Share Subscription Agreements
Introduction
Share subscription agreements, which are commonly encountered in start-up investments, set out the terms and conditions of an investor’s participation in a company as a shareholder by subscribing the new shares issued in a capital increase. This article examines the purpose and key provisions of share subscription agreements.
Purpose
In case of share subscription via capital increase, an investor pays the subscription price -- in other words the investment amount -- to the company. The investment amount is calculated in accordance with the company valuation, which is injected into the capital by way of a capital increase with share premium. In a capital increase with a share premium, the amount corresponding to the nominal value of newly subscribed shares are transferred to the company’s capital account, and the remaining amount is transferred to a capital reserve account. Thus, the company uses the share premium amount transferred to a capital reserve account for conducting and developing its business. How the investment amount will be used by the company (for instance, product development, expansion abroad, marketing activities, etc.) is designated in the share subscription agreement.
The difference between a share subscription agreement and a share purchase agreement arises here. In the transfer of shares, the transfer price of the shares is paid by the transferee to the transferor shareholder and the transferor shareholder uses the transfer price as they wish. Whereas, in share subscription, the investment amount is paid to the company and used by the company for a specific purpose.
Key Provisions
The key provisions of share subscription agreements are the information on the number, group and price of the shares that the investor will have in return for the investment, details of the closing general assembly meeting regarding the capital increase, closing conditions, representations and warranties, and indemnification provisions.
General Assembly Meetings Regarding a Capital Increase
The most important obligation of a company and its existing shareholders in the share subscription agreement is to ensure that the general assembly[1] meeting is held for the capital increase in a way that will enable the investor to subscribe for the newly issued shares. The general assembly meeting regarding the capital increase is defined as the closing. The most important obligation of the investor is to undertake and pay the investment amount to be invested in the company as capital. In this respect, information regarding the shareholding structure before the investment round and the shareholding structure to be formed after the investment round, the total investment amount, the share premium amount, and information regarding the closing general assembly are set forth in detail in the share subscription agreement.
In this capital increase realized through share subscription, each shareholder has a statutory pre-emptive right, which is defined as the right to purchase new issued shares pro rata to their shareholding in the capital, under art. 461 of the Turkish Commercial Code numbered 6102 (“TCC”). That said, the pre-emptive rights of the shareholders may be limited or removed by the company in the presence of valid reasons and with the affirmative vote of at least sixty percent of the capital. Shareholders may also waive their pre-emptive rights. In the event that a new investor invests in the company, the existing shareholders must either waive their pre-emptive rights or the usage of the pre-emptive right must be limited or removed by the company in order for the new investor to subscribe to a capital increase. In addition to the pre-emptive right arising from the law, if there is a shareholders agreement executed between the existing shareholders, privileges regarding the capital increase may also be granted in favor of the existing shareholders in this shareholders agreement. In such a case, the shareholders having privileges arising from the existing shareholders agreement must also waive them.
Closing Conditions
In a share subscription agreement, the completion of the investment round, in other words, holding the closing general assembly meeting regarding the capital increase, may be subject to certain conditions. Examples of closing conditions include obtaining permission from the Competition Board,[2] absence of material adverse changes, and non-violation of representations and warranties in the period from the signing to the closing. On the other hand, some legal risks regarding the company can be determined in the due diligence conducted by the investor before making the investment decision. The investor may request that the identified risks be eliminated before the completion of the investment round. In this case, all the actions that must be completed by the company or the founders in order to eliminate the identified risks should be designated as closing conditions in the agreement.
If it is not possible to eliminate the risks identified as a result of the legal due diligence before the completion of the investment round, or if these risks are not of the quality and quantity to prevent the investor from making the investment, the actions to be taken to eliminate the risks can be designated as post-closing obligations that must be fulfilled within a certain period after the completion of the investment round.
In practice, it may be possible that the closing conditions are not fulfilled by the obligatory party within the period specified in the agreement. Therefore, it can be set forth under the share subscription agreement that if the closing conditions are not fulfilled by the obligatory party within the period, the other party will be granted the right to waive the fulfillment of the conditions, to postpone the closing, or even to terminate the share subscription agreement, depending on the nature of the conditions.
Representations and Warranties
One of the most important reasons for an investor to invest in a company is the representations and warranties they receive from the founders.[3] The purpose of the representations and warranties given by the founders is to paint a picture of the business being invested in,[4] and to determine the responsibility of the founders if the company does not comply with this picture.
The main representations and warranties given by the founders in the share subscription agreements are as follows:
- The company is in compliance with the applicable law and there is no violation of any applicable law,
- There is no encumbrance on company shares,
- All of the company assets defined in the agreement belong to the company or are leased by the company or the company has the right to use them,
- Company financials are kept in accordance with generally accepted accounting principles or international financial reporting standard (IFRS),
- All contracts to which the company is a party are in effect and enforceable,
- The company possesses the ownership or license right of the intellectual and industrial property rights required for the activities of the company,
- All taxes are duly paid within the scope of the applicable law,
- Other than those that are disclosed, there are no guarantees, sureties or similar obligations given by the company,
- Other than those that are disclosed, there are no lawsuits or arbitrations filed against the company that will adversely affect the activities of the company.
