Allen & Overy LLP
Allen & Overy LLP
In this section, we set out our thoughts on what should really matter to an investor, and why. We hope this helps you understand the investor’s perspective, and allows you to approach negotiations in an informed and effective way.
So … you have signed a term sheet and your lead investor has asked their lawyers to prepare a first draft of the transaction documents. You begin to review the transaction documents and think about how to approach negotiations with the investors.
1. GOVERNANCE RIGHTS
There is no running away. This topic matters both to an entrepreneur and an investor in an early stage company.The starting points for both parties are often at the opposite ends of a spectrum. It can often be challenging to understand where the compromise is to be found.
From a legal perspective, the foundations of governance rights are easy to explain.
Most businesses are formed as private companies. A private company is a separate legal “person” from its shareholders and directors with the ability to enter into obligations, incur liabilities and undertake actions in its own capacity.
Since the company is a legal “person” separate from its shareholders, it needs to have a separate “mind”.In most countries, the “mind” of a company is its board of directors.
Most early stage companies are established with the founders as directors and shareholders of the company. When the company obtains investment from third parties, these third parties often become shareholders in the company.
Sometimes, shareholders will want to be a part of the “mind” of the company, by having the right to appoint an investor director. The motivations for this may vary – the shareholder may do so to help chart the direction of the company, or to keep an eye on things.
In our experience, many investors are driven by both considerations – they want to help the company chart its path forward and also help influence the thinking of the “mind”. However, as the board makes decisions by a simple majority, the level of influence on the “mind” may be limited. If one director on a board of five feels a certain way but the other four do not, that one director is outvoted.
(i) Reserved Matters
Therefore, most investors impose a list of matters which require the investor director’s positive vote, to give the investor director a veto even where the investor director is outvoted. These are referred to as “reserved matters”. Reserved matters comprise important matters considered by the board that investors view as being of particular significance. As most investors do not want to end up running the company, the list of reserved matters tends to be reasonably scoped to cover matters which the investors care most about.
A reasonable list of reserved matters is an indication that the list has been put in place to ensure that the board (as a whole) acts in the best interests of all shareholders. This is the basic duty of a director and should not be controversial. Therefore, the discussion is often focused on arriving at the right list of reserved matters with reasonable thresholds to ensure the smooth running of the company.
(ii) Shareholders’ Reserved Matters
The duty of the directors to act in the best interests of all shareholders was referred to above. While this provides protection for all shareholders, it can sometimes put directors in a difficult position.
Take for example a decision asked of the board which would go against the fundamental interests of certain shareholders. A director appointed to the board by that group of shareholders will be put in a difficult position. If he votes in the company’s best interests, as his duties require him to under the law, he could be perceived as acting against the interests of his appointing shareholder. From a legal perspective, the director must fulfil his or her fiduciary duties but this position may go against commercial reality from the appointing shareholder’s perspective. By contrast, however, shareholders do not owe a duty to each other or the company, and can vote freely in accordance with their wishes (however rational or otherwise). As such, arrangements are made to separate the decision-making duties.
For routine or operational matters, these are typically decided by the board. For matters that may affect the wider interests of the shareholders, these matters are generally tabled for a vote of the shareholders.
This means that a curated list of matters to be reserved to the shareholders, together with their relevant thresholds, needs to be agreed upon, taking into account the interests which need to be protected. From an investor’s perspective, this list should be focused on matters relating to the company’s financial well-being or its core business. Where a decision may prejudice the financial interests of investors, it is reasonable for the investors to have a say.
Ultimately, governance is a balance. When the company does well, the investors and founders do well. Appropriate governance is a tool by which to achieve that.
2. LIQUIDATION PREFERENCE
Liquidation preference is a unique concept that you are likely to come across only in venture capital deals. Therefore, it is important for all parties involved in a transaction to understand its real purpose in a venture capital deal.
Liquidation preference is intended to give certain shareholders preferential rights over others in the distribution of proceeds in a liquidity event.
From an investor’s perspective, this provision is important as it balances the risk taken by the investor in investing in an early stage company by giving the investor an opportunity to recover his investment before the proceeds from a liquidity event are distributed more widely.
In this light, it is important to consider a few things:
(a) What is the preference stack between shareholders?
(b) What is the preference amount?
(c) Does the investor receive the preference amount and also a share of the remaining proceeds with the ordinary shareholders?
(d) What is a liquidity event?
(I) Preference stack
Broadly speaking, there are two approaches.
The first approach is the conventional “vertical stack”, where newer investors rank ahead of earlier investors in terms of distributions.
