Understanding Funding and Financing through the CVCA – Part 6: Articles of Amendment, Defining the Nature of the Investment
In our ongoing journey through the Canadian Venture Capital & Private Equity Association (CVCA) model documents, we've delved into the intricacies of term sheets, subscription agreements, shareholders’ agreements and ancillary agreements – documents that lay the groundwork for investment transactions. This week, we're ending our series with an overview of the Articles of Amendment, a crucial document that details the nature of the investor’s equity in a startup.
When a company is incorporated, Articles of Incorporation are filed with the government to legally establish the existence of a corporation. When a company takes on additional financing, Articles of Amendment are used to make changes to the Articles of Incorporation. While the other model documents form the bedrock of the transaction itself, the Articles of Amendment are particularly significant because they outline the specifics of the company’s share structure, including the different classes of shares, their respective rights, preferences, and limitations. For many founders, this might be the first detailed exposure to share terms since the company's incorporation.
Key Components of the Articles of Amendment:
Classes of Shares
The Articles of Amendment define different classes of shares, such as common shares and preferred shares. Each class has distinct rights, preferences, and limitations. This differentiation is critical as it determines the control dynamics within the company and the financial benefits that accrue to each class. In Canada, classes of shares can be further divided into individual series, with each series also having unique terms that differentiate it from others of the same class. With each additional round of financing, Articles of Amendment are filed to establish new series of shares (commonly designated as Seed Preferred Shares, Series A Preferred Shares, Series B Preferred Shares etc.)
Voting Rights
Different share classes typically have different voting rights. Each voting share held by a shareholder entitles the holder to one vote. Typically, both common shares and preferred shares have voting rights. However, the voting rights of preferred shares are usually only applicable to the extent the preferred shares are convertible into common shares (as described in the “Conversion” section below) or on certain protective matters (as described in the “Preferred Share Protective Provisions” section below). It is important to understand the different voting thresholds throughout the Articles where multiple classes of shares are involved and how the shareholders’ agreements affect these voting thresholds.
Preferred Share Protective Provisions
Preferred share protective provisions are critical elements that safeguard the interests of preferred shareholders, typically institutional investors, in certain scenarios. These provisions serve to protect the rights and preferences of preferred shareholders, ensuring they maintain a level of control and influence over key company decisions. Examples include alterations to the terms of the preferred shares, authorization of senior shares, or adjustments to the company’s share capital structure.
Dividends
Dividends are payments made by a company to its shareholders out of its profits or reserves. Dividends are a rarity in the startup world. The Articles of Amendment in standard CVCA transactions generally specify that for common shareholders, dividends will only be distributed if and when declared by the board of directors. For preferred shareholders, the dividend rights specify that preferred shareholders will receive a distribution of dividends concurrently with common shareholders. Investors want the security of knowing that when the common shareholders are paid any dividends, they too will receive the same.
Liquidation, Dissolution and Winding Up
It is important for companies to know the procedures and rights of shareholders in the event of the company's liquidation, dissolution, or winding-up. This section outlines the priority of payments to shareholders, as well as any special rights or preferences granted to certain classes of shares upon liquidation. As you may recall, investors insist on liquidation preference in the term sheet. This means preferred shareholders will be paid out before the common shareholders to the tune of at least their initial investment amount. This de-risks investing for certain categories of investors, because they know they will get their money back first if things don't go well.
Anti-Dilution Mechanisms
Anti-dilution mechanisms are safeguards used by investors to protect their ownership stake in a company from getting reduced (or "diluted") in value during future financing rounds. These mechanisms protect investors from dilution and maintain their proportional ownership in the company. There are different types of anti-dilution mechanisms (e.g., broad-based, narrow-based, full ratchet, etc.) and the Articles of Amendment will specify which formula to use and how adjustments should be calculated.
Conversion
"Conversion" refers to the ability of investors to change one type of security they hold into another. Preferred shares often carry the option to convert into common shares under certain conditions. These conditions can be automatic such as upon the occurrence of a qualified financing round or optional at anytime at the discretion of the preferred shareholder. Conversion rights allow preferred shareholders to participate more fully in the company's growth. The Conversion Ratio is a key aspect of conversion. It determines how many common shares a preferred shareholder receives for each preferred share they convert. The ratio is usually set at the time of the initial investment but can be adjusted (for example, through anti-dilution provisions if new shares are issued at a lower price). The conversion features allow investors to start with a more protected share class (preferred shares) and switch to a potentially more profitable but riskier share class (common shares) under favorable conditions.
The Articles of Amendment serve as a roadmap for navigating the complexities of the post-financing landscape. Once formalized, shareholders are aware of their rights, responsibilities, and protections.
This concludes our 6-part series on the CVCA Model Documents. At MT❯Ventures, we are here to help! Whether it’s walking you through the basics of a CVCA equity financing or helping you through the complex legal drafting, our goal is to make financing as easy for you as possible.
