The charter, also known as the certificate of incorporation, plays a critical role in venture capital financing. It incorporates key terms from the term sheet and stock purchase agreement, and it must be carefully drafted to reflect the capitalization, rights, and preferences of various stakeholders. As companies evolve and raise additional capital, the charter is amended to authorize new shares and adjust terms accordingly. While early amendments may be straightforward, later-stage changes can become administratively complex due to the need for board, stockholder, and class approvals.
Filing mechanics and strategic considerations
Delaware is the preferred jurisdiction for incorporation due to its predictable legal environment, business-friendly courts, and streamlined filing processes. Companies can reserve names in advance, expedite filings, and utilize preclearance services to avoid delays during time-sensitive transactions. Filing the charter is often a prerequisite to closing a financing round, as it authorizes the securities being sold.
Companies are encouraged to file trademarks concurrently to protect brand identity and should ensure good standing by timely payment of franchise taxes. A buffer of authorized shares, both common and preferred, is recommended to provide flexibility for future grants, warrants, or additional closings.
Watch part one of our NVCA document series on the charter
Capitalization and share authorization
The charter reflects the company’s capitalization, including existing common shares, option pools, warrants, SAFEs, convertible notes, and preferred shares. A typical initial charter authorizes around 10 million shares of common stock to allow for granular equity grants and operational flexibility. If applicable, Preferred stock authorization covers existing and anticipated issuances in follow-on closings, including shadow series for converted convertible securities. Authorization buffers are also advisable to accommodate unforeseen needs.
Shadow preferred stock, issued upon conversion of safes or notes, mirrors the terms of the new preferred series but reflects discounted investment amounts. These shares vote with their corresponding series and may require consideration of adjustments to voting thresholds for such series.
Economic Terms: Dividends and liquidation preferences
Dividends are generally non-cumulative and payable only when declared by the board. However, cumulative dividends may appear in later-stage or growth rounds, accruing annually and potentially compounding. These can significantly impact payouts at exit and should be carefully considered.
Liquidation preference provisions, often referred to as the distribution waterfall, determine how proceeds are allocated in a liquidity event. Structures include:
- Seniority: Payouts to senior classes prior to junior classes
- Pari Passu: Equal footing among classes
- Non-Participating: Return of preference or return on an as – converted to common stock basis.
- Participating: Preference plus pro-rata share (on an as-converted to common stock basis) of remaining proceeds
- Capped Participation: Participation up to a defined multiple return on invested capital
These terms set the precedent for future rounds and must be negotiated thoughtfully to strike a balance between investor protections and founder incentives.
Watch part two of our NVCA document series on the charter
Governance provisions and voting rights
The charter outlines, among other things, the voting rights and board composition as among the preferred and common stock. Common stock typically carries one vote per share, while preferred stock votes on an as-converted basis (typically starting at 1:1). Preferred shareholders often elect particular directors and receive protective provisions, such as veto rights over major corporate actions such as mergers, amendments, new issuances, and board changes. These rights safeguard minority investors and become increasingly complex as the shareholder base grows.
Conversion mechanics and anti-dilution protections
Preferred stock may convert to common either optionally or mandatorily. Optional conversion allows investors to do so when economically advantageous, such as during a lucrative exit. Mandatory conversion is triggered by events such as an IPO or a vote by preferred holders, with thresholds negotiated between the company and investors to strike a balance between flexibility and control.
Anti-dilution protections guard against down rounds by adjusting the conversion ratio of preferred stock. Full ratchet anti-dilution provisions reset the conversion price to the new, lower price in a down round, while broad-based weighted average formulas offer a more moderate adjustment based on the size and price of the new issuance. These protections are triggered only by issuances below the original issue price (determined separately with respect to each series of preferred stock) and exclude common scenarios, such as stock splits or equity grants under incentive plans.
Pay-to-play and redemption rights
Pay-to-play provisions incentivize investors to take part in future rounds by penalizing non-participation, typically through forced conversion to common stock. These provisions are rare and usually reserved for distressed or down-round scenarios, however, with the reset in valuations in the last few years, we have seen a significant increase in pay-to-play provisions.
Redemption rights allow investors to require the company to repurchase their shares after a set period, often five years. While uncommon, these provisions are important to certain investors, particularly late-stage investors who have certain internal requirements around liquidity timing. Accordingly, these provisions serve as a liquidity mechanism and can influence company behavior, including prompting exits. Redemption rights are powerful and can significantly impact a company’s trajectory if granted to investors, let alone exercised.
FAQs: Understanding charter documents
What is the charter of a company and how does it differ from bylaws?
A company’s charter, or certificate of incorporation, legally creates the company and defines its capital structure and certain shareholder rights. Corporate bylaws, by contrast, largely govern various internal procedures like board meetings and officer roles.
Is the charter the same as articles of incorporation in every state?
Yes. In most US jurisdictions, the terms charter, articles of incorporation, and certificate of incorporation refer to the same foundational corporate filing used to form a corporation.
What role does the charter play in corporate governance?
The charter of a company defines the rights of stock classes, voting powers, and limitations of director authority. It also interacts with state corporate law, especially for Delaware corporations, where charters are binding contracts with stockholders.
Can the company charter be amended after incorporation?
Yes. A corporation may amend its charter with approval from its board of directors and stockholders. Amendments typically occur during financing rounds to authorize new stock or adjust voting rights.
Do LLCs have a charter like corporations?
LLCs do not file a corporate charter. Instead, they file articles of organization and are governed by an operating agreement amongst the LLC and its members.