The venture capitalist’s objective is to realise its investment. Generally, it will require a relatively high capital profit to compensate for the risk, time, and other resources associated with the financial investment.
The initial investment will contemplate a timeline and horizon for realization. It may be between two to three to seven to ten years. Obligations may be provided in the agreements to assist in the realization of the investment. In the absence of specific provisions, there is limited scope for a minority shareholder or even a majority shareholder to force the realization of the shares and investments.
The promoters may be obliged to use reasonable endeavors or best endeavors to realise the investment. Best endeavors imply an obligation to do everything possible in the circumstances, regardless of cost and difficulty. Reasonable endeavors are a lesser obligation limited to what is reasonable.
Contractual Rights I
The investor may require an option by which, if it does not realise its shares by other means within a certain timeframe, the promoters are obliged to purchase the shares at a price. The price may be determined by a formula. The investor may be entitled to require the company to repurchase the shares, subject to having sufficient distributable reserves and the ability to do so. The promoters may be obliged to purchase if the company fails or is unable to do so.
In many other cases, there would be no legally binding obligation to realise the company as such. However, there will be provisions to incentivise and ensure that realization is possible. The investors may be entitled to sell their shareholding with a pre-emption option for the promoters. The purchase may occur by agreement between the promoters and the investors at any time.
From the promoters’ perspective, they would not wish the investors to have the right to exit at too early a stage in the investment. The investors may undertake to keep those shares or part of those shares for a minimum period.
In some cases, the promoters may have the right to buy out the investors, such as when the investors become insolvent or there is a change of control. This may occur prior to the projected realization date, and it may occur compulsorily under the agreement in such circumstances. In practice, a minority shareholding or non-controlling shareholding interest is of limited value.
Contractual Rights II
The investors may be entitled to sell to a third party once the relevant pre-emption procedure offering shares to the promoters has been exhausted. It may be that there are no pre-emption provisions, and the investor is free to sell from the outside after a certain period, more commonly after a certain period.
There may be drag-along and tag-along rights. In the case of drag-along rights, where an offer is made to the investors, they have the right to require the other shareholders to sell on the same terms. In the case of tag-along rights, where the investor seeks an external buyer, they must ensure that the promoters can sell out on the same terms if they so require.
The investors may realise their shareholding in accordance with drag-along or tag-along arrangements when the promoters sell. It may be provided that if the majority shareholders wish to sell to an outsider, they must procure that the offer is made available to all shareholders, including the investors, on the same terms.
Repurchase by Company
Companies and Taxation Legislation were amended in 1990 to facilitate the repurchase of shares by a company. Provision was made for the issue of redeemable ordinary shares. Capital gains tax treatment was made available on the repurchase, subject to conditions.
The repurchase by the company of its shares may be possible when the company has substantial undistributed funds, preventing taxation charges that would otherwise arise. However, the repurchase of shares in the ordinary course may amount to a distribution subject to income tax. Capital gains tax treatment requires a substantial reduction in shareholding.
Refer generally to the sections on corporation tax. In cases of investor exits rather than partial interim repurchases, the transaction will be capital in nature. Investors typically aim to secure capital gains tax treatment.
This is, however, contingent upon factors such as whether it involves a corporate entity, a tax-exempt fund, private investor, or other entity like a private investment partnership. At times, investors may prefer income treatment, or the tax outcome might be neutral for them.
Commonly, the ambition in a venture is for the company to eventually seek a public quotation. If there’s only an initial offering, buying investors might not be feasible as the primary purpose is to raise additional capital. A secondary offering, involving existing shares, may enable shareholders to realise their investment. This secondary offering might accompany a primary offering.
The investment agreement could grant investors the right to realise their investment fully during a public quotation, prioritizing them over other shareholders. Alternatively, it may provide for equitable participation in a secondary offering by promoters and investors. However, an offering usually requires the consent of most shareholder bodies.
The investment agreement will likely need negotiation specific to the circumstances of a public offering. It’s unlikely to provide specifics in advance, usually containing only general principles. Investors might have options to subscribe for additional shares or convert loan stock to shares, and they might have the right to redeem redeemable shares for outstanding loans.
While making the company public theoretically enables all shares to be liquid, securities laws generally restrict participants from selling shares initially. Therefore, promoters may seek transfer restrictions to allow the shares’ market to establish itself without significant early sales.