Wednesday, February 6, 2019

Investing in the USA and Russia: Comparison


The institution of shareholder agreements is emerging in Russia. The founders sign them among themselves at a very early stage and thus give each other rights regarding their shares in certain situations.

In the US, shareholder agreements at the stage of incorporation of a startup are not practiced (although something similar is introduced by investors at a later stage and entitles investors to the founders). Instead of a shareholder agreement in the United States, the protection of the project is determined in the contract for the acquisition of a share directly between each founder and company. Thus, if one of the founders leaves the project, then the principle of vesting works, and the company has the right to buy back part of its shares at the original (usually close to nominal) price. How much she can buy out depends on the specific conditions of the westing and on how much the founder has worked in the project. If the founder wants to sell his share or its part to a third party, the right of the first refusal works, and the company can force it to sell its share to the company instead of a third party at the price offered for it by a third party.

In fact, there is no big difference between these approaches. But instead of trying to persuade all shareholders to approve a single contract that governs their relationship, here it seems to me that a simpler mechanism is used - a standard contract for each founder with the company. The new shareholder, therefore, should not be included in the general contract and will not know the conditions of the vesting, for example, or its acceleration by other shareholders.

Shares and their blurring

Shares in LLC are distributed by percent between founders. In order to introduce a new shareholder, the share of current shareholders has to be redistributed. Current shareholders share their shares with a newcomer, and there are often agreements on the non-dilution of some shareholders who will not have to share, with others who take over the blur.

In corporations that are the most used legal entities for startups in the United States, shares are determined by the number of shares issued to a shareholder in relation to all shares issued by a company.

The company's board of directors, its governing body, may additionally issue shares to both new and current shareholders, but only within shares authorized for issue in the company's charter (Certificate of Incorporation or Articles of Incorporation, depending on the state). If there are not enough authorized shares and you need to increase their number, then a majority vote of shareholders is required.

One of the easiest ways that start-up investors in the United States are protected against blurring is the restriction of authorized shares in the charter to the number of shares currently required by the company.

When it comes time to add a new investor, current shareholders vote, and the charter is rewritten with more shares and often with additional rights and privileges of shares for the new investor.

Different classes of shares

In LLC, in general, different classes of shares are impossible, therefore purely corporate nuances are already beginning here.

Thus, both ordinary shares (CommonStock) and preferred shares (PreferredStock) can be authorized by the charter of a US corporation. According to the convention, the founders and employees receive ordinary shares (or options to buy them), and investors - preferred ones. Each class of shares can then be divided into series, although it is much more typical to see different series of preferred shares than ordinary ones.

Why do we need different classes and series of shares? The fact is that the company's charter can fix not only the number of shares of different classes and series but also their various rights and privileges. But the charter does not allow differentiation between shareholders of the same class. Accordingly, if investors entered into different periods of time have agreed with the company on different conditions, and everyone wants to fix their rights in the charter, then each subsequent investor has to issue a new series of preferred shares (from here Series A PreferredStock, Series B PreferredStock, and etc.).

Those who are familiar with the practice of creating start-ups in Russia are asking the obvious question: why all these difficulties are different classes and series of actions and changes in the statute that need to be submitted to the state if investors can be fixed in the shareholder agreement instead of the charter? And here there is a small, but very important nuance - the rights enshrined in the shareholder agreement are contractual rights. Accordingly, if they are not respected, and the investor is suing the company, then at best he will receive compensation for damages to the extent that the investor can prove in court. If his rights are enshrined in the charter and they are not respected by the company, then the investor, who is suing because of this violation, is no longer asking for damages, but for canceling that transaction or canceling the action that violated his rights.

Because of this potential risk, the likelihood that a company will violate the rights of shares specified in the charter is much less than the probability that only a contractual obligation will be violated.

On this basis, Russian investors in start-up projects registered under US law should not avoid investing in preferred shares, but rather the opposite — insist on buying preferred shares with key rights reflected in the charter.

Other risks

The significant difference that I have noticed between investors in the United States and in Russia is manifested in the weight that investors attach to the risk of banal fraud on the part of the founders.

Start-up investors in the United States realize that the probability of success of a startup is already so small, and the probability of losing all or most of their contribution is so high (start-ups are a very speculative area) that it’s simply meaningless to defend against insignificant risk.

Russian investors, on the other hand, often spend a lot of time and effort on introducing mechanisms to control the company's operating activities, the founders and the company's cash flows.

Of course, fraudsters are everywhere. But if the American investor has a low level of trust in the founders, and he is afraid that he will be “thrown”, he will simply not enter the project. After all, the founder on the collar will not build the next Facebook, Tesla or Amazon.