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The difficulty of raising funds for technology companies that are at various stages, both in the initial stage (Pre Seed) and later stages, is known and complex.
In advanced capital raisings, various considerations and changing circumstances influence the company’s decision to turn to external investors or raise capital internally within the company. Take for example a case where the business is struggling and does not have enough cash to survive without additional investment. In such a difficult situation, the company may prefer to quickly raise a relatively small amount of capital internally from its existing shareholders (either by borrowing or by selling shares) rather than raising capital from external investors, which may take longer and involve existing shareholders. giving up a significant portion of their stakes in the business for a relatively small and lower value investment (downside).
Judicial control of internal capital raising
A company wishing to raise capital internally addresses its request to all of its current shareholders (without prejudice to the preferential rights of specific shareholders of the company and subject to other contractual constraints).
Existing shareholders will naturally seek to invest additional sums in the company in return for less value. The difficulty arises when some of the shareholders refuse to join in an insider investment that effectively both dilutes and depreciates their holdings. These situations raise many questions relating to the relationship between the shareholders themselves (majority versus minority, etc.), as well as between the shareholders and the company’s lenders/creditors.
A similar issue arose in Civil Case 44736-03-19 (Tel Aviv District Court) Maimon v Unavoo Food Technologies Ltd et al. (hereafter: “The Unavoo Affair”), in which the court held that, given the shareholders’ personal interest in investing, when a company raises capital internally, its decision to do so must be subject to rigorous scrutiny.
It should be noted that while, provided they have been made on the basis of relevant considerations, in good faith and in the interest of society, courts are generally reluctant to interfere in a commercial decision of the institutions of the company (shareholders and board of directors) (Business Judgment Rule), but when those making this decision have a conflict of interest, the court applies a strict standard of review.
Thus, a decision to raise capital within the company, which has been taken and endorsed by shareholders or directors in conflict of interest, is necessarily equivalent to an operation in which the decision-makers have a personal interest, since after all, the same shareholders are the ones who invest in the company and determine the amount of investment and the value of the company on which their investment will be based.
In the Unavoo case, a minority shareholder sought the annulment of the company’s decision to raise capital internally on the grounds that it was based on an enterprise value significantly lower than its true value, the raising of capital would, in his view, have caused a massive dilution of his holdings in the company.
Since, as noted above, the approval to raise capital internally had been given by shareholders who had a conflict of interest, the court decided that his interference and scrutiny of the company’s decision were justified.
Her Honor Judge Ruth Ronen therefore held that in light of the fact that a decision to raise capital internally can harm the assets of shareholders who do not participate in the investment, it should first be considered whether whether or not this investment is urgently needed by society. , and if such a necessity is not found, then because of the harm that could be caused to shareholders who do not participate in the investment, it is excluded. It should be noted that provided it is made at fair value, then even if the shareholder’s shares are to be diluted, the investment must not harm or reduce the fair value value of its holdings in the company.
For example, suppose that a shareholder (who does not participate in the internal raising) owns 30% of the company’s capital on the eve of the investment. If the value of the amount raised was real or even exaggerated, then even if the shareholder’s shares are diluted to 20%, this still reflects the real value of their stakes in the company. Conversely, in the case of an investment whose prescribed value is less than the actual value, the shareholder’s share in the company will be diluted more than necessary, because it is both diluted and devalued. .
Returning to the Unavoo case, there, contrary to previous court rulings regarding the raising of capital within a business in times of crisis, Her Honor Justice Ronen ruled that due to the consequences of internal recruitment, with the personal profit being derived from the low valuation by the investing shareholders and conversely the unnecessary harm being caused to the non-investing shareholders as noted above, the shareholders participating in the capital raising had the burden of proving that the The proposed valuation reflected the true value of the company.
Ultimately, the court decided to approve the internal raise, albeit based on a valuation of the company that the parties would determine later in the court proceedings.
Fundraising is a complex process. As with any business process, before the process begins it is important to try to define what the desired outcome should be, on many levels, including the amount that needs to be raised, the value of the business and whether funds must come from external sources. investors or be raised internally. In the latter case, following the Unavoo ruling, policy makers need to give serious thought to whether to raise capital internally and the terms under which the investment should be made, particularly where there is a risk that shareholders not participating in the investment may be adversely affected by it.
Finally, note that a classic solution to similar problems has been provided by providing capital to the company in the form of a convertible loan, in which the actual valuation of the company is deferred to a later stage.
Originally published October 2021
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.