Although representations and warranties on many issues are given by the founders, there may be some transactions in which the company violates these representations and warranties. In such a case, the founders prepare and present to the investor a disclosure letter containing all the actions and transactions in which the representations and warranties set out in the agreement have been violated. If the investor accepts the disclosure letter, they cannot claim compensation from the founders regarding the actions and transactions set forth in it by alleging that the relevant representations and warranties have been violated.
There are also some representations and warranties given by the investor in the share subscription agreement. However, these representations and warranties are related to very limited issues such as the investor having the necessary authority to conclude the agreement and not being a party to any lawsuit or arbitration that would prevent them from fulfilling the obligations under the agreement.
If a situation contrary to the representations and warranties set out in the agreement arises until the closing date, the investor may be given the right to refuse to complete the investment round. In the event that a situation contrary to the declarations and warranties occurs after the closing, the investor's damages arising from this violation are compensated by the founders within the framework of the indemnification provisions and the founders may be obligated to remedy the violation in question.
Indemnification
An investor invests by relying on the picture drawn by representations and warranties. Therefore, the breach of representations and warranties in share subscription agreement or the fact that they do not reflect the real situation of the company poses a great risk for the investor. In practice, there are sometimes situations where representations and warranties are violated or do not reflect the truth. In principle, representations and warranties used in mergers and acquisitions are a promise of special qualifications in the legal sense that are defined under art. 219 of Turkish Code of Obligations No. 6098 (“TCO”) as "qualities declared by the seller against the buyer."[5] The fact that the company does not have the qualifications set forth under representations and warranties is legally defined as a defect, but it is controversial among scholars whether the provisions of the Turkish Code of Obligations on warranty against defects is applied to share subscription agreements. Therefore, the scope of indemnification to be requested by the investor in case of breach of representations and warranties should be designated in detail in the agreement.
The indemnification provision may cover only the direct damages of the investor arising from the violation, as well as the indirect damages. In case of more than one founder, whether the founders will be jointly and severally liable for the indemnification obligation is determined in the agreement.
Indemnification provisions may be subject to time and monetary limitations. A time limitation is a limitation on the period of time in which the investor must notify the founders after learning of the situation giving rise to the indemnification claim. The investor must direct their claim for indemnification to the founders within this period, otherwise they cannot claim indemnification. The monetary limitation is determined by de minimis and basket provisions. A de minimis limitation means that the founders will not be liable to compensate the damages claims of an investor which fall below a certain monetary threshold. Only the claims exceeding the de minimis threshold are accumulated, and the investor cannot make a claim against the founders unless the second threshold, defined as the basket, is exceeded.[6] On the other hand, an upper limit can also be determined, so that the founders will not indemnify the damages claims of the investor exceeding the investment amount or a certain percentage of it. The scope of time and monetary limitations varies according to the subject of the breached representation and warranty, the size of the investment and the negotiation power of the parties.
Conclusion
Share subscription agreements set forth the terms and conditions for an investor to participate in a capital increase through share subscription and become a shareholder in a company. In order for an investor to become a shareholder in the company, a closing general assembly meeting regarding the capital increase is held by the company and the newly issued shares are subscribed by the investor. Detailed information on when and how the closing general assembly for the capital increase will be held is designated in the agreement. Holding the closing general assembly meeting may be stipulated as subject to the fulfillment of certain conditions defined as closing conditions. Closing conditions are determined for each investment, especially by considering the results of the due diligence. Representations and warranties that determine the qualifications of the invested company are among the indispensable provisions of the share subscription agreement. The scope of the representations and warranties and the indemnification to be claimed by the investor in case of their violation is determined according to the negotiation power of the parties by considering the characteristics of each investment.
[1] While the general assembly decides on the capital increase in joint stock companies registered in the principal capital system, the board of directors decides on the capital increase in joint stock companies registered in the registered capital system.
[2] In accordance with art. 7 of the Act on the Protection of Competition numbered 4054 and art. 5 of Communiqué on Mergers and Acquisitions Requiring Permission from the Competition Board numbered 2010/4, it may be necessary to obtain permission from the Competition Board, in order to complete the investment round. In this case, obtaining the required permission from the Competition Board should be designated as a prerequisite for the completion of the investment round in the share subscription agreement.
[3] In practice, although it is seen that the representations and warranties are generally given by the founders, they can also be given by the existing shareholders or the company.
[4] Kling Lou R./ Simon, Eilen Nugent/ Goldman, Michael: Summary of Acquisition Agreements, 51 U. Miami L. Rev. 779, 1997, p. 783 (https://repository.law.miami.edu/umlr/vol51/iss3/10) (Access Date: 21.12.2021)
[5] Esin, İsmail G.: Birleşme ve Devralmalar, On İki Levha Yayıncılık, 2021, p.189.
[6] Esin, İsmail G.: p.203.
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