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									Internet – Financing start-ups 27/6/00 4:29 pm Page 1




            Financing of technology start-ups –
            the legal issues
            by Martin Kurer, LL.M., Stefano Codoni, LL.M., and Jasmin Ghandchi, LL.M., Badertscher Dörig & Poledna


                             The ability to obtain financing for a technology start-up will always require a
                             proper legal structure of the start-up and its relations with third parties.The
                             following presentation touches upon key issues, but is not intended to provide
                             any legal advice.


                             Types of companies for start-up                              • In the event of a capital increase, a drawing right is
                             activities                                                     provided for existing shareholders; under certain
                             Too often, founders of start-ups do not focus early            circumstances it may however be limited by the
                             enough on the corporate structure necessary to obtain          shareholders meeting that approves the capital
                             financing. In view of the high risk involved, only the         increase.
                             types of companies not characterised by the unlimited
                             liability of at least one natural person are generally       Equity
                             taken into consideration when setting-up a start-up          Cash and contributions in kind
                             activity. Under Swiss law there are two types of             When establishing a corporation contributions in kind
                             companies with this feature, i.e. the corporation            are possible. However, not everything considered to be
                             (Aktiengesellschaft, art. 620-763 Swiss Code of              of value by the founders may be used, and
                             Obligations, CO) and the limited liability company           contributions in kind are subject to valuation by the
                             (Gesellschaft mit beschränkter Haftung, art. 772-827         auditors.This may be of interest for example in the
                             CO).                                                         case of joint ventures or start-up corporations set up
                                 Although the setting-up of a limited liability           by founders that already own rights in a new
                             company may be cheaper (minimum company capital              technology. Contributions in kind are not only limited
                             Chf 20,000, 50% of which must be paid in) and its            to the case of the setting-up of a company and may
                             management may be less costly (no auditing is                also be used to increase the share capital.
                             required), there are some serious drawbacks in this          Venture capital investment/private equity
                             type of company.The main disadvantage is that the            Investors are generally prepared to make venture
                             transfer of limited liability companies’ stakes is more      capital available to a start-up company only if they are
                             complicated. In addition, the maximum company                granted certain rights that would allow them to
                             capital is Chf 200,0000. A limited liability company         monitor the activity and, if necessary, to intervene.
                             cannot be listed at the stock exchange (but a                Further, they tend to include safeguards in the
                             transformation to a corporation is possible) and, the        transaction that enable them to limit their losses in the
                             typical requirements of a venture capital partner can        event their investment turns out to be a bad one.
                             hardly be accomplished in the case of a limited              Different types of shares
                             liability company. For all these reasons, the limited        There are two main ways to achieve these goals when
                             liability company is not suitable for a start-up activity    carrying out a share capital increase to issue new
                             that may need a certain flexibility as to its capital        shares to be allocated to venture capital investors. By
                             structure and that may aim at an IPO in the short or         amending the original articles of incorporation it is
                             middle term. However, it is still widely used by             possible for the parties involved to provide for
                             people not focussing on the financing side.                  different types of shares.The articles of incorporation
                                 The main features of a Swiss corporation relating        may be amended to the effect that the shares to be
                             to financing are the following:                              issued to the investors will enjoy specific preferential
                             • Minimum par value of shares is Chf 10; so-called           rights (preferred shares). Generally these rights are
                                 ‘penny stocks’ therefore do not exist (it is currently   higher dividends but also preferential liquidation
                                 under discussion if the minimum par value should         proceeds or additional pre-emptive rights for the case
                                 be reduced).                                             that in the future new shares will be issued.
                             • To a limited extent it is possible to provide for              The articles of incorporation may also provide
                                 different types of shares (see below).                   that the voting right is determined by the number of
                             • Authorised and conditional share capital can be            shares owned by each shareholder irrespective of
                                 provided for (within limits).                            the par value of the shares.The issuing of shares



