Guide to investor rights

When we refer to investors' rights, we refer to the legal and financial protection granted to investors when receiving shares in a start-up. It can also refer to certain privileges. In the early stages, a start-up can raise funds through convertibles. The founder will receive the money but does not need to issue shares at that stage.

Jan 27 · 9-minute read ·

investor rights

When we refer to investors’ rights, we refer to the legal and financial protection granted to investors when receiving shares in a start-up. It can also refer to certain privileges. In the early stages, a start-up can raise funds through convertibles. The founder will receive the money but does not need to issue shares at that stage. However, as the company grows, it will raise more funds through equity financing funding rounds. Now investors will receive shares and their accompanying rights.

Each round of financing and different types of shares may carry different legal rights and protection for investors. Investors usually expect to receive preferred shares in an equity funding round. This means they will have special rights compared to the founder and other team members holding ordinary shares.

Common types of investor rights

Although each round of equity financing may be different and investors will negotiate different rights and protection, the following are key rights investors will typically expect following an equity financing round.

Liquidation preference

The name explains this right – when it comes to liquidation, the preferred shareholder will get “preferred” treatment over ordinary shares. Preferred shareholders will receive a certain amount of money before any other shareholder when the company has cash that can be distributed to shareholders. This refers to liquidation, winding up, or dissolution of the company. It also applies when the company has a net profit for distribution. This is most typically set at 1x their original investment amount (e.g. they receive the amount they invested before anyone else can receive a distribution). Consider carefully before accepting a preference higher than 1x as this can have a material impact on a future exit.

You get several types of liquidation preferences.

• Participating, meaning the investor will get their portion of the money before ordinary shareholders and share in any remaining proceeds on a pro-rata basis. This is quite aggressive and less common (also referred to as “double-dipping”).

• Non-participating preference does not allow them to share in the remaining proceeds, but states that they receive the higher of the liquidation preference multiple (e.g. 1x) and their pro rata share of the proceeds. This is the more typical structure.

• Investors could also convert their preferred shares to ordinary shares at a fixed conversion rate (which will include any anti-dilution adjustments – see below). This would typically only be used where the pro rata portion of the proceeds is expected to be higher than the liquidation preference multiple. It may also need to be used where an exit is being done through IPO as most listing rules do not allow for the type of rights that preferred shares typically carry.

Liquidation preference is probably the most significant financial right investors have.

Anti-dilution rights

Anti-dilution rights are protective provisions to protect an investor’s economic rights. It protects the value of the investor’s stake in your startup when you raise funds in the future at a lower valuation, and issues new shares at a lower price than what the investor paid.

Anti-dilution rights can grant the investor additional shares for free. Alternatively, the amount of proceeds they are entitled to upon an exit can be adjusted (this is referred to as the conversion price and the formula basically refers back to the number of shares the investor originally receives plus an additional amount to compensate for any anti-dilution – this has the advantage of not requiring costly filings and amendments to physically issue new shares to investors at the time of the anti-dilution event).

Rights relating to reserved matters

Reserved matters refer to certain important decisions reserved for approval by investors (either at shareholder or board level or both). Investors essentially have the right to veto decisions on these matters. It usually requires that holders of a certain percentage of preferred shares must vote to approve any action relating to these matters. If the right is granted to apply to board-level decisions, one or more directors appointed by the investors must approve the decisions.

Reserved matters could include decisions related to significant business transactions, senior appointments, litigation, changes to the company’s capital structure, issuing new shares, etc.) Reserved matters are usually outlined in the company’s articles of incorporation and/or shareholders’ agreements.

Right to appoint board members

Investors may ask for the right to appoint a company board member. It is more typical to expect a larger or more “involved” investor to require such a right (often referred to as a “lead investor” in your equity funding round).

Share transfer restrictions

Share transfer restrictions limit a shareholder’s ability to transfer their shares. The purpose of share transfer restrictions is that the company can keep control over who owns its shares, protect investors from founder departures and to allow existing investors a priority on purchasing shares.

