What Is Financing Through Class Shares (Preferred Shares)? An Overview of Series A Agreements and Procedures
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
Management teams of startups preparing for a Series A raise sometimes come to me with a full set of drafts from the investors' counsel and say, "I don't know where to start." This is the moment when a volume of documents that was not visible when the term sheet was agreed suddenly arrives as formal agreements.
Investors often present four documents: an investment agreement, a shareholders' agreement, a distribution agreement, and the terms of the class shares as an exhibit to the articles of incorporation. The receiving side has to review these across the board. We are also frequently asked about the premises themselves: what each document provides, and why the company is raising money by choosing preferred shares in the first place. Even founders who have raised money through J-KISS at the seed stage may be facing the design of preferred shares for the first time, and it is natural to feel uncertain. The overall chronology of legal matters leading up to Series A is organized in What Is Startup Legal Work? An Overview of the Legal Matters Needed from Seed to Series A.
At Series A, the company may also consider how to treat shares and stock acquisition rights issued before then. Issues such as the conversion of existing J-KISS, the issuance of stock options, and the treatment of shareholders who invested in past rounds proceed in parallel, so not only the document review but also the organization of resolution items tends to become complicated. Here I look at the overall picture of financing using preferred shares and how the agreements exchanged in practice fit together.
The Purpose and Effect of Financing Through Preferred Shares
At the seed stage, financing using stock acquisition rights such as J-KISS is often used, but here I deal with the case where the company issues preferred shares at Series A and welcomes investors as shareholders. The label "Series A" by itself does not determine the method of financing.
At the heart of why preferred shares are chosen is the liquidation preference. When a company is dissolved or liquidated, preferred shareholders can receive a predetermined amount from the assets remaining after the company's debts and other obligations are paid, ahead of common shareholders. This mechanism allows investors to limit downside risk to a certain extent even when the company's valuation is relatively high. As a result, investors find it easier to accept a relatively high valuation. However, if no residual assets remain, no distribution is made, so it must be understood that this is different from a guarantee that the invested principal itself will be repaid.
From the founders' perspective as well, this structure can be a reasonable landing point. If the company tries to raise at a high valuation using common shares, investors tend to try to lower the valuation itself to limit their risk. In many situations, I think it is easier for both sides to reach agreement by keeping the valuation at a level consistent with the business plan while adjusting investor risk through the design of rights, such as the order of distribution of residual assets and conversion terms.
The terms of class shares must be set out in the articles of incorporation under Article 108 of the Companies Act and are made public as registered matters. Therefore, the design of rights attached to preferred shares does not remain a private agreement between the parties, but becomes content that also applies to shareholders who acquire that class of shares in the future. Whether or not something has this external effect is a premise to keep in mind at all times when working through the agreements.
The Structure of the Agreements and the Flow of Procedures Under the Companies Act
The Series A procedure proceeds as a single sequence from agreement on the term sheet to final registration. First, the issuer and investors broadly agree on the valuation and the main terms of the preferred shares in the term sheet, and that agreement is then reflected in the individual draft agreements.
The four-document set mentioned above is a typical structure when the agreements are prepared separately. However, this is a typical example in practice, and there is no legal obligation to divide the documents into four. Depending on the matter, the provisions may be consolidated into a single agreement. Before reading through the individual documents, the main items to check across the entire set of drafts you have received are as follows.
- Consistency between the term sheet and the investment agreement, shareholders' agreement, distribution agreement, and articles exhibit
- The position in the articles of incorporation where the terms of the class shares are incorporated, and the structure of the exhibit
- The connection between existing J-KISS and the stock option pool and the resolution items
- Whether the definition of management shareholders includes corporate entities such as asset management companies
- The denominator, percentage, and aggregation rules in the definition of majority investors
When the terms are split across multiple documents, discrepancies tend to arise, such as a particular term being included in the investment agreement but not reflected in the shareholders' agreement, so you need to read while cross-checking each document. At the same time, a perspective of steadily advancing the procedures under the Companies Act is indispensable. The statutory steps are: a shareholders' meeting resolution to determine the subscription terms and amend the articles of incorporation, a class shareholders' meeting resolution where necessary, making the amendment to the articles effective, receiving payment, and applying for registration. Immediately before payment, also confirm that all conditions precedent (closing conditions) set out in the investment agreement have been satisfied.