Under this scenario, the newest investor(s) at the top of the stack take their preference amount in a liquidity event first. The remaining proceeds are then made available to the second ranking investor(s), and so on. If there are insufficient proceeds to make a full distribution within a slice of the stack, the investor(s) at that slice of the stack will share the proceeds pro-rata. The investors sitting below that slice of the stack will not receive a return.
The second approach is the “flat stack”, where all investors, regardless of the round they participate in, sit alongside each other in the same slice of the stack. Each investor will take a pro-rata share based on its investment amount. Any residual amounts will be made available for distribution pro-rata to the next group of shareholders ranking below.
(II) Preference amount
The preference amount refers to the amount an investor is entitled to be returned during the distribution within the slice of the stack in which the investor sits.
This amount is almost always determined by reference to a multiple of the actual amount invested by the investor in subscribing for that share.
In Southeast Asia, there are varying approaches to determining the multiple to be applied in any particular venture capital deal. While it is common to see multiples of between 1x to 1.5x in this region, investors will typically propose a number which reflects the relative risk of the business.
For example, if the company is in financial difficulty, an investor putting in funds may ask for a higher multiple to compensate for the risk undertaken at the time of the investment.
Ultimately, this is a commercial negotiation.The higher the multiple within a single stack, the less funds there are for distribution to junior stacks.
(III) Receiving liquidation preference amount and/or percentage of proceeds
Depending on the terms of the agreement, investors can receive the preference amount and a portion of the remaining proceeds (“Participating Liquidation Preference”) or can choose between receiving the preference amount on the one hand, and converting their preference shares to ordinary shares, hence sharing the proceeds with ordinary shareholders pro rata to their ownership of the business (“Non-participating Liquidation Preference”) on the other.
In the Non-participating Liquidation Preference scenario, where the company does not perform well, the liquidation preference provides down-side protection to investors by giving them returns in priority to ordinary shareholders. However, if the company does well, investors will voluntarily convert their preference shares into ordinary shares in a liquidity event in order to participate in the distribution of the company’s proceeds.
(IV) Liquidity event
A liquidity event refers to an event which triggers the liquidation preference. While founders and investors tend to debate the preference stack and the preference amount, lawyers are often left to debate what constitutes a liquidity event. Founders and investors are encouraged to carefully consider this to ensure that economic outcomes are reflected in the drafting.
There is a fairly well-understood category of events which fall into the category of liquidity events – namely if the company is liquidated or wound up. What is less clear and up for negotiation is whether a sale of the company will constitute a liquidity event and, if so, whether such liquidity event requires the sale of all or of just a majority of shares in the company. On a sale of shares, parties should consider whether it would make more sense for the buyer to pay a standard price for each share acquired, or if the buyer should pay a different price for different series of shares acquired (for example, $5 for a Series C share, $2.50 for a Series B share, and S$1 for a Series A share).
(V) Summary of liquidation preference
Liquidation preference can be a difficult topic in any negotiation. Sitting behind words on a piece of paper is a complex spreadsheet trying to account for how the distribution waterfall will be allocated. It is therefore important to pay attention to the nuances in the construction of the preference stack.
Most term sheets require the company and/or the founders to give “customary representations and warranties” leaving lawyers with the task of defining what is “customary”.
A representation or warranty is essentially a statement of fact made in a contract, to confirm that the stated fact is true (e.g., “The company has no borrowings other than as set out in the audited accounts”). In the example given, what the statement requires is the company’s and/or founders’ confirmation that the company has no borrowings other than as set out in the audited accounts. If the statement is untrue or not accurate, the company will need to disclose (in a separate document called a disclosure letter) the circumstances which make that statement untrue or inaccurate.
Once the disclosure is made, there is no liability accruing to the person making the representation or warranty, provided that the disclosure is accurate at the time it is made.
The key difference between a representation and a warranty is simply the legal consequences of making an inaccurate representation or warranty.Broadly speaking, a misrepresentation will provide more options for redress, which a lawyer will advise parties on.
Therefore, it is more common to see statements characterised as warranties.If a warranty is inaccurate, the party who made the warranty will have to compensate the other party for the loss suffered as a result of such inaccuracy.
In venture capital investments, it is appropriate to view warranties as a method of obtaining information and/or verifying information that has been provided to investors. This is meant to cover information previously provided, and as at the date the warranties are given.Warranties are not generally meant to cover future matters or projections, and are most certainly not intended to function as a guarantee of performance.
Viewed in this context, if the company or the founders are unwilling to stand behind the information provided to investors, there is a wider issue to be considered.
As long as accurate information is provided to investors, whether during the due diligence process or the disclosure process, warrantors should not be too concerned about giving warranties.
