Sherif Hefni

Partner, Levari LLP


Anyone who has ever founded or operated a start-up knows that fundraising and building good, clear, strong relationships with investors is key to the framework upon which the success of their business rests. Start-ups often face difficulties with legalities when it comes to raising funds and a start-up will generally reach a certain phase in its life where it begins to approach venture capitals (VCs) and investors for its series A funding. Once such a phase has been reached and preliminary funding has been approved, the VCs will generally begin the process of investigating the legal structure of the start-up and ensuring that it accords with what they, as investors, consider to be a sound framework to guarantee the security of their investment.

In order for both sides to protect their interests, it is worth understanding the intricacies of these agreements, so as to ensure that everyone is protected. Ideally, the framework created would guarantee a win-win situation for both sides.

The investigative process covers the following:

Financial and Legal Due Diligence:

This is a formal process during which the disclosure of key information takes place. The start-up will be required to disclose all its financial records dating from the time of incorporation, including profit and loss, expenditure, bank accounts, payroll and client contracts. This enables the VCs to gain an understanding of the financial position of the company and its liabilities.

With regard to legal due diligence, the start-up will be required to disclose all information and make available all company documents, including Articles of Association, the Directors’ Register, Shareholders’ Register, any registered intellectual property (trademarks, copyright) and the Board and shareholders’ minutes since incorporation.

It is important for start-ups to be fully transparent and forthcoming during this process, as later the company will sign warranties attesting to the fact that all relevant information has been disclosed. Start-ups often worry that such information may be not be kept secret, however the VCs will send a term sheet for signature which highlights the main terms agreed upon; within those terms there will be a confidentiality clause which states that the parties undertake to keep all information related to the transaction and due diligence private and confidential. The VCs’ lawyers and auditors, who undertake the due diligence, also have an obligation to keep such information private and confidential.

It is therefore not only advised but wholeheartedly recommended that owners of start-ups be fully transparent throughout this process, in the full knowledge that their rights will be safeguarded.

Shareholder’s Agreement:

At the beginning of the process, the VCs or investors will have discussed with the founding team their collective preferred corporate structuring, whether this be an offshore holding company in the BVI, Mauritius or the Cayman Islands, or perhaps a local holding company. It could be that the start-up already has a good and sound legal structure in place. In any case, a Shareholders’ Agreement will be required, to formalise the structure and, again, to ensure that the rights of both parties are respected. The Shareholders’ Agreement (SA) or Shareholders’ Subscription Agreement (SSA) is one of the most important documents in any investment transaction. As such, we would always recommend that the founders of any start-up begin to familiarise themselves with the terminology and main aspects of a SSA prior to the formal inception of their entity.

There is always confusion as to which provisions belong to the SSA and which to the Articles of Association (AoA). To clarify, the AoA constitute the bye-laws of a company, governing its day-to-day management, and they include any limitations on the company’s objects. Common provisions in the AoA include:

  • Provisions relating to separate classes of shares and their respective rights and provisions relating to the variation of those rights;
  • Procedures for the issue and transfer of shares (including pre-emption rights and restrictions on transfer);
  • Provisions for the notice of shareholder and director meetings and their proceedings (including quorum and voting);
  • Provisions for the appointment of directors and (if appropriate) the company secretary, the powers of the directors and how they are to be exercised, and how directors’ conflicts of interest are to be managed;
  • Provisions permitting the directors to share information belonging to the company with the shareholders that nominated them for appointment;
  • Restrictions on borrowing powers and certain other restricted matters.

The confusion frequently arises as to which provisions go into the AoA and which into the SSA. There are no hard and fast rules, but the divisions outlined below are often followed:

  • Object and scope of the venture. This is normally found in the SSA.
  • Capitalisation and funding. This is normally found in the SSA.
  • Board composition and management arrangements. This is normally found in the SSA.
  • Distribution of profits (including dividend policy). This is normally found in the SSA.
  • Provisions for dealing with deadlock. This is normally found in the SSA.
  • Termination provisions. This is normally found in the SSA.
  • Restrictive covenants. This is normally found in the SSA.
  • Rights to appoint and remove directors. This is normally found in the AoA.
  • Quorum for board and shareholder meetings. This is normally found in the AoA.
  • Procedures for shareholders’ meetings. This is normally found in the AoA.
  • Division of shares into classes. This is normally found in the AoA.
  • Chair’s casting vote. The chair’s casting vote at shareholder meetings is commonly contained in the AoA.
  • Notice provisions. This is normally found in the AoA.
  • Share transfer provisions (including pre-emption rights). This can be in either the SSA or AoA.
  • Minority protection (veto rights, tag along rights and so on). This can be in either the SSA or AoA.
  • Drag-along rights. This can be in either the SSA or AoA.

In the event of a conflict between the SSA and the AoA, which document is likely to prevail?

Although in some circumstances the SSA can be registrable under certain jurisdictional laws as provided in the Company Act of 2006 in the UK, which would eliminate any conflict issues, it is generally more common that the Shareholders’ Agreement would prevail and be enforceable between the parties, without the need for registration. If the SSA stipulates that, in the event of a conflict pertaining to the AoA, the shareholders will use their voting powers to amend said AoA, the requirement of registering the SSA does not arise because this SSA does not of itself amend the AoA and would not have needed to be passed as a special resolution had it not been agreed by all the shareholders.

In practice, the circumstances of the conflict and the interpretation of the SSA and AoA may determine which document takes precedence. In Dear and Griffith v Jackson [2013] EWCA Civ 89, for example, in which a Shareholders’ Agreement obliged the parties to ensure that a shareholder would be periodically re-appointed as a director but the Articles of Association permitted the other directors to remove him, the Court of Appeal said that in fact there was no conflict. The Shareholders’ Agreement was to be read as if it did not purport to affect the removal provisions in the articles (especially as some of the directors had no knowledge of the terms of the Shareholders’ Agreement and were entitled to take the articles at face value and to assume that the removal article would work).

As such, the founders of start-ups need to also be aware of the numerous restrictions and duties to which they may be subject under Company law, insolvency and other legislation – particularly in the case of their being directors. Principally there are seven general duties of which we advise founders to be aware if they are appointed to the position of Director. These are:

  1. To exercise reasonable care, skill and diligence;
  2. To promote the success of the company;
  3. To act within their powers;
  4. To exercise independent judgement;
  5. To avoid conflicts of interest;
  6. To declare any interest in a proposed transaction or arrangement;
  7. Not to accept benefits from third parties.

Finally, where an investment is to occur in an offshore holding company, we always recommend that the start-ups ensure that any transactional documents such as the AoA and SSA are checked to ensure that they have been constructed in compliance with local laws, through a local lawyer.

Understanding SSA and AoA terminologies is an essential skill for start-ups, particularly when it comes to negotiations with VCs or investors, so as to protect their interests. As such, start-ups in this situation may be well advised to seek the support of a law firm that has experience in this field.