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            with different par value may therefore lead to             • broader restrictions on transferability, full right of
            privileged voting rights. Shares with privileged voting        first refusal, lock up;
            rights may be used by venture capital investors to         • right of sale in the event of sale of other
            exercise the control on the company even if they               shareholders;
            own less then 50% of the capital. However, such            • information of shareholders on a regular basis;
            shares are often used by the founders of the               • exit clauses; and
            company who are managing it to keep the control of         • non-competition provisions.
            the company in spite of a higher investment by             Although a shareholders’ agreement is generally not
            venture capitalists.                                       directly enforceable against the company, it can
                The introduction of such shares with privileged        nevertheless be a very effective means. If a shareholder
            voting rights may represent a means for the                intends to vote its shares in the shareholders’ meeting
            corporation founder to retain the majority of the          in a way that conflicts with the shareholders’
            voting rights in spite of an investment by a venture       agreement provisions, the other party may apply for an
            capitalist. An important limit to this type of shares is   injunction preventing the defaulting shareholder from
            however that the par value of the common shares            doing so and obliging him to vote in a certain way
            may not be higher than 10 times the par value of the       (specific performance). Liquidated damages clauses are
            shares with privileged voting right.                       also frequently provided for in such agreements.
                A corporation may also issue non-voting shares             To ensure that all the parties involved duly
            (Partizipationsscheine). For obvious reasons this type     perform the shareholders’ agreement, it is often
            of security is less attractive for venture capital         agreed that the shares are given to an escrow agent
            investors. If different types of shares are issued, each   who should vote them in the shareholders’ meeting
            category of shareholder has the right to have at least     in accordance with the guidelines set out in the
            one representative in the board of directors; this is      shareholders’ agreement. Also, such a measure is
            again a means of control for both the founders and         allowed to the extent that it is not abused to avoid
            the venture capital shareholders.                          restrictions on transferability set out in the articles
                The articles of incorporation can also provide for     of incorporation.
            restrictions to the transferability of the shares.The      Binding key-employees
            law only allows a limited number of possible               Swiss law allows long-term employment contracts and
            restrictions.The restrictions are even more limited if     limited non-competition covenants. Proper assignment
            the shares are listed on a stock exchange. Although        of intellectual property created will always be key.
            it is controversial in some cases, a restriction on        Employees’ stock options
            transferability may indirectly lead to a ‘right of first   Start-up companies worldwide tend to reward their
            refusal’ of the current shareholders if one of them        managers and employees through stock option
            intends to sell its stock.                                 incentive schemes. In Switzerland, the use of stock
            Shareholders’ Agreement                                    option schemes may be particularly interesting for
            Unlike under the laws of other countries it is not         their beneficiaries from a tax law point of view.
            possible under Swiss law to provide for special classes    Basically, options are taxed as income of the employee
            of shares enjoying more extensive or different             when they are granted and not when they are
            preferential rights than those set out above. However      exercised. Consequently, if the value of the shares
            other additional safeguards may be crucial from the        increases, the increase would represent a capital gain. In
            perspective of a venture capital investor. Such            Switzerland there are no taxes on capital gains made
            safeguards are therefore generally included in             by natural persons.Alternatively, if the shares lose their
            shareholders’ agreements entered into by the investors     value, the beneficiary will have paid higher taxes than
            with the founders. Shareholders’ agreements may            he would have paid if it had received the bonus in cash.
            contain, for example, provisions with respect to:             In order to enable a corporation to deliver the
            • veto rights for investors in the case of important       shares if the employees decide to exercise their
                decisions (e.g. mergers, changing of core business,    options, the shareholders’ meeting may amend the
                etc.) (but not shadow management issues);              articles of incorporation and provide for a capital
            • procedure for the appointment of board of                increase subject to condition.To the extent that the
                directors’ members;                                    employees exercise their stock options, new shares
            • obligation to set up stock option schemes;               will then be issued and the share capital will
            • anti-dilution provisions in the case of capital          automatically be increased. It is worth noting that an
                increase;                                              increase of capital subject to condition may not be
            • modifications of the legal framework relating to the     higher than half of the existing capital.
                pre-emption rights;                                       The corporation may also acquire its own shares