Therefore, lawyers taking a considered approach to negotiating warranties will ensure that:
(a) the scope of warranties sought is appropriate for the transaction;
(b) the warranties are not forward-looking (i.e., do not function as a guarantee of future performance); and
(c) the liability of the company and/or the founders who are giving the warranties is appropriately limited.
From an investor’s perspective, the key warranties which should be regarded as non-negotiable include:
(a) information which has been provided is true, accurate and not misleading (including by omitting to provide additional relevant information);
(b) no material information has been withheld; and
(c) the company has complied with all material laws applicable to its business (including in respect of licensing and anti-bribery and corruption laws).
Often, the number of pages setting out warranties exceeds that reflecting the other terms of the investment.Therefore, complaints that this is excessive are understandable. However, the list of warranties tends to be long as they are typically quite specific and carefully scoped (as opposed to being broadly given). This avoids the warrantor being inadvertently tripped up if a broadly worded warranty is interpreted differently by other parties.
Ultimately, the business of investing into early stage companies is a risky one. At a minimum, the decision to take a risk should be based on accurate information, and that is one of the main functions of warranties.
There are two aspects to the concept of anti-dilution.
The first aspect deals with preserving the value of shares held by existing shareholders in a future down round.
The second aspect involves pre-emption rights and seeks to ensure that existing shareholders are able to maintain their shareholding percentages.
(I) Preservation of value in a future down round
A down round occurs when shares are issued at a lower price per share than in an earlier issuance of shares. Investors are therefore keen to protect their shares from devaluation in any future down round and preserve the perceived value initially paid for the shares. Imagine paying $10 for a product one day and someone else paying $5 on the next day!
Investors in early stage companies often subscribe for preference shares which are convertible into ordinary shares at a fixed conversion price. Where an investor has been granted anti-dilution rights, in the event of a down round, the conversion price of the preference shares will be adjusted downwards to take into account the reduced issue price of the new shares. The manner of adjustment depends on the anti-dilution mechanism adopted. The most commonly encountered anti-dilution mechanisms are:
(a) broad-based weighted average formula; and
(b) full ratchet.
Of these, the broad-based weighted average formula is more widely used by far.
The broad-based weighted average formula takes into account the magnitude of the impact of the down round. As there is a smaller impact to the value of existing shares if fewer shares are issued during the down round, the adjustment to the conversion price will be smaller if few shares are issued, and larger where a large number of shares are issued during the down round. This formula is described as “broad-based”, as the valuation impact takes into account all outstanding ordinary shares in the company, together with all preference shares, options and other securities on an as-converted basis (that is, on the basis that they are assumed to have been converted into ordinary shares in accordance with their terms).
By contrast, under the full ratchet mechanism, the conversion price of all preference shares previously issued will be reduced to the price of the new issuance, regardless of the number of new shares issued in the down round and the actual impact to the value of the existing preference shares. Illustrations of how the various anti-dilution mechanisms are applied in different scenarios can be found in the Lexicon.
(II) Pre-emption rights
In general, the level of control that a shareholder exercises over the company and the matters over which a shareholder has a veto, are closely linked to the size of its shareholding.
Where shareholders enter into a shareholders’ agreement to govern their rights and obligations, more rights are given to those with larger shareholdings. In addition, in most shareholders’ agreements, a shareholder’s right to appoint directors to the board and the number of directors such shareholder may appoint are also linked to the size of its shareholding.
In order to maintain the same degree of control, investors will want to ensure that they are able to maintain their shareholding percentage at the level held following their initial investment. This is achieved by providing investors with a right to subscribe for further shares in proportion to their initial shareholding whenever the company issues new shares. This is known as a pre-emption right, and serves as another form of anti-dilution right.
A pre-emption right works as follows: where a company proposes to issue new shares, it must first offer those new shares to its existing shareholders and allow each shareholder to subscribe for its proportionate allocation of the new shares. The company will only be able to issue new shares to new investors if existing shareholders reject the new shares. This way, an existing shareholder that wishes to maintain its level of shareholding in the company can simply subscribe for the new shares offered to it.
Certain investors such as venture capital funds have a fixed investment horizon and will look to exit before the end of that period to return funds to their own investors. Given the importance of achieving an exit, the shareholders’ agreement would usually document the exit strategy and give investors a right to require an exit if certain criteria are met. A fair amount of discussion on this point should be expected at the early stages of all investment negotiations.
The most commonly contemplated exit options are an initial public offering (an “IPO”) or a trade sale. In an IPO, the company’s shares are listed on a stock exchange, providing greater liquidity for investors by allowing them to sell their shares on the public market to retail and institutional investors.
A trade sale involves an acquisition by a third party either of the shares of a company or of its assets. Other potential exit options include secondary sales by investors and share buy-backs by the company.