Sometimes some of these restrictions are exclusively in favour of preferred shareholders. Alternatively, they may be exempted from these restrictions.

The restrictions can take many forms, including:

Pre-emption rights

Pre-emption rights are also called subscription rights. It gives existing investors a priority right to invest in future equity funding rounds. They have the right to buy new shares before it is offered to additional investors. This is a necessary right for investors to maintain their percentage ownership in the company, i.e., protect them from dilution of their ownership when new shares are issued.

Right of first refusal

Right of first refusal gives the shareholder a priority right to buy existing shares from another shareholder before they can be transferred to a third party. The right of first refusal can be structured in many ways. For example, the selling shareholder can establish a price with a third party and then offer the shares to the existing shareholders to see if they want to buy at that price, or they oculd first solicit offers for the shares from existing shareholders and then either sell at that price or choose to sell at a higher price to a third party.

These rights can backfire, as they can limit the ability of a shareholder to sell their shares if the potential buyer feels the process could be undermined by an existing shareholder taking the shares instead. As a result, significant investors are often exempted from the obligation to offer their shares to other shareholders first. At the same time, it might apply to founders and smaller investors.

Drag-along rights

Drag-along rights allow majority shareholders to force the minority shareholders to sell their shares along with the majority. Minority shareholders are forced to sell their shares to the same buyer at the same price when enough shareholders want to sell their shares to a specific third party. “Majority” typically means at least a majority of all investors. Sometimes it will stipulate that it requires the approval of the founders as well.

Drag-along rights ensure that minority shareholders can’t block a deal and that the startup is “sellable”.

Tag-along rights

Tag-along rights give minority shareholders the right to “tag along” when shareholders want to sell their shares. So, when shareholders propose to sell their shares to a third party, the investor with a tag-along right may also sell a portion of their shares to the same buyer at the same price.

Major investors might want to avoid being subjected to other investors’ tag-along rights as they can impact their ability to exit (i.e. by forcing a larger number of shares that need t be bought to complete the transaction, making it more expensive). As a result, tag-along rights are often limited to transfer by founders and are only given to investors.

Restrictions on the founders

Investors could ask for the right to restrict the founders from performing specific actions.

Usually, there are two types of restrictions.

  • Lock-up restrictions

This restriction prohibits the founder from selling their shares for a specific period. Investors often invest in the founder as much as they do in the startup. A lock-up period ensures the founder stays long enough to develop the business.

  • Vesting restrictions

This restriction can be referred to as “reverse vesting” or a repurchase right. It gives the startup the right to repurchase shares from a founder if the founder leaves before a specific date.

Founders typically already own all their shares. If the vesting period isn’t completed, the company has the right to repurchase shares from the founders should they want to leave.

The primary purpose of this restriction is to ensure that the founder remains committed to the company. As an investor, you want the founder to stay and actively participate in the business to deliver what was promised in the funding round. Without a “reverse vesting” right, investors might find themselves in a situation where the founder leaves after a short period and keeps all their shares.

Other investor rights

Dividend rights

Investors may have a right to receive a certain preferred dividend, e.g. an amount equal to 8% of their original investment amount per year, rolling over to the next year if the company cannot pay it or does not declare a dividend that year. This is a relatively aggressive right and can have a material impact on the exit proceeds of founder and investors without this right.

Right to access information

Investors have the right to access certain information and documents of the company (primarily the company’s books, accounts and financial satements), as well as potentially the right to visit and inspect business premises.

Investor rights are crucial for investors to ensure they can protect the value of their investment. Some of these rights, however, could limit the startup’s ability to raise more capital.

Investors and founders must understand their respective rights and how the enforcement of these rights would impact the startup’s future. When negotiating rights, it is in the interest of all parties to consider the future interests of the startup.

With Clara‘s resources and guidance, you can make informed decisions and set your start-up for long-term success. Sign up today to get started.

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