It is common for start-ups and established companies to regularly raise funds from investors for growth and expansion. One of these mechanisms is the issuance of new shares. The issuance of shares may refer to either ordinary or preference shares depending on the class of shares the company wishes to offer to the investors. This concept is commonly referred to as raising capital through issuance of shares/equity in the company or subscription shares.
On 14 December 2020, AirAsia X Bhd announced the issuance of shares to new investors under a special purpose vehicle (SPV) to raise capital in the company where the incorporated SPV sought a minimum subscription of RM50 million. This is a common way for a public listed company to attract more investors and attain more funding by issuing shares to the public. This article will give a detailed explanation on the concept and features of subscription shares and will focus on private limited companies.
Subscription shares are shares that investors subscribe to for a purchase price in exchange for equity in the company. These shares can take the form of ordinary or preference shares with an option of being bought back by the company at a later date for a fixed conversion price and within a fixed period of time. This issuance of shares can only be done by the company itself and such shares are bought by a potential investor that is commonly known as a subscriber. In the case of subscription shares, the funds invested by the investor will be deposited directly into the company’s account for the issuance of the new shares. This is different from share purchase agreements, whereby the purchasers and vendors sell and transfer the sale shares and the purchase price is paid to the vendor.
A subscription of shares may be used at any stage of a business for a private limited company. The nature of the subscription agreement will differ depending on the type of share being issued such as ordinary, preference or convertible redeemable preference shares. It is important to differentiate between a sale and purchase/share sale agreement on the one hand and a share subscription agreement on the other. The former relates to sale and transfer of shares in a company from an existing shareholder and from existing share capital in the company. The latter relates to subscriptions where there is an issuance of new shares or classes of shares in a company meaning the share capital of the company is increased to cater for the new shares.
Share subscription agreement
When an investor has agreed to invest in a company by a subscription of shares, a share subscription agreement (“SSA”) is entered into between the investor (also referred to as “subscriber”) and the company. The SSA acts as a promise by the company that it will issue a certain number of shares to the investor at a specific price. The SSA will commonly set out the amount of investment sum in exchange for the number of subscribed shares in the company. Other terms of the agreement include the subscription date on which the investor must pay the subscription price for the shares and/or the date on which the investor may convert or redeem (as the case may be) such shares in circumstances that involve redeemable convertible preference shares.
It is pertinent to note the distinction between ordinary shares and preferential shares wherein the former cannot be converted to preference shares whereas the latter can be converted to ordinary shares. The lack of shareholder voting rights for preference shareholders means ownership is not diluted by issuing preference shares, as compared to issuing ordinary shares.
In an existing company, when a new issuance of ordinary shares is issued, a decrease in an existing shareholder’s ownership may occur. Subject to the company’s articles of association/constitution, a portion of the new issuance of shares may be purchased by existing shareholders so as not to dilute their current shareholding in the company. It is also commonly referred to as anti-dilution rights or the first right of refusal.
Similarly, when subscribing for ordinary shares, to protect the rights of the investors/subscribers in the company in future issuance of shares, the SSA may encompass clauses that provide the investor the right to maintain their percentage of ownership in the company. Such anti-dilution rights consist of offering current shareholders in the company an option to buy a proportionate number of shares in any future issue of shares subject to the company’s constitution/articles of association. The importance of this clause is to protect the investors/shareholders from the risk of seeing new shares issued at a lower price than what was previously paid by the investors. For example, this clause protects an investor, who originally bought shares for RM20 per share, from a future situation where the company issues new shares at RM15 per share. In such an instance, the SSA should cater for either a “weighted average” provision or a “ratched-based” provision. In the case of the former, the share price offered will be the difference between the original price and the new price. In the case of the latter, the shares will be sold at a lower price.
It is common for companies seeking investors to firstly issue a term sheet setting out the type of shares being offered and investment structure. The term sheet also makes reference to an outline of provisions typically captured under the SSA.
Share subscription agreement vs. shareholders agreement
A share subscription agreement and a shareholders agreement are regularly executed simultaneously. However, these two agreements have key differences in their respective nature. As opposed to a share subscription agreement, a shareholders agreement will contain all the details regarding ownership, shareholders rights and obligations, share transfer restrictions and management of the company. All shareholders of the company will be required to sign the shareholders agreement, which contrasts to a share subscription agreement that is only entered between the investor/subscriber and the company.
In a share subscription agreement, there are standard clauses that are to be expected in the agreement. It may include the following:
- Conditions precedent: This clause is used to set out the conditions that are necessary to be fulfilled prior to the subscription of shares. An example is that the directors/shareholders of the company may be required to pass certain resolutions before the issuance of new shares.
- Confidentiality: This is a standard non-disclosure clause that provides for the information exchanged between the investor and the company to remain confidential. In light of confidential information and trade secrets being discussed and exchanged during the allotment of shares, it is essential that confidentiality clauses are included under the SSA.
- Restraint against competition: This clause will entail that the investor is restrained from competing with the company for a set period of time. This acts as a safeguard to the company’s interest so that the investor does not benefit from and compete against the company, typically for a certain number of years. However, it is pertinent to note that certain restraint of trade and non-competition clauses are unenforceable in Malaysia.
- Tranches: This clause will set out the details of the transaction that are usually set out in the term sheet. This will include the subscription price, how many shares are being issued, the prescribed limits, and any vesting conditions.
- Warranty and indemnity: This clause may typically state that all of the information given by the company is true and accurate and that either party will indemnify the other against any losses, liabilities and damages that occurred if any party is in breach or damages has occurred. Such a clause would promote full and frank disclosure of important information and further protects the company and the investor from any potential fraud.
The subscription of shares allows for the investor/subscriber and the company to benefit from the transaction. In turn, this will allow the company to generate more capital whilst the investor/subscriber will be entitled to a percentage of ownership in the company or preferential rights to dividends as a preferential shareholder. However, it is essential that the terms in the SSA are negotiated and drafted accurately to reflect and record both parties intentions. It is always best practice to ensure that agreements, including SSA’s, are non-ambiguous and accurately reflect the intentions of both parties. Disputes typically arise in share subscription agreements where key elements relating to conditions, rights of each party and nature of share transfers are not set out effectively.
By Cassandra Nicole Thomazios and Mira Mashor
Note: This article does not constitute legal advice to any specific case. The facts and circumstances of each and every case will differ and therefore will require specific legal advice. Feel free to contact us for complimentary legal consultation.