updated on 23 January 2024
QuestionHow does the ruling in DnaNudge v Ventura Capital impact the future of venture capital and private equity transactions?
In October 2023, in DnaNudge Ltd v Ventura Capital GB Ltd  EWCA Civ 1142 the Court of Appeal upheld a High Court decision that a conversion of preference shares into ordinary shares under a mechanism set out in the articles of association (articles) constituted an abrogation of the special rights attached to the preference shares. The court held that, to require conversion of the preference shares, class consent should’ve been obtained. The Court of Appeal ruled that the mechanism set out in the articles, effectively entitling the holders of the ordinary shares to automatically convert preference shares to ordinary shares, was null and void.
In 2021 DnaNudge Ltd (DnaNudge), a startup medical and health technology company, received funding from two investors Ventura Capital Ltd (Ventura) and Sumitomo Mitsui Trust Bank Limited (Sumitomo). The two investors invested just over £40 million in the company in return for Series A shares (preference shares). Attached to these shares were special rights such as the preferential repayment of capital initially subscribed and a cumulative preferred return until the next funding round at a specified pre-money valuation.
In connection with the new funding, DnaNudge adopted new articles with some provisions originating from the British Private Equity & Venture Capital Association model articles for early-stage investments. The provisions of interest were Article 9.2(a), stating that preference shares would “automatically convert” to ordinary shares, upon written notice of the “investor majority”, (defined as the aggregate of Series A shares and ordinary shares) or an initial public offering. Article 10.1 provided that the special rights attached to a class of shares may only be varied or abrogated with the written consent of more than 75% of the holder's consent.
In May 2022, various ordinary shareholders comprising an investor majority gave written notice requiring preference shares to be converted into ordinary shares under Article 9.2(a). Subsequently, Ventura commenced proceedings to challenge this.
At the first instance, it was held that the automatic conversion provision had to be subject to the class consent requirement set out in Article 10.1
DnaNudge's first submission in its defence provided the share conversion didn’t amount to a variation of rights attached to the preferred shares. Rather, the automatic conversion clause involved an exchange of shares. The rights attaching to the preferred shares remained identical both before and after the share conversion. The High Court rejected the company's submission, ruling in favour of Ventura. The conversion of the preference shares meant for all purposes that the special rights attached would no longer exist upon the conversion, amounting to a variation.
The Court of Appeal upheld the first instance judgment by the High Court, focusing on common commercial sense. It was clear that the special rights attached to the preference shares were carefully designed to apply in specific scenarios and Article 10.1 offered protection to the preference shareholders. Therefore, the unfettered power presented for ordinary shareholders to convert the preference shares to ordinary shares at any time, including the exact timeshares were designed to benefit the preference shareholders (eg, liquidation or an exit) meant Article 9.2(a) produced a bizarre regime, which made no commercial or logical sense. DnaNudge was a rare case where the tension between Article 9.2(a) and Article 10.1 was a clear drafting misstep, which didn’t readily appear when reading the provision but became apparent on the examination that it couldn’t have been what the drafter meant as it made no 'rational sense'.
The courts also held that when construing articles of association, their powers of contractual interpretation are limited to the extrinsic facts. The context is considered from the perspective of a third party reviewing the constitutional documents such as, those available at Companies House and common commercial sense. The matters about commercial context known by the parties wasn’t considered by the court.
This case highlights the importance of drafting clear non-conflicting provisions in the articles of association. Resultantly, the court highlighted that something had clearly gone wrong in the drafting, meaning it had to step in to make rational and coherent sense of the articles. In this case, when and how a conversion of shares would amount to a variation of rights attached to a class of shares was put under a spotlight.
Mechanisms relating to the variation of shareholder rights are often heavily negotiated in venture capital and private equity deals and are often not straightforward. Therefore, parties relying on an automatic conversion are advised to consider addressing directly the risk highlighted by DnaNudge. They can do this by going further to expressly state in which circumstances a conversion will (or will not) amount to a variation or abrogation of share rights, which may require class consent.
Hope Oraka is a trainee solicitor in the private equity team at Taylor Wessing.