What stockholder approval is necessary to complete a venture financing?

August 7, 2007

Most venture financings require the creation and issuance of a new series of preferred stock.  This typically requires an amendment of a company’s Certificate of Incorporation in Delaware (or Articles of Incorporation in California).  The stockholder vote requirements for these actions are governed by state law and the Company’s charter (COI or AOI) and bylaws.  The stockholder vote requirements under Delaware law and California law are outlined below.

Delaware

General.  Delaware corporate law provides that an amendment to the Certificate of Incorporation requires the approval of a majority of the outstanding stock entitled to vote and at least a majority of the outstanding stock of each class entitled to vote as a class.  (For example, common stock is a class, and preferred stock is a class.)  The shares and classes entitled to vote are determined by the Certificate of Incorporation.

Class Vote Requirements.  Delaware corporate law provides that a “class vote” is required if the amendment to the Certificate of Incorporation does any of the following:

• Increases or decreases the par value of the shares of the affected class(es) (subject to certain limited exceptions);
• Increases or decreases the aggregate number of authorized shares of the affected class(es); or
• Adversely affects the powers, preferences, or special rights of the shares of such class.

For the purposes of the class vote, different series of the same class are not treated as a separate class unless the amendment to the Certificate of Incorporation adversely affects the powers, preferences or special rights of such series.  The position of a class or series of shares relative to other classes or series is not a power, preference, or special right of the shares, so that the provisions granting a class vote where the powers, preferences, or special rights are affected adversely do not apply to an amendment that creates a class or series with rights, powers and preferences prior to those of one or more existing classes or series of stock.

Though not expressly required under Delaware law, the holders of common stock often have a vote when new senior preferred stock is issued.  This is because the corporation typically needs to increase the authorized number of common shares to allow for the future conversion of the newly issued preferred stock into common stock.  If the corporation already has sufficient authorized common stock to allow for the conversion of the new preferred stock, a new class of preferred stock could be created without common stockholder approval.  In addition, the number of authorized shares of common stock may be increased by a vote of the majority of the outstanding stock of the corporation if the Certificate of Incorporation allows.  Most typical Certificates of Incorporation for venture-backed companies provide for this flexibility to avoid a separate common stockholder vote in a future venture financing.

Practical answer.  Generally, the necessary stockholder approval for a venture financing for a Delaware corporation (assuming properly drafted articles avoiding a separate common vote) will be (i) a majority of all shares on an as converted to common basis (due to the general stockholder approval requirement to amend the Certificate of Incorporation under Delaware law), (ii) a majority of all preferred stock on an as converted to common basis (due to the need to authorize additional preferred stock triggering a class vote), and (iii) any other approval required by the protective provisions in the Certificate of Incorporation, such as a separate series approval or super-majority approval.

California

General.  California corporate law provides that amendments to the Articles of Incorporation require the approval of a majority of the outstanding shares.

Class Vote Requirements.  California corporate law provides that a class vote (in addition to the affirmative vote of a majority of the outstanding voting shares) is required if an amendment to the Articles of Incorporation does any of the following: 

• An increase or decrease in the aggregate number of authorized shares of such class (subject to certain limited exceptions);
• An exchange, reclassification or cancellation of any part of such class (including a reverse stock split, but excluding a forward stock split);
• An exchange, or creation of a right of exchange, of any part of such class into another class;
• A change in the rights, preferences, privileges or restrictions of the shares of such class;
• The creation of a new class of shares with rights, preferences or privileges prior to the shares of such class or an increase in the rights, preferences or privileges or the number of authorized shares of any class with rights, preferences or privileges prior to the shares of such class;
• Dividing any class of preferred shares into series having different rights, preferences, privileges or restrictions or authorizing the Board of Directors to do so; or
• The cancellation of or otherwise affecting accrued, unpaid dividends.

For the purposes of the class vote, different series of the same class are not treated as different classes unless such series are affected by an amendment to the Articles of Incorporation differently than other series of the same class.

Practical answer.  Generally, the necessary shareholder approval for a venture financing of a California corporation will be (i) a majority of all shares on an as converted to common basis (due to the general stockholder approval requirement to amend the Articles of Incorporation under California law), (ii) a majority of all common stock (due to various provisions triggering a class vote), (iii) a majority of all preferred stock on an as converted to common basis (due to various provisions triggering a class vote), and (iv) any other approval required by the protective provisions in the articles of incorporation, such as a separate series approval or super-majority approval.  The fact that holders of common need to approve an amendment of the Articles of Incorporation to facilitate a typical venture financing for a California corporation is one reason why venture funds prefer Delaware.  Venture funds don’t want common holders to have the ability to block a future financing.

(Side note:  For some reason, it’s “stockholders” in Delaware and “shareholders” in California.  One bit of assorted trivia in case anyone cares.)

Comments

  • Mark

    From an entrepreneur’s point of view, California incorporation appears better because it gives common a meaningful vote. So why would a California entrepreneur want to incorporate in Delaware?

    Thanks for all the great posts.

  • http://www.startupcompanylawyer.com Yokum

    Any California-incorporated company receiving venture financing will generally need to reincorporate to Delaware in connection with the financing. Thus, it is easier to incorporate in Delaware to begin with in order to avoid the hassle of reincorporating later. Reincorporation will require a review of the company’s contracts to make sure that the reincorporation doesn’t accidentally trigger termination or other provisions of the contracts. However, I recently completed an investor-side Series C financing of a California company where the investors did not require a reincorporation in connection with the financing.

  • Pingback: Venture Hacks — Control is a one way street