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                             and hold them in stock in order to then deliver them           conversion or option rights for the creditors.This
                             to employees who exercise their options. However, a            means that the lender will have the opportunity to
                             corporation can only own a maximum of 10% of its               have its loan converted in equity (loan with conversion
                             share capital (20% for a period of two years).                 rights) or have its loan repaid, but is granted pre-
                                                                                            emptive rights to new shares (loan with option rights).
                             Loans                                                          The necessary basis in the articles of incorporation can
                             Collateral                                                     be achieved by way of conditional capital increase.This
                             The funding of a start-up company with loans is often          is however subject to the limitation that a conditional
                             quite difficult because the company is not in a position       capital increase may not be higher than half of the
                             to offer sufficient collateral. Under Swiss law a pledge is    existing capital.
                             only valid if the pledged assets do not remain in              Subordinated loans
                             possession of the debtor.Therefore it is not possible to       According to art. 725 CO, if the balance sheet shows
                             have a floating charge on the chattels of the company          that the company creditors’ claims are no longer
                             since the debtor still physically controls these.Also the      covered by its assets, the board of directors must
                             reservation of title (e.g. the creditor has the title of the   notify the judge who may start a bankruptcy
                             goods that should serve as collateral but the same             proceeding. If a start-up company is granted substantial
                             remain with the debtor who can dispose of them)                loans it is possible that in the starting phase an ‘article
                             would in many cases be regarded as void at least in the        725 CO’ situation arises.The law provides that it is
                             event of bankruptcy of the debtor, i.e. when the               possible for the creditors to subordinate their claims
                             security is really needed.                                     to those of other creditors. In such a case the
                                 A possible alternative is the assignment by the            subordinated loans will not be taken into consideration
                             debtor of its present and future claims against its            when determining whether the judge has to be
                             customers. By a written agreement and the                      notified.
                             notification to the customer it is also possible to            Due diligence
                             simply establish a pledge on such claims. Especially in        Prospective borrowers (as well as any company
                             the initial phase, however, start-ups seldom have very         intending to go public) should always bear in mind that
                             high claims and it is far from sure that they would            there will be considerable due diligence examinations
                             get any proceeds in the future. Nevertheless, the              of their books, structure and contracts.A professional
                             claims for future licence fees could be a relevant             organisation of the structure and relationships will
                             asset.                                                         always pay off.
                                 Under Swiss law in addition to chattels or real
                             estate, rights can also be pledged. If the start-up            Initial Public Offering (‘IPO’)
                             company owns any intellectual property right, such             Reasons for an IPO
                             right might be used as collateral.This is particularly         The majority of start-up companies consider the IPO
                             true for trademarks and patents but also for                   as being a very important step in the development of
                             copyrights, for example, in software. Again, it might          the company. Not only does the IPO enable the
                             be very difficult to give a valuation of such rights, in       company to obtain equity and allows future offerings in
                             particular for new technologies.                               order to obtain additional equity, but the company will
                                 In contrast, it is often argued that the pledging of       also be more widely known. From a venture capitalist’s
                             non-patentable or not patented know-how is not                 perspective, the IPO is the most favourable investment
                             possible since in case of the realisation of the pledge        exit allowing the investment of free capital in new
                             (leading to a compulsory sale) of the know-how, the            ventures. Furthermore, the broad investor’s community
                             same would automatically become public knowledge               obtains the possibility to invest or disinvest in the
                             and therefore worthless. As in any other transaction           company easily by purchasing or selling the listed
                             collateral may also be provided by third parties close         equity securities on the market.
                             to the company, mainly the founders (pledge on                 The Swiss Exchange New Market
                             private assets, personal guarantees). Securitisation of        In order to offer rapidly growing companies an easier
                             certain assets is possible.                                    entry into the Swiss capital market, the Swiss Exchange
                             Special types of loans, profit participation                   (‘SWX’) enforced as of June 1, 1999 the Additional
                             and convertible loans                                          Listing Rules for the listing under the SWX New
                             There might be some measures to make the loan more             Market (‘ALR’).The SWX New Market is designed for
                             attractive for the creditor. It is, for example, possible to   (young) fast-growing Swiss and foreign companies
                             agree that the interests to be paid shall be a percentage      which are “characterised by an orientation towards
                             of the profit of the company instead of a pre-defined          opening up new markets for their products, utilising
                             interest rate.Another possibility is to provide for            innovative technologies, or developing new products or



