This post is a summary of a lecture I attended on Redeemable Convertible Preferred Stocks (RCPS).
The following links may also be helpful:
ZUZU - Redeemable Convertible Preferred Stocks (RCPS)
HELP ME - Everything About Preferred Stocks and RCPS - Procedures, Methods, and Registration
The Meaning of a Contract#
A contract is when the declarations of intent of two or more legal entities align in content.
Formation of a Contract#
- Contracts are generally formed through offer and acceptance, and when the parties' intentions align, the contract is considered established
- A contract can also be established through implicit agreement
- If intentions align, verbal agreements naturally count as valid contracts
- A written contract is evidence that proves under what intentions the contract was concluded
Breach of Contract#
- When a contract is concluded, rights and obligations are granted to each party. In many cases, parties fail to fulfill their obligations or fulfill them incompletely
→ This is called a breach of contract, and the party who failed to fulfill their obligation must bear responsibility - When claiming monetary damages because the other party failed to fulfill their obligations
→ The amount of damages must be clearly proven; if not proven, there's a risk of losing the case - Non-compete agreements, confidentiality clauses
- Predetermined damages, penalties, liquidated damages (penalty + damages)
Parties#
Contract Parties#
- Investor, startup (investee company), interested parties (major shareholders or key directors)
- A stock subscription agreement is a contract where the investee company issues shares and the investor subscribes to them, so theoretically only the investor and investee need to sign
- It's common to include interested parties (major shareholders, key directors) as contract parties so the investor can grant rights and obligations to them as well
Angel investor — An individual who provides investment capital to early-stage ventures lacking funds, serving as a foundation for nurturing high-tech industries.
Relationship with Shareholders' Agreement#
Since the major shareholders and investors who are parties to the shareholders' agreement are already included as parties to the stock subscription agreement, the content that would go into a shareholders' agreement is often included in the stock subscription agreement instead.
Redemption Right#
The right to receive back the investment principal and interest (generally 6%~10% annually) when exercising the redemption right.
A right that reduces the investor's investment risk.
Conversion Right#
The right to convert preferred shares (such as RCPS) acquired through investment into common stock.
The right to enjoy the benefits of the investee company's increased stock value by converting to common stock.
Preferred shares: Shares with special conditions regarding certain rights, referring to any shares other than common stock.
Redeemable Convertible Preferred Stock#
A type of preferred stock that grants both redemption and conversion rights.
Voting rights can be granted just like common stock. Investors can realize profits by receiving dividends.
If the company's value rises significantly, RCPS can be sold to a third party at a high value to realize profits, and in cases of mergers and acquisitions, they can be converted to common stock before the acquisition.
Exercise Period#
It's common to set the exercise period starting 2 or 3 years after issuance.
→ Since institutional investors' fund maturity periods are often 2 to 3 years, the redemption exercise period is also commonly set at around 2 or 3 years.
The shorter the redemption period, the more disadvantageous it is for the investee company → Better to push it to 5+ years.
Nature of RCPS - Debt or Equity#
There are often minimum qualification requirements of less than 1,000% debt-to-equity ratio.
The higher the debt ratio, the less likely you'll qualify. A lower debt ratio is better.
The debate: Debt vs. Equity
- Under K-IFRS (Korean International Financial Reporting Standards) adopted by listed companies, RCPS is classified as debt
- Under KFAS (Korea Financial Accounting Standards) applied to unlisted companies like startups, RCPS is classified as equity
If unlisted companies also classified it as debt, the high debt ratio would make bank loans and fundraising difficult.
| This could even lead to capital impairment.
Since the investor can exercise the redemption right and demand the investment back, classifying it as debt rather than equity more accurately reflects reality.
Capital impairment — A state where net assets (equity) are less than legal capital.
For a normal company, the financial state should be: Equity = Legal Capital + Surplus.
RCPS Subscription Agreement#
Conditions Precedent#
Items that must be completed before the contract execution and stock subscription.
- Procedural matters for the transaction to be valid and proper
- Matters concerning the substantive purpose of the transaction
Representations and Warranties#
Representations are the underlying facts of the transaction — violation constitutes grounds for rescission.
Warranties guarantee certain facts — violation constitutes breach of contract leading to liability for damages or grounds for termination.
It's common to include matters that couldn't be clearly identified in legal and accounting due diligence, or matters that must be complied with. Even if the stock acquirer already knew that the representations and warranties were untrue, the stock transferor's liability for breach of representations and warranties should still be recognized.
Transfer — The act of transferring property to another person through a legal act by the property right holder.
Acquisition — The act of receiving something from another person.
Liability for Damages#
From the investor's perspective
It's advantageous to explicitly state that even matters the investor already knew at the time of the contract can be subject to claims for damages due to breach of representations and warranties.
Adding a proviso — This shall not apply to matters the investor knew or could have known at the time of executing this contract.
- Explicit sandbagging clause
- Pro-sandbagging clause
From the investee company's and interested parties' perspective
It's advantageous to explicitly state that the investor cannot later claim damages for matters they already knew at the time of the contract.
- Anti-sandbagging clause
Share Transfer Restrictions#
It's common to include clauses restricting interested parties from disposing of their shares.
Preemptive Purchase Right#
When an investor or interested party wishes to dispose of their shares, the right for the interested party or investor to purchase those shares first.
Tag Along Right#
When an investor or interested party wants to sell their shares, the right for the interested party or investor to also sell their shares together. Essentially, the investor's shares get sold alongside.
Drag Along Right#
A clause that forces interested parties to dispose of their shares when the investor disposes of theirs.
→ A notoriously unfavorable poison pill clause for interested parties — you could lose your company in an instant.
Put Option#
The right for the investor to demand that the company or interested parties purchase all or part of the investor's shares in the company when certain events are discovered or occur.
→ This is a clause that requires very careful examination.
This should be deleted → Cases where there is a seizure, provisional seizure, provisional disposition, or auction filed against the company's important assets.
Joint Liability of Interested Parties#
No-fault joint liability
Regarding indemnification under this article, the company and interested parties bear joint and several guarantee liability for their respective obligations.
→ Dangerous. This clause needs to be modified.
Revised version
If the representations and warranties of the company or interested parties set forth in Article 3 are false or inaccurate, or if the company or interested parties intentionally or negligently violate or fail to perform their obligations under this contract including matters set forth in Article 4, the company or interested parties at fault shall compensate the investor for any damages incurred thereby.
Attribution of fault — A civil law concept meaning the reason for which responsibility must be taken.
No great thing is created suddenly.
— Epictetus