The Division of Roles Among the Agreements and the Definitions of the Parties
Each document presented governs a different time horizon and a different range of parties. Understanding these boundaries makes it easier to judge which issues should be negotiated in which document.
The investment agreement is a document that mainly governs the process up to the execution of payment (closing). Its core consists of representations and warranties, conditions precedent, and closing procedures, and much of its role ends once payment is completed. However, it contains provisions that remain in effect for a certain period after closing, such as indemnification claims based on breach of representations and warranties, so you need to check the survival period of each provision.
The shareholders' agreement is a document that governs the ongoing governance relationship after the shares are issued. It contains provisions that apply throughout the period the investors remain shareholders, such as the appointment of directors, prior consent for important matters, information rights for investors, and restrictions on share transfers and rights of first refusal. Whereas the investment agreement is aimed at the single point in time of closing, the shareholders' agreement continues to relate to the management of the company after issuance. Note that even if an act is carried out without the prior consent required under the shareholders' agreement, liability for damages for breach of contract may arise, but the corporate act itself under the Companies Act does not automatically become invalid.
The distribution agreement is a document that sets out how sale proceeds will be allocated among shareholders when the company's shares or business are transferred through an M&A transaction or similar. Because the provisions on the distribution of residual assets in the articles of incorporation presuppose the liquidation of the company, the articles alone do not automatically apply to the distribution of M&A sale proceeds. In particular, in an M&A by share transfer, the company itself continues to exist and the buyer pays the consideration for the shares to the selling shareholders, so the distribution agreement must clearly set out the covered transactions, the parties to the agreement, and the method of allocating the acquisition consideration. Because the consideration for a business transfer goes to the company, distributing it to shareholders requires separately checking the procedures such as dividends or liquidation, the statutory restrictions, and taxation.
The terms of the class shares, as an exhibit to the articles of incorporation, are established as part of the articles, and the terms of the shares to be issued and other matters are registered. Anyone who acquires that class of shares becomes a shareholder on the basis of the defined rights. Whereas the investment agreement and shareholders' agreement are contracts only between the parties who agreed to them, the articles of incorporation also bind those who become shareholders in the future. For example, with a veto right, the choice between making it a prior consent matter in the shareholders' agreement, effective only between the contracting parties, or establishing in the articles shares that require a resolution of the relevant class shareholders' meeting for specified matters, is made in light of this difference in effect.
The definitions of the parties also need to be checked. On the investor side, there may be a lead investor who takes the leading role and follow investors who participate on the lead's terms. In rounds with multiple investors, a definition of "majority investors" is also included. This refers to investors who meet a specified percentage (such as two-thirds or more) of a denominator set in the agreement, such as the number of shares or voting rights, and is determined individually or in aggregate. It does not necessarily mean a single majority shareholder, so check in advance which combination of investors would satisfy the requirement given your company's capital structure. On the issuer side, "management shareholders" may include not only the founders as individuals but also corporate entities such as asset management companies, which affects the scope of transfer restrictions on their shares and of representations and warranties.
Consistency with the Existing Capital Policy
At the Series A stage, the connection with the capital policy built up until then becomes a major issue. Proceeding without sorting out the conversion of previously issued J-KISS, the issuance of stock options, and the treatment of existing common shareholders leads to omissions in resolution items.
