A corporation's charter is the legal document that forms the corporation and principally sets forth the corporation’s equity securities' economic rights and certain fundamental governance provisions. The charter authorizes the number and classes of shares the corporation can issue and specifies each class’s rights, preferences, and privileges.
The following outlines important considerations and common issues that may arise when drafting a charter document in the venture financing process.
Watch part one of our NVCA document series webinar on the Charter.
How to determine the number of authorized shares of common stock and preferred stock?
The number of authorized shares of common stock should be sufficient to cover the outstanding common stock, the equity grants (i.e., outstanding options and option pool reserve), the exercise or conversion of outstanding warrants and other convertible securities, and the conversion of the authorized preferred shares. The number of authorized shares of preferred stock should be sufficient to cover the existing preferred stock, any preferred stock issuable upon the exercise of preferred stock warrants, conversion of other convertible securities (i.e., convertible promissory notes and Simple Agreements for Future Equity (SAFEs), and the maximum preferred stock issuable in the new round of financing. In the case of each of the common and preferred stocks, the corporation may want to consider authorizing an additional buffer for future issuances.
Are “shadow” securities of preferred stock necessary in the financing?
A “shadow” series of preferred stock is used to accommodate the conversion of convertible securities, such as SAFEs or convertible promissory notes, which have a lower per-share conversion price than the main series of preferred stock in the qualified financing. A shadow series has identical terms to the main series, except for the original issue price, which affects the liquidation preference, the conversion price, and the anti-dilution adjustment threshold.
What are liquidation preferences?
The liquidation preferences determine the order and amount of the distribution of proceeds with respect to the corporation’s securities in a liquidation event, which also applies to an exit event. The liquidation preferences of a class or series of preferred stock can be senior, junior, or pari passu among the different series of preferred stock and can be participating or nonparticipating with the common stock with respect to the proceeds in an exit event. The liquidation preferences framework is also called the ”waterfall.” Some common considerations are how to deal with escrows and earnouts in the waterfall and how to protect the preferred stockholders in different circumstances, so they receive the benefit of their bargain with the corporation.
Voting provisions in the charter cover the voting rights of the common and preferred stockholders and effectively establish the relative power between the founding team and the investor base. The key voting provisions of the preferred stock relate to the board composition and the protective provisions, or the veto rights, of the preferred stockholders. The board composition determines the relative number of directors elected by each series of stock, and whether certain directors are mutually elected by holders of different series and/or classes of stock—for example, a director may be mutually elected by both the preferred and common stock. The protective provisions give the preferred stockholders the right to approve or veto certain fundamental corporate transactions, such as an exit event, an amendment of the charter, an issuance of senior or pari passu preferred stock, or an increase (or decrease) of the number of directors.
Watch part two of our NVCA document series webinar on the Charter.
Converting shares into common stock
Conversion is the ability of the preferred stockholders to convert their shares into common stock, either at their option or upon certain events, such as an initial public offering (IPO) or a pay-to-play scenario. Conversion is important because it determines how the preferred stockholders participate in the upside potential of the company, as well as how they exercise their voting power.
Anti-dilution provisions are designed to protect the preferred stockholders from the dilutive effect of issuing new shares at a lower price than the original purchase price of the preferred stock. There are two main types of anti-dilution provisions: weighted average and full ratchet.
Weighted average is the more common and less severe method, which adjusts the conversion ratio based on a formula that considers the new shares' number and price. Full ratchet is the rare and more drastic method, which changes the conversion ratio to match the lowest price of the new shares.
Pay-to-play — Incentivizing participation in subsequent financings
Pay-to-play provisions incentivize existing investors to participate in subsequent financing rounds by imposing penalties on those who do not. Pay-to-play transactions are complex and require careful consideration and structuring. Accordingly, they are not common and are usually used as a last resort.