Non-proportional capital increases in VC transactions

23rd April 2020  

by Giancarlo Maniglio

The non-proportional capital increase can be a useful tool in venture capital operations, where the venture capitalist's participation is often associated not only with a capital contribution but also with the contribution of expertise and other benefits to the company (so-called smart money). The company can, in fact, allocate to the investor a number of shares or a share that is not proportional to its current shareholding, with a corresponding reduction in the shareholdings of the other shareholders.

Through this instrument, newly issued shares or quotas are still offered in option to all shareholders in proportion to the number of shares or the value of the quota already in their hands, i.e. there is no restriction on shareholders' pre-emptive rights. Each shareholder will subscribe to the capital increase for his or her part and will pay the amount subscribed. The non-proportionality emerges at the subsequent moment of the assignment of the shares, because it will be possible to foresee in favour of some shareholders - such as the venture capitalist - the assignment of a number of shares or a share not proportional to the contribution made.

There are two articles of the Civil Code dealing with non-proportionality: Article 2346, fourth paragraph, on joint stock companies, which states that "each shareholder shall be assigned a number of shares proportional to the portion of the share capital subscribed and for a value not exceeding that of its contribution. The by-laws may provide for a different allocation of shares"; and Article 2468 on Srl, which states that "unless the memorandum of association provides otherwise, the shareholders' shareholdings shall be determined in proportion to the contribution".

In order to approve a non-proportional capital increase, the unanimous consent of the shareholders is considered necessary. Alternatively, it is advisable to include in the memorandum of association, or at the same time as the resolution to increase the share capital, a specific clause in the articles of association that allows for the resolution of non-proportional capital increases by majority vote, with the care taken to provide also for the non-operationality, in these cases, of the pre-emption and approval mechanisms that may be applicable to the transfer of option and subscription rights.
The non-proportional assignment may therefore be formalised in this way: by the provision in the by-laws of an express clause; by prior agreements between the shareholders; by a majority or unanimous resolution, depending on the relevant provisions of the by-laws.

The assignment of new shares on a non-proportional basis can be easily linked to the presence, in the investment agreement, of pay to play clauses that "oblige" the venture capitalist to participate in new financing rounds subsequent to round A, on pain of the possible conversion of preference shares into ordinary shares or the loss of particular rights. In this case, the investment agreement may well provide for an allocation of shares or units or an increase in the par value of the portion greater than that proportionally due.
In order to ensure that the entire capital increase is then covered, it is considered that it must be fully subscribed in order to avoid, as a general rule, that only shareholders who are required to contribute less than the nominal value of the shares assigned (which would result in the issue of shares below the nominal value, which is not permitted by the law), subscribe.

It should also be considered the possibility of recognising directly in the articles of association, in favour of the venture capitalist and for all or certain capital increases, whether for payment or free of charge, a right of option more than proportional to one's shareholding, through the use of share classes, special rights or share classes in the case of Srl-Pmi. These prerogatives may be effective immediately upon the entry of the venture capitalist into the company structure or may be subject to the occurrence of certain events that may affect the company or the investor (through the conversion of shares or the recognition of special rights subject to condition precedent).

In this sense, the maximum 154 and 155 of the Company Commission of the Milan notary's Board of Directors have expressed their opinion, which respectively allow for a more than proportional pre-emptive right with respect to the shareholding held, valid in all cases of paid share capital increase (with the exception of increases in kind), without prejudice to the right of withdrawal of shareholders who have a less than proportional pre-emptive right and the right to obtain an increase in their shareholding in a more than proportional manner during the free share capital increase.
Finally, it should be noted that a non-proportional allocation may also apply in the event of a voluntary reduction in share capital or distribution of reserves or profits of the company.