First, J-KISS conversion. It is common for the J-KISS issued until then to be designed to convert into preferred shares upon the Series A financing. The calculation of the conversion price and the design of the share classes to be issued differ from matter to matter. Under a design based on Coral Capital's J-KISS version 2.01, when the conversion price at the next qualified financing differs from the Series A issue price, a separate class such as Class A1 (a class of shares exclusively for conversion) may be established. In that case, the liquidation preference amount and the acquisition price used when acquiring the shares in exchange for common shares are set to match the conversion price, so the content of the proposed amendment to the articles should be checked closely. The J-KISS conversion procedure itself is covered in J-KISS Conversion (Exercise) Procedures: A Practical Guide to Avoid Scrambling at Series A. The basic mechanism of J-KISS is organized in What Is J-KISS? Structure, Capital Policy, and Key Points for Founders.
Next, the stock option pool. Investors often ask for a pool to be set up or expanded in preparation for future hiring, and the degree of dilution of founders' stakes changes depending on whether this dilution is included in the pre-investment valuation (pre-money) or the post-investment valuation (post-money). The shareholders' meeting often resolves J-KISS conversion, the issuance of stock options, and the election of officers on the same day, so it is important to finalize the agenda items early.
In addition, where there are existing investors who invested in common shares in the past, their contractual economic treatment may be aligned with the preferred shares, or their shares may be changed to a different class. Using the term "deemed preferred shares" in an agreement does not automatically change the class of shares under the Companies Act. Build the agreement while distinguishing between merely granting contractual economic treatment and actually changing the class of shares through the necessary amendment to the articles and the consent of shareholders.
Overview of This Series and Where to Consult
Here I have looked back at the overall picture of financing through preferred shares at Series A from the perspective of the structure of the agreements and the flow of procedures.
This series continues with Designing the Terms of Preferred Shares: Review Points for Liquidation Preference, Conversion, and Down-Round Adjustment, which covers the liquidation preference, conversion terms, and down-round adjustments in the terms of class shares; Review Points for Investment Agreements: Practice from the Issuer and Management Shareholder Side, which covers investment agreements from the perspective of the issuer and management shareholders; Review Points for Shareholders' Agreements: Prior Consent Matters, Information Rights, and Obligations of Management Shareholders, which covers shareholders' agreements with a focus on prior consent matters and the obligations of management shareholders; What Is a Distribution Agreement? Practice on Distribution in M&A and Deemed Liquidation Clauses, which covers distribution in M&A and deemed liquidation clauses; and Procedures for Issuing Preferred Shares: From Amending the Articles and Class Shareholders' Meetings to Registration and Closing, which covers the procedures from amending the articles of incorporation through registration and closing.
The provisions in preferred share investment agreements that founders should watch especially closely as a matter of management judgment are also taken up in Provisions Founders Should Review as a Management Decision in Preferred Share Investment Agreements. Because each document is linked to the others starting from the term sheet, I hope you will look ahead through the procedures across the whole series.
LegalAgent provides end-to-end support for financing using preferred shares, including Series A, from reviewing the agreements to designing shareholders' meeting resolutions and handling registration procedures. Please feel free to consult us about organizing your overall capital policy, including existing J-KISS and the stock option pool.
Frequently asked questions
Why is Series A financing done with preferred shares?
By obtaining preferential rights such as a preferential distribution of residual assets, investors find it easier to take on risk even at a price higher than that of common shares. For founders, too, keeping the value of common shares down makes it easier to keep the exercise price of stock options low, so the design is rational for both sides.
What agreements are signed in a Series A round?
The four main documents are the investment agreement, the shareholders' agreement, the distribution agreement, and the terms of the class shares as an appendix to the articles of incorporation, each with a different role. Procedures such as a shareholders' meeting resolution and a change registration are also required.
If we have already raised funds through J-KISS, what happens in the Series A?
In many cases, J-KISS converts into shares at the same time as the Series A closing. Procedures such as exercise notices, consent forms and registration arise in parallel with the contract negotiations, so early planning is needed.
Services connected to this topic