A fundamental issue in any equity investment, and particularly in first and early stage funding, is the question of the dilutive effect of further issues of shares.
In most deals, an investment of GBPx buys the investor y percent of the equity. Clearly, if further new shares are subsequently issued to a third party, that issue will dilute the original investor's holding - in other words, it will have a lower percentage of the equity. Of course, the value of the original investment should also increase as a result of the further money put in by the third party. In any event, it would be very normal for the documentation entered into at the outset of any investment to set out the rights of each party in relation to further issues of shares.
Section 89 of the Companies Act 1985 provides that any issue of new shares for cash must be carried out on a pre-emptive basis - in other words, each shareholder must be given the chance to subscribe for a pro rata number of any new shares and therefore maintain its percentage shareholding at the same level. Section 89 does not apply to non-cash issues and, further, can be disapplied in a company's articles of association or by a special resolution of shareholders (one which requires a 75 percent majority).
If section 89 is disapplied, then it will be a matter for the discretion of the board as to the terms on which the new shares are issued. In practice, as stated above, it would however be normal for the investment documentation to expressly deal with the position.
A third party investor will normally require anti-dilution protection which will conventionally translate into a right to veto any further dilutive share issues. In practice, of course, any further fund raising would need the consent and co-operation of the existing third party investors in any event. Commercially, they would normally have the choice of either "following their money" i.e. putting in the further investment or accepting the dilutive effect of a third party investment. The recent prevalence of "down round" financing i.e. further funding which is required to bale a business out of trouble or service the cash burn requirements of a company and which is offered on more favourable terms than those offered to initial investors has led many players to require an option or warrant to enable them to participate in any "down round" on such terms that their average subscription price per share across their whole investment equals the new cheaper price at which the "down round" shares are being offered. Of course, holding a veto over any further share issues would allow the initial investors to require this at the relevant time anyway, but it is becoming increasingly common, especially in early stage technology investments, to agree this sort of thing up-front.
An important point to note for management teams is that, in effect, much of this further dilution is likely to be suffered by management, as any third party investor will view such arrangements as "internal business" and will insist on the further investment being structured so that it does not dilute the third party investor.
Another specific point to flag in terms of further share issues is the position of incubators. Because a number of incubators are not permitted under the rules of their funds to invest beyond a certain stage of a company's life, they may not be in a position to follow their money and are therefore likely to have a very specific stance on further dilutive share issues which will have to be negotiated on an investment by investment basis.
With regard to the position of the existing management, it would be rare for the third party equity investors to allow them to veto further share issues. In practice, of course, the support and continued motivation of the management team is going to be very important to any further fund raising and therefore they will need to be on side. However, it would be unusual for management to have any sort of veto on further share issues and the most that they would usually hope to negotiate up front would be a right to participate in any further fund raising pro rata - which may be of little benefit to them if they do have the funds available at the time.
If you would like further information on this or any other corporate issue, please contact David Day at david.day@cms-cmck.com or by telephone at +44 (0)20 7367 2948.
