Analysis of the 2018 Amendments to the Company Act (No.3) – Can the amended Company Act save Fund-Raising for Startups?
Author: Eve Tsai
One of the purposes of the 2018 amendment to Company Act (the “2018 Major Amendment”) is to create a friendly environment for startup companies. This is reflected in the increased flexibility in fundraising for a non-public company through issuing shares or bonds. While the 2018 Major Amendment is indeed praiseworthy as it removes many obstacles for these startup companies, it might still be insufficient to make a significant difference to the overall situation in Taiwan if other factors such as a more active M&A market do not come into play.
Photo Courtesy Philipp Birmes CC0（Cover Page）
Photo Courtesy Negative Space CC0（Inner Page）
After the 2018 Amendment, Article 157 of the Company Act removes previous restrictions related to preferred shares in a non-public company, which include multiple voting rights, veto power on specific matters, one reserved seat of director, and restriction on transfer of special shares. It is generally believed that this will incentivize investors as there is now more flexibility in the negotiating process, which in turn makes it easier for startup teams in the initial fundraising process. In addition, by purchasing “golden shares” or preferred shares with multiple voting rights, the original team can ensure its control over the company.
The main purpose for using “preferred shares” in the Silicon Valley is to provide the venture capital firms, who actually pitch in the money, safeguards that they will get enough returns by agreeing on the value of the preferred shares beforehand, and they will receive the residual upon dissolution should the startup business fail. To prevent the original team from backing out, a “vesting system” is usually put in practice. Under this system, when the startup team receives funds, founders’ shares will be returned to zero but be “re-vested” annually. This means each of them will receive a certain percentage of shares by the end of the first year, with the rest re-vested in parts monthly.
However, after the 2018 Major Amendment was made to permit “preferred shares”, a new practice emerges among startup businesses in Taiwan – to “use preferred shares to keep the founders from leaving.” What investors deemed valuable is the ideas and expertise of the founders, they unsurprisingly premise their funds on condition that the founder will not leave the company immediately after they pitch in. To ensure this, investors now require the founders to purchase preferred shares with restrictions on transfer.
Silicon Valley’s “vesting system” stands out in two ways. First, it creates long-term value of the company by incentivizing founders to fully devote themselves in it. Second, when the founder is no longer interested in the company and is set to leave, shares that have not been re-vested can be canceled and shares of the investors and other shareholders increased in proportion.
The amended Company Act also significantly loosen restrictions on corporate bonds. Prior to the 2018 Major Amendment, the total amount of corporate bonds of a company shall not exceed the net remainder of all assets in hands of the company after deducting all liabilities so as to protect the creditors. Now, such limit is removed for a non-public company. Some say that this will allow startup companies with potentials but have few assets at the moment to raise funds more swimmingly.
The net worth of the company as a cap is determined only upon the issuance of the bond and may change subsequently; however, the ability of the company to pay their debts, in fact, depends on the cash flow generated from operation. It is apparent that the net worth cap cannot protect creditors. As such, neither Britain nor the United States imposes such restrictions on the issuance of corporate bonds. While it is true that the amendment removes the cap, if the creditors still demand to place security interests against the bond offering, then the government’s claim that it will “make startup fundraising easier” might be overstated.
In light of the above discussion, we can see that the 2018 Major Amendment is essentially scrapping those out-of-date restrictions on fund-raising, providing medium and small-sized non-public companies with more flexibility, and returning the legal system to what it should have been. This alone will not be sufficient to transform Taiwan into another Silicon Valley. To achieve that lofty goal, multiple factors such as the activeness of the M&A and capital market, how an investor evaluates the value of a startup company, and the ability of legal professions to deal with complex relevant provisions must come together. Otherwise, the much-celebrated amendment might turn out not with a bang but a whimper.