May 2024 – In less than two months, businesses will have the opportunity to start using a new corporate vehicle available in Bulgaria – the variable capital company (“VCC”). The VCC structure has been designed to give more flexibility to founders and start-ups while reducing initial incorporation costs. But does this flexibility also benefit investors?
Below are some considerations that investors should keep in mind before investing in a VCC:
- Increased importance of a thorough corporate due diligence – To date, entrepreneurs in Bulgaria have tended to use limited liability companies to start their businesses. Investors can quickly and easily verify the title over shares and the capital and shareholding structure of such companies through an online search in the Bulgarian Commercial Register. This will not be the case with VCCs. Verification of the capital and ownership structure of a VCC will require careful review of the company’s articles, statutory books, shareholders’ ledger and shareholders’ resolutions from past annual meetings, among others.
- Need for stronger anti-dilution protection – VCCs can easily issue various instruments that may affect their capital structure, e.g., convertible loans, preference shares, and share options. Moreover, existing shareholders do not have statutory pre-emption rights upon capital increases. This requires an elaborate anti-dilution protection in the articles and the shareholders’ agreement to capture all possible situations that may lead to changes in the VCC’s capital.
- Squeeze-out risk – The articles of a VCC may provide for cases in which the shareholders’ meeting may require the investor to transfer its shares. The VCC may also have the right to acquire the stake of a shareholder (legal entity) upon a change of its control. However, Bulgarian law remains silent as to the financial terms of such compulsory share transfers. It is therefore crucial for investors to explicitly regulate these terms from the onset of their investment.
- Repurchase of own shares affecting the financial stability of a VCC – A VCC can repurchase its own shares in a number of cases, such as when a shareholder fails to comply with drag-along obligations or when a shareholder is dismissed and their participation in the company is terminated. However, there are no statutory limitations or requirements regarding the funds that the VCC can use for the repurchase. This may put at risk the financial stability of the VCC or harm the interest of third-party creditors, including investors with convertible loans. One possible solution is for the VCC to create special reserves that can be used to repurchase the shares. Such a risk exists in the case of a reduction of the VCC’s capital, as the law does not provide for any special protection of creditors prior to distributions to shareholders as a result of the capital reduction.
- Liability of the controlling shareholders for actions of the VCC – The Bulgarian Commercial Act introduces, for the first time, the concept of “piercing the corporate veil”. This means greater responsibility for shareholders with controlling stakes, in particular investors that (i) hold more than one-half of the votes in the shareholders’ meeting; (ii) can appoint more than one-half of the members of the management board; or (iii) have the right to exercise a decisive influence over the VCC based on contractual arrangements (such as shareholders’ agreements). Such investors will be liable to the company’s creditors for any actions or transactions of the VCC that have been invalidated with respect to creditors pursuant to certain claims. The liability may be invoked if the investors, in exercising control over the VCC, have acted with the intention of harming the interests of the company’s creditors.
- Convertible loans protection – Despite the explicit regulation of convertible loans, Bulgarian law does not stipulate their automatic conversion into shares. Investors will have to ensure they have sufficient contractual protection against undue delay or failure to convert a loan into shares. A precise conversion mechanism should be included in the VCC’s articles.
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Converting a VCC to another company type – The regulation of VCCs indicates that some of the specific rights and instruments are available only to VCCs. Although most of these can be structured in other company forms (e.g., joint-stock companies or limited liability companies), there is some confusion as to what happens to own shares, options, or convertible loans issued by the VCC after its conversion into another company type. Investors should ensure that the shareholders’ agreement includes appropriate contractual terms and procedures applicable upon conversion. Careful consideration should also be given when preparing and approving the plan for the conversion.
Among the main reasons for introducing the VCC structure in Bulgaria are its flexible capital structure and enhancement of equity investments. As a result, the new regulation gives founders and investors more freedom to agree on the terms of their shareholding and investment compared to other company forms. However, the flexibility entails less statutory protection for VCC shareholders and third-party creditors. A greater focus on tailoring the terms of the VCC’s articles and the shareholders’ agreement is needed to manage the risks of equity investments.