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            services” (article 1 ALR).1 Since its establishment, 11        into account for determining the adequate distribution.
            companies (seven Swiss, two Israelian, one Dutch and           Shareholders who agreed amongst themselves
            one US) were listed on the SWX New Market (others              contractually or otherwise to a restriction regarding the
            are in the process of being listed). Since March 1, 2000       purchase, sale or exercise of voting rights will be
            the SWX New Market has its own dividend adjusted               deemed as one shareholder.
            index, the SWX New Market Index.                               Capital increase. According to the ALR a capital
            Listing requirements                                           increase is required for the listing on the SWX New
            The requirements for listing and continued listing on          Market.At least 50 % of the proceeds of the offering to
            the SWX New Market, the so-called ‘New Market’, are            be placed have to origin from the capital increase paid
            set forth in the ALR.They differ from the listing rules of     in cash.This requirement as well as the following two
            the SWX, (‘LR’), the so-called ‘Old Market’, mainly            requirements are special additional requirements which
            regarding the more lenient requirements for listing            do not exist for a listing on the SWX.
            which shall be compensated with stricter disclosure            Market making. The issuer must add to his application
            and reporting requirements.The provisions of the LR            for listing on the SWX New Market a declaration of a
            regarding the listing requirements apply to the New            member of the SWX in which the member
            Market to the extent that the ALR does not contain             undertakes to ensure the maintenance of the market
            any differing or additional rules.The main listing             for the securities to be listed for a certain period of
            requirements for the SWX New Market are basically              time.
            the following:                                                 Lock-up period. Finally, the listing on the SWX New
            Track record. The issuer must have produced audited            Market requires the proof of the undertaking by each
            financial statements for at least one full fiscal year.        member of the management who owns more than 2%
            Compared to the required 3-year track record under             of the outstanding equity capital or who controls more
            SWX this is an important relief for start-up companies.        than 2% of the voting rights. Each shareholder and/or
            Equity capital. At the time of the listing the issuer must     the issuer are not permitted to sell nor to use any
            have equity capital in the minimum amount of Chf               other remedies which directly or indirectly can qualify
            2,500,000.Again, this requirement can be more easily           as a disposition of equity securities for the period of
            met than the corresponding requirement for the listing         six months after the listing.
            on the SWX ( Chf 25,000,000).                                  Listing prospectus. In general, the listing prospectus
            Capitalisation. The market capitalisation of the equity        should be in English.The SWX Admission Board can
            which, at the time of the listing, is in public hands or is    grant exceptions. It must contain the financial
            being publicly placed must amount to the minimum of            statements for at least one year as well as additional
            Chf 8,000,000. In contrast, the LR requires Chf                information such as details of the lock-up requirement
            25,000,000 for the listing on the SWX. In the case of          and full information in relation to any risk (e.g. unusual
            an IPO the market capitalisation is calculated on the          competitive conditions, expected expiration of patents
            basis of a sustained off-floor trading capitalisation and,     and/or licenses, dependency on certain markets or on
            in the absence of this, on the basis of the expected           shareholders, particular information of management
            capitalisation.                                                members).
            Number of equity securities. The minimum number of             Requirements for continued listing
            equity securities to be offered is 100,000. Furthermore,       The requirements for continued listing, mainly
            the securities have to be negotiable.This requirement          reporting requirements, consist of the following:
            may be relevant if registered shares with restricted           Reporting. In addition to the annual reports the issuer
            transferability are involved. Such securities may be listed    listed under the SWX New Market is obliged to
            if the restrictions do not disturb the market. If              prepare quarterly reports latest two months after the
            securities of a foreign issuer are being offered, the          closing of the relevant quarter.
            equity securities must have been issued in compliance          Accounting standards. Subject to some exceptions,
            with the applicable laws, in particular with the law           any published reports must be based on a true and fair
            governing the incorporation of the issuer.                     view of the accounts and must comply with the
            Distribution. It is required that at the time of listing the   International Accounting Standards (IAS) or the US
            securities have an adequate distribution.The distribution      Generally Accepted Accounting Principles (US-GAAP).
            of securities listed on the SWX New Market is deemed           Ad-hoc publicity. Any price sensitive facts which have
            to be adequate if 20% of the total equity capital or 20%       arisen in the sphere of activity of the issuer and which
            of the outstanding equity securities have been placed in       are not public knowledge have to be disclosed to the
            public (25% for securities listed on the SWX).Any              SWX Admission Board and the market.The definition
            securities holdings representing more than 5% of the           of price sensitive facts is rather vague and therefore it
            voting rights or of the equity capital will not be taken       might be difficult to have clear guidelines on this issue.



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                             Company analysis. A special requirement for the                       The authors of this article would like to thank
                             securities listed on the SWX New Market is that for                   Mr Juerg Stahl for his very valuable input from the
                             the first two years after the listing, the lead manager of            viewpoint of the provider of capital.
                             the IPO must ensure that at least two investment
                             research studies per year are conducted by the issuer
                             and submitted to the SWX Admission Board.                                                                           Authors:
                                                                                                                                     Martin Kurer LL.M.
                             Conclusion                                                                                            Stefano Codoni LL.M.
                             The above comments show that a start-up company                                                      Jasmin Ghandchi LL.M
                             considering an IPO should take into account that                        (Members of BDP’s Technology & Transaction Group)
                             many formal requirements have to be met and                                                   Badertscher Dörig & Poledna
                             constantly up-dated.Therefore, it is important that                                                    Mühlebachstrasse 32
                             the start-up company begins at a very early stage, and                                                          PO Box 769
                             not just before the IPO, to ensure that legal                                                              8024, Switzerland
                             requirements are met.                                                                                   Tel: +41 1 266 2066
                                                                                                                                    Fax: +41 1 266 2070
                             Reference:                                                                                            E-mail: kurer@bdp.ch
                             1                                                                                                   E-mail: codoni@bdp.ch
                                 Translation of the ALR published by the SWX; this
                                 translation as well as the translation of the Listing Rules for                               E-mail: ghandchi@bdp.ch
                                 the Swiss Stock Exchange will be used herein.                                                    Web-site: www.bdp.ch




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