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Change of Control Provisions

One of the thorniest issues in negotiating startup financing arrangements is a provision for change of control in the event that certain performance benchmarks (e.g., successful development of a prototype, commencement of production, customer acceptance of the product or turning profitable) are not met, or the startup defaults in its obligations under the financing agreement. Often venture investors will require that the control of the startup, normally vested in the founder/management group, switch and vest in the investor group upon occurrence of such a triggering event.

Such change of control provisions can be effected by irrevocable proxies or voting trust agreements. Irrevocable proxies usually must be coupled with an interest in order to be enforceable. Irrevocable proxies are more simple control mechanisms than voting trust agreements, which require that all parties deposit voting shares with a trustee, with somewhat complicated provisions for the voting of those shares. If there is no interest with which the proxy may be coupled in order to comply with such a statutory requirement, then the voting trust agreement, though more complex, would have to be employed.

While founders of the startup are usually reluctant to accept such change of control provisions, the investors are equally determined to obtain control of the startup if and when its founders fail to meet its business plan, default in their major obligations, or become financially insolvent. Such change of control provisions must be approached objectively from both sides so as to not be lopsided or create resentment on the part of the founders, or suspicion that actual control is being sought at the outset by the investors.

Preferred share agreements often provide for a voting switch giving the preferred shares the right to elect a majority of directors in the event the startup does not pay preferred shares dividends in a timely manner, or for mandatory redemption of the preferred shares where the startup fails to meet its obligations under the preferred shares provisions. Sometimes agreements incorporate "creeping" change of control clauses which provides that the investors are entitled to a gradually increasing percentage of the authorized directors as successive defaults in dividend or redemption payments occur.