Why “Preferred Shares” Is Not Preferred by Startups in Taiwan?

Author: Chia-heng Seetoo

The Benefit of Preferred Shares in Startup Deals

The use of preferred shares plays a critical role in fundraising deals of startup companies. For example, there is an entrepreneur E who owns certain technology, know-how and develops his own business plan. E may also have a small amount of cash which is insufficient to support his startup project. Then a venture capital fund VC plans to participate in the series A financing project of E’s new company NewCo, and VC is willing to inject NTD 9 million cash on E’s company. E and VC intend to establish a 40-60 equity structure, in which VC will be a 60% majority shareholder.

If NewCo’s capital structure could only consist of common shares, then E may propose the following equity structure: E will acquire 40 common shares in NewCo by contributing E’s technology, know-how and business plan (assuming that E can overcome the intellectual property rights appraisal process and capital verification issues under Taiwan laws), and VC will acquire 60 common shares in NewCo by injecting NTD 9 million cash.

E’s above proposal has flaws and may be detrimental to the interests of both E and VC. From VC’s perspective, E’s startup project is still at a very early stage and the realistic chance of success is very small. If NewCo starts to operate and it does not take very long for everyone to understand that E’s business plan simply will not work and to liquidate NewCo, VC would like to get back most (if not all) of the remaining cash after NewCo is liquidated. Under E’s proposed equity structure, if NewCo still had a net equity of NTD 5 million at liquidation, VC could only get back 60%, or NTD 3 million, while E (the other holder of common shares) could receive up to NTD 2 million. VC will not accept this outcome, because not only VC is unable to get all the hard money back, but also this created a wrong incentive for the entrepreneur E.

E’s original proposal may not at all beneficial to E himself under the current tax regime of Taiwan. Assuming that E’s technology, know-how and business plan qualify as the “intellectual property rights” contributed to a new company under Article 35-1 of Taiwan’s Act for Development of Small and Medium Enterprises (“SME Act”), and NewCo is moderately successful after a few years, then E’s potential income tax liability may be very significant. To illustrate this tax concern, let’s assume a multinational conglomerate M intends to acquire 100% shares in NewCo at NTD 300,000 per share, and both VC and E will sell their respective shares in the same deal. If E could not prove the original acquisition cost of his technology, know-how and business plan, then E’s original acquisition cost will be treated as 30% of his disposition price under Article 35-1 of the SME Act, and the remaining 70% (in this case, 40*70%*300,000 = 8.4 million) will be included as E’s taxable income.

Using a combination of preferred shares and common shares in NewCo’s capital structure can alleviate the above problems. Now, E will acquire 40 common shares by injecting NTD 400,000, and VC will acquire 60 common shares by injecting NTD 600,000. In addition, VC will acquire certain number of series-A preferred shares in NewCo by putting an additional NTD 8.4 million, and each series-A preferred share will be designed to give its holder (in this case, VC or other institutional investors) a priority claim to the remaining assets of NewCo when NewCo is liquidated. This means, VC, as a holder of series-A preferred shares, will receive distribution of liquidated assets first, and holders of common shares will get back their money only after preferred shareholders are paid off. This means, VC can get back most of the remaining money if NewCo fails. If NewCo’s business succeeds, then when E sells his common shares, the capital gain arising from E’s disposition will be taxed in accordance with the default rules in the Business Income Tax Act, without having to worry about proving the original acquisition costs of technology, know-how and business plan contributed as capital injunction.

The Regulatory Restrictions on the Use of Preferred Shares by Taiwanese Companies

While the above idea should be common knowledge among investment managers of venture capital funds and business lawyers, Taiwanese non-public companies rarely issue preferred shares to its venture capital / private equity investors due to various restrictions in the corporate registration practices promulgated by Taiwanese authorities.

Article 157 of the Company Act of Taiwan is the most relevant provision about the use of preferred shares, which requires that when a company limited-by-shares issues preferred shares, that company must specify the order, fixed amounts or fixed rates of dividends on such preferred shares; the order, fixed amounts or fixed rates of claim to residual property when the company is liquidated; the voting order, restriction or lack of voting rights of such preferred shares, as well as other rights and obligations associated with such preferred shares and holders of such shares. Article 157 does not place any other restriction upon the rights and obligations of preferred shares, therefore, the original intent seems to be deferring to what the issuing company and the prospective investors have negotiated about the terms of such preferred shares.