Investors often want the right to request an IPO after a certain period of time has passed since they first made their investment. The exercise of this right is often subject to certain conditions being met, such as the company obtaining a determination from an investment bank or other financial advisor that the state of the company and market conditions are favourable for an IPO, the IPO achieving a minimum company valuation, or the IPO taking place on a specified stock exchange.
These criteria seek to ensure that the right to require an IPO is exercised only when the company has reached an appropriate stage, and prevents the right from being triggered prematurely.
(a) Trade sale
A trade sale may involve a share sale or an asset sale. The purchaser may be a strategic buyer (i.e., another player in the market such as a competitor) or a financial buyer (e.g., a private equity fund).
A trade sale may constitute a liquidity event, in which case the liquidation preference described above (under section 2 “Liquidation Preference”) would apply
(b) Secondary sale
As companies remain private for longer, secondary sales are becoming an increasingly important exit mechanism.
The main difference between a trade sale and a secondary sale, as the terms are commonly used, is that a trade sale involves the sale of a majority or substantially all the shares in or assets of a company by all or a number of shareholders, while a secondary sale involves the sale of a smaller stake by a shareholder.
Although a secondary sale is often carried out at the same time as a fundraising round (incoming investors would purchase a mix of new “primary” shares issued by the company and “secondary” shares from existing shareholders), the company does not receive any funds in a secondary sale as all proceeds are paid to the selling shareholder.
(c) Ancillary sale-related provisions
(i) Drag along and tag along rights
The shareholders’ agreement will often provide drag along rights to the majority shareholder or a group of shareholders together holding a majority of the shares in the company. A drag along right is useful where a purchaser wants to purchase 100% of the shares in a company, as it allows the holder of the drag along right to “drag” the other shareholders in the sale to the purchaser.
Often, where the majority shareholders are given a drag along right, the minority shareholders would ask for a corresponding tag along right. Where the majority shareholders wish to sell their shares to a purchaser, a tag along right allows minority shareholders to “tag along” and sell their shares to the same purchaser at the same price and on the same terms. This allows minority shareholders to exit together with the majority without being left behind.
(ii) Right of first refusal/Right of first offer
The shareholders’ agreement usually grants shareholders a right of first refusal (a “ROFR”) where any shareholder proposes to sell its shares to a third party. This right allows each of the other shareholders to purchase its proportionate allocation of those sale shares at the same price and on the same terms that a third party purchaser has offered the selling shareholder.
An alternative right is a right of first offer (a “ROFO”), which requires a selling shareholder to first allow the other shareholders to make an offer for the sale shares. Only after the selling shareholder has considered and rejected any such offer, would the selling shareholder be permitted to seek offers from third parties.
Financial investors usually prefer a ROFO over a ROFR as it is less restrictive on their ability to exit, while preserving the spirit of these provisions (by allowing existing shareholders to make an offer for shares being sold).
(III) Share buy-back
A (much) less common exit option is a buy-back of shares by the company at the request of investors. Given the uncertainty around the successful completion of an IPO or trade sale, a buy-back is often viewed as providing a guaranteed exit to investors.
However, Singapore law imposes restrictions on the number of shares that can be bought back by a company. This will have to be taken into account during negotiations and at the time of any future buy-back. That said, a buy-back is unlikely to provide outsized returns and serves primarily as downside protection or to allow investors to exit at the end of the life of their fund.
Kelvin is Executive Director and General Counsel at Openspace Ventures. He has worked in private equity and venture capital, both as an external legal advisor and an in-house lawyer, since 2008. Prior to assuming his current role at Openspace, he was a M&A lawyer at an international law firm, working in its London, Tokyo, Dubai, Hong Kong and Singapore offices. He is qualified in England & Wales and Singapore, and obtained his bachelor’s and master’s degrees in law from the London School of Economics.
Brendan Hannigan is a Singapore based corporate partner with a practice concentrated on M&A transactions across the ASEAN region. He has experience in a wide range of commercial and corporate finance matters including public takeovers, private acquisitions and disposals, joint ventures, strategic investments, restructurings and general corporate work, acting for a range of clients including large listed corporations, family owned companies, growth corporates and financial sponsors.
Heather Ong is a senior associate, with experience acting for a range of technology firms, multinational corporates and financial institutions and on cross-border M&A transactions globally across a broad range of sectors. She is qualified in Hong Kong and England and Wales, and has worked in Singapore, Hong Kong and London.
Disclaimer: This article is intended for your general information only. It is not intended to be nor should it be regarded as or relied upon as legal advice. You should consult a qualified legal professional before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising.
Published 29 May 2020