimize risk and maximize potential returns.
What are liquidation preferences, and why are they included in VC financing agreements?
Liquidation preference determines how proceeds are distributed in case of a company sale, IPO, or liquidation.
Types:
1x liquidation preference (most common): Investor gets back at least what they invested before common shareholders receive anything.
Participating preferred: VCs get their money back AND a proportionate share of remaining proceeds.
Non-participating preferred: VCs choose between their original investment or their equity share (whichever is higher).
What is founder vesting, and why is it important in VC-backed startups?
Founders earn their shares over time instead of owning them all upfront
Prevents early departures from damaging the company.
Protects investors from a founder leaving with a large equity stake.
Ex: 4-year vesting with a 1-year cliff → Founders earn 25% of their shares after 1 year, then monthly after that.
What are protective provisions, and how do they benefit VC investors?
Protective provisions give VCs veto power over key company decisions.
Common provisions:
Selling the company → VCs must approve M&A deals.
Raising additional funding → Prevents dilution of existing investors.
Changing board structure → Ensures VCs retain influence.
What are tag-along rights, and why do minority shareholders need them?
Tag-along rights allow minority shareholders to sell their shares when majority shareholders sell.
Why it matters:
Protects minority investors from being left behind.
Ensures VCs get the same deal as founders.
How do down rounds affect startup valuations, and how do investors protect themselves?
Reduces the value of existing shares.
Dilutes founders and early investors.
Investor Protections:
Anti-dilution clauses (full ratchet or weighted average).
Liquidation preferences ensure VCs recover their investment first.
Main differences between U.S and Italian articles of association
- Convertible preferred shares are rarely used in italy (Participating preferred shares are widespread)
- Antidilution clauses don’t rely on conversion ratio but instead grant additional shares to the protected investors
How are Italian (and European) companies using of U.S.-Inspired Mechanisms in the articles of association?
- Co-sale clauses (Drag along and Tag along) are widely used
- SAFEs are getting popular
- Adopting vesting schemes
- Gradually moderanizing corporate framework to be StartUp friendly from SRL to SME SRL
Key features of the SME SRL
compared to a SRL
- Flexible corporate governance
- Can issue special financial instruments to attract investors
- Voting agreements and investor protections
- More freedom in structuring share classes and control rights
- No minimum capital requirement