Ministry of Economic Affairs (“MOEA”), the administrative authority in charge of the interpretation of the Company Act, issued a number of interpretation letters that restricted the freedom of contract between the issuing companies and its investors. For example, a 2001 interpretation letter issued by MOEA stated that a company may not specify in its articles of incorporation that one preferred shares to be convertible to multiple common shares. The statutory text of the Company Act does not contain this restriction on the conversion ratio. Because the Department of Commerce, MOEA is responsible for all corporate registration in Taiwan, it would reject any attempt to insert a clause allowing a preferred share to be converted into multiple common shares in the articles of incorporation, and startup companies and venture capital funds would enjoy less degree of freedom structuring their fundraising efforts.

Voting rights of preferred shares are also restricted. A 1983 MOEA letter stated that a preferred share cannot have multiple votes, because in MOEA’s view, the general principle in the Company Act is “one share, one vote” and the text of Article 157 of the Company Act referring to “restrictions” cannot be interpreted as allowing one preferred share to have multiple votes, and the “order” only means the priority of voting among different classes of shares. Under this long-standing interpretation letter, a holder of preferred shares issued by a Taiwanese company may have one vote per share, or no vote at all, but other arrangements are not permitted. The MOEA interpretation is not necessarily the only reasonable one, because the text of the Company Act also does not clearly stipulate such restriction, and imposes another restriction on a company’s ability to structure the voting rights among different classes of shareholders.

Practically, a startup company may introduce different investors at different stages of its growth, and each such investor may have its own investment strategies and concerns, therefore, the law should have been interpreted in a way that permit the maximum flexibility among the company and its investors so that they may design a capital structure and voting arrangements suitable to their unique situations.

MOEA also imposes its own conception on how stock dividends should be given to holders of preferred shares. In two interpretation letters made in 2002 and 2009 respectively, MOEA stated that the stock dividend receivable by holders of preferred shares may only be common shares. This is yet another non-statutory restriction without any rationale or explanation from MOEA. Needless to say, MOEA’s position arguably trumps against the text and the intent of the Company Act about preferred shares, which is to permit the investors and the issuing company to negotiate their own terms and not to be intervened by the corporate registration authority.

The conservative mindset possessed by the MOEA when dealing with corporate registration may be more difficult to change than the above interpretation letters imposing non-statutory restrictions. The 2011 amendment to the Company Act already removed the statutory restriction on what corporate funds may be legally used to buy back preferred shares, and the current Company Act does not prohibit a company limited-by-shares from issuing redeemable preferred shares. In recent years after the 2011 amendment, however, there were still many instances where the MOEA acted conservatively or non-cooperatively when the articles of incorporation of a company contains provisions relating to redeemable preferred shares or the right of preferred shareholders to request a buyback, so that it took considerably longer for that company to finish its registration process and to begin deploying its investors’ funds. A startup company cannot afford to deal with such delays, as the timely injection of capital will always vital to its early establishment.

Concluding Remarks: Deregulation Is More Important than Subsidy

If Taiwan wants to improve its investment environment and to promote and encourage the growth of startup companies, the government’s amount of subsidy is not the key, but the change and “deregulation” of the corporate law, such as the restrictions upon preferred shares discussed above. The “deregulation” starts from the change of the conservative mindset among the government officials. If the MOEA can abolish these interpretation letters, and start to trust the ability of the entrepreneurs, the institutional investors, and professional intermediaries (corporate lawyers, financial advisors, and accountants) to resolve their differences, Taiwan can move one step closer to Silicon Valley. Before “deregulation” becomes reality, Taiwanese entrepreneurs should give serious thoughts on establishing an offshore holding company (in places like the British Virgin Islands or the Cayman Islands) as the vehicle to receive funds from investors.

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If you have any questions about any of the topics discussed above, please contact:

Chia-heng Seetoo
+886.2.7733.7067
chiaheng.seetoo@innovatus.com.tw

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