When it comes to raising money for your start-up, by the time things get around to doing the paperwork you might think that the hard part is behind you. You would be wrong. In the initial rounds of funding, it can be next to impossible for entrepreneurs to negotiate the terms on which they receive funding. The investor has a definite upper hand, offering to inject much needed capital, and can use this to push harsh terms which could impact you for a long time. For this reason, it is important to know the implications of what an investor is asking for, and to know when to push back hard. Here, we discuss some of the key contentious areas for start-ups when negotiating the terms of investment.
The metaphorical ‘pound of flesh’ for investors, a liquidation preference offers them downside protection in the event your company is liquidated or has a trade sale. It entitles the investor to a guaranteed return on his investment, typically a factor of x times their initial investment on a first-out basis, i.e. before anyone else is given any proceeds. In subsequent rounds of funding, other incoming investors will look to stack their liquidation preference on top of existing investors. The clear downside to investors piling on too much liquidation preference on their shares ahead of the founders and employees is the inverse relationship it has with the value of the latter. The more people have a right to recover money ahead of your own shares, the less appealing your shares become to you and your employees. You don’t want only crumbs left to rummage through, and this makes understanding and controlling this right at all stages of investment critical.
An ideal situation for an entrepreneur would be to have a capped liquidation preference, calculated keeping a close eye on the valuation of your company (don’t go above 1x). The liquidation preference should also be non-participating, i.e. where the investor gets first-right to sale proceeds on his preference shares only, but cannot subsequently also get a share in the remaining proceeds to be distributed among the equity shareholders (which would be a participating, or double dip liquidation preference).
Right of first offer (Rofo) /refusal (Rofr), and co-sale
A Rofo or Rofr comes into play when a sale of your company’s shares is contemplated. A Rofo requires the selling investor to first offer the shares sought to be sold to existing investors, and if a third party can beat the price offered by existing investors, the seller is free to sell them to such third parties. Inversely, a Rofr requires that the seller, after obtaining a price from third parties, offers this price to existing investors. If they are able to better the price, then they have the right to buy those shares over the third party. A co-sale, also referred to as a tag along right, kicks in when existing shareholders look to sell their shares to third parties, beyond a Rofo/Rofr, the other shareholders have the right to have all or a part of their shares ‘tagged’ and also being sold.
A best case scenario for an entrepreneur would be to reject a request for such rights altogether. However, this is easier said than done and these provisions have become fairly commonplace across all levels of funding. When faced with insistence on these rights, you can consider granting them with a few favourable riders. Grant the rights only to major investors (and not all investors), restrict a pro-rata multiplier on the right and cap the right at 1x, and push for a Rofr over a Rofo, and one that applies to you as well, thus enabling you to purchase shares over unwanted third parties in the event of an investor’s sale.
Board representation and affirmative voting rights
Board seats for incoming investors are a common ask across investment stages. This ensures that the investor stays involved in the day-today decision making in the company. As an additional layer of control, investors also typically provide start-ups a large number of affirmative voting matters, where decisions ranging from expenditures to business plans, contracts, marketing campaigns, ESOP pools, adoption of accounts and others, require the affirmative vote of the investor director. While this can give the investor comfort, if these rights are too vast, they can interfere with your independence. Affirmative voting rights should thus be limited to activities that would have a genuine impact on the investor, or those on which an investor’s input would be critical, and not activities where founders need breathing room to take business decisions. It will also always be helpful for you/your directors to have majority representation on the board.
Investors will often demand that the founders and their shares are locked-in for a number of years after the investment, meaning that the founders are restricted from selling their shares in the company till the expiry of this period. This is a fairly standard ask, and may even seem reasonable, given that you will/should not be looking to exit your own company anytime soon. Having said that, it is always better to have leeway in terms of your shareholding, and a good way to negotiate this with an investor would be for your shares to unlock in a staggered manner, such as in intervals of one year. This will give you some flexibility, and the investors will in any case, continue to have the right to buy these shares off you.
An anti-dilution right means that in subsequent rounds of funding, if the price-per share is negatively impacted, say in a situation where you are raising a new round but at a lower valuation, the value of the original investor’s shares is kept secure. There are two common types of anti-dilution protections, a full ratchet (which sounds just as painful as it is), and a broad based weighted average.
The full ratchet will adjust the investor’s initial conversion price as if he has only invested in your down-round (a subsequent round of funding where the company issues shares at a lower price than the previous round). Sounds confusing? Here’s a quick example: the company issues 1,000 preference shares (convertible into 1000 equity shares) priced at 100 Rupees a share in its Series A round, to an investor holding a full-ratchet. At series B, a down-round, the company issues 1000 more preference shares, but has to price them at 50 Rupees a share. The full ratchet will entitle the investor (who earlier had a conversion price on the basis of 100 rupees a share) to a conversion calculated at a share price of 50 Rupees a share and not at 100 Rupees in order to maintain his value, thus getting more shares for the same investment, and correspondingly diluting the founders’ equity (assuming they hold the outstanding equity). The lower the valuation and higher the number of shares issued in the down-round, the worse is the dilutive effect on the founders, a lesson some founders have had to learn the hard way.
The lesser evil, the broad-based weighted average, will see the company adjusting its original conversion or issuing additional shares, based on the number of shares actually issued at a lower price in the down-round, and not on all of the shares. This will limit the anti-dilution to the dilutive effect of the down-round, offering an incremental right, and not a blanket right on all the shares issued previously.
As the quantum of investment in your company grows, transactions will start to look like an increasingly complicated jig-saw puzzle. To make sure that all the pieces come together the way you need them to, you must have the foresight to know what is in store, and work with your advisors to fully understand the long-term implications of every right and obligation you sign up for, from the very beginning.