Document Spotlight: A&R Charters in Venture Financing Deals

An overview of amended and restated charters in venture financings.

This article is one of a series by HyperDraft spotlighting transaction documents in venture financing deals. Deals are busy and often the basics are glazed over in practice. Our team has been there practicing in the trenches and understands the need for quick refreshers. This series aims to quickly fill in the blanks with a brief overview of common topics.

What is a Charter?

A charter (“Charter”), also called a certificate of incorporation or an articles of incorporation, is a document filed with the Secretary of State or registrar of the state in which the company was incorporated. A Charter is the main governing document for a company and a company is not officially formed until the Charter is filed.

A Charter generally contains (among other things):
(i) the authorized number of shares for each class and series of stock of the company,
(ii) the rights and privileges of the company’s stock, and
(iii) voting thresholds to waive such rights and privileges.

What role does a Charter play in a venture financing deal?

In a venture financing, a company drafts an amended and restated Charter (“A&R Charter”) in order to include the new series of preferred stock being sold. The company will need to increase its common stock within the A&R Charter to account for any conversion of the additional preferred stock into common stock.

The Charter covers provisions that apply to the classes of stock as a whole. Other rights that may apply to only certain stockholders are ordinarily covered in separate agreements (i.e. management rights letters, voting agreements, etc.). Once the draft of the A&R Charter is final, it needs to be filed in the company’s state of incorporation before the new class of preferred stock can be sold.

What are key provisions of an A&R Charter?

An A&R Charter is divided into several parts (for an example of a typical A&R Charter, check out the NVCA form). The key parts of an NVCA form A&R Charter are the following:

1. Background Information

An A&R Charter begins with the basic corporate information and then is divided into articles. The first through third articles meet certain state corporate statutory requirements by listing the name, address of registered office, state of incorporation, and general business purpose of the company.

2. Authorized Stock

The fourth article creates and authorizes a certain number of shares for each class (i.e. common and preferred) and series of stock (i.e. Series Seed). A company must be careful to increase the number of authorized shares of the company by at least the number of shares being sold in the financing transaction. This increase includes an adequate number of shares of common stock for the preferred stock to convert into.

Companies usually authorize more shares of stock than are necessary for the financing, which is called a “buffer.” The “buffer” is usually small because investors want to limit how many additional shares can be issued without their approval.

3. Common Stock

The fourth article also sets forth the rights and restrictions of the common stock. This article describes the voting rights of the common stock which is typically one vote for every share of common stock and the voting rights reserved for common stock under the law.

Occasionally, the company will give different classes of stock different voting powers by giving a class of common stock “supervoting” rights. Usually the founders will hold the supervoting common stock and employees will receive simple one vote per share common stock. A typical class of supervoting common stock will have ten votes per share. Founders need to have significant leverage to maintain supervoting rights and investors will usually want to either flatten the voting structure or have their preferred stock convert into supervoting stock.

4. Preferred Stock — Dividends and Liquidation Preference

The second part of article four of an A&R Charter usually describes the rights, powers, and preferences of the preferred stock, including dividends and liquidation preference.

Dividends can be cumulative or non-cumulative. With cumulative dividends, if the minimum dividend is not paid each year, then it accumulates and is added to the amount that is payable to preferred holders (i.e. the company is sold or preferred stock converts to common stock). With non-cumulative dividends, there is no yearly accrual of the dividend. Both dividends are payable to investors only when the company decides to pay them at their sole discretion. As most startups are hard pressed for cash, they almost never declare dividends.

As we discussed in a prior article, the preferred stockholders receive a liquidation preference in the Charter. This preference allows the preferred stockholders to be paid out before any funds from a deemed liquidation event before the common holders. The preferred stockholders can opt to convert their stock to common stock and forgo their preference. They will do this if they will receive more funds by converting to a common stockholder rather than a preferred stockholder.

A deemed liquidation event is defined in the Charter and will include major corporate actions, including wind-ups, mergers, acquisitions, transfers of a majority of the voting stock, or a sale of substantially all of the company’s assets.

5. Voting Rights

Each preferred stockholder votes based on the voting power of the common stock the preferred stock converts into. This “as converted” concept is important because it can mean that a preferred stockholder will be able to have more than one vote per share of preferred stock they hold. This occurs in two situations: (i) each share of preferred stock converts into more than one share of common stock or (ii) the class of common stock the preferred stock converts into is entitled to more than one vote per share.

The stockholders are also provided certain voting rights relating to the board of directors, including the rights for:

(i) each class to elect and remove directors,

(ii) the preferred holders to elect preferred director(s), and

(iii) the common holders to elect common director(s).

Ordinarily, the class that elected its director can remove that director. In most cases, the investors, the key common holders, and the company will enter into a voting agreement, which we will explore in a future article, that further defines these rights.

This section also contains covenants which are often called protective provisions. As we discussed in a prior article, protective provisions restrict the company from taking certain actions without a certain percentage of investor approval. This voting threshold is set forth in a company’s Charter (i.e. majority, a supermajority, or a specific percentage of each series of stock).

6. Conversion and Anti-Dilution Provisions

The conversion of preferred stock is covered in section four. Typically, each share of preferred stock is convertible into one share of common stock. The conversion ratio is subject to adjustment to offset dilution if certain events occur. These events include stock splits, dividends being paid on the common stock, and financings at a lower price that what the investors paid for their stock (i.e., a down round). The Charter sets forth the conversion price which initially is equal to the original issue price. Generally, the conversion ratio is equal to the conversion price divided by the original issue price. A down round results in a reduction of the conversion price and an increase in the conversion ratio.

As we discussed previously, anti-dilution provisions protect investors from their investment losing value in the event that the stock price falls below the price the investors paid. These are typically included in the Charter and most commonly broad-based weighted average is used to calculate an anti-dilution adjustment.

In the NVCA form, the defined term “Additional Shares of Common Stock” is important as it governs what type of stock issuances trigger an anti-dilution adjustment. Any security that is convertible into common stock can result in an adjustment. This section will also exclude certain types of stock issuances from triggering anti-dilution protections. For example, stock issuances to employees as part of an incentive plan will not trigger anti-dilution protection.

Mandatory conversions are described in section five as being triggered by certain instances, including when a company holds a public offering of a certain threshold (set forth in the Charter) or a specific percentage of preferred stock holders elects to convert.

7. Miscellaneous Provisions

• Amendment and Modification — The fifth article allows the board to amend the bylaws, without this provision under Delaware law, any amendment to the bylaws would require a full stockholder vote. This right will typically be subject to any voting requirements contained in the bylaws or other sections of the Charter.
• Officer and Director Indemnification — The ninth and tenth articles eliminate directors’ liability for monetary damages and allow the company to enter into indemnification agreements with directors and officers. This is important for venture capital firms that have a representative on the company’s board because venture capital firms will likely insist that their representative enter into an indemnification agreement with the company.
• Corporate Opportunity Doctrine — The eleventh article relaxes the corporate opportunity doctrine for investors and their board representatives. The corporate opportunity doctrine prevents officers and directors from personally benefiting from opportunities that should belong to the corporation. The exclusions in this provision are important to many venture capital firms since they often have representatives on the boards of other portfolio companies and do not want to risk a lawsuit for pilfering business from the company.

Tying it All Together

A Charter is a document filed with an entity’s state of incorporation to establish a company and it typically details the governance, structure, objectives, operations, and other major details of the company. Commonly, in a venture financing, a company’s Charter will be amended and restated to accommodate the new preferred stockholders and any negotiated changes to the rights, preferences and privileges associated with the preferred stock.

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