In the previous article of this series we discussed the strategy to be adopted by founders while negotiating a term sheet with a VC fund. Now, on to certain important legal terminology. It is necessary for founders to be aware of and understand the implications of the legal jargons which could impact their rights in the business.
Liquidation preference
First and foremost – the liquidation preference. Liquidation preference is the investors’ right to get their investment amount back before the holders of common shares (equity shares) get any returns. The common shares are usually owned by the startup’s founders and employees. The preference applies when the startup undergoes a sale of its business by way of any corporate action or it distributes profits to its shareholders. With respect to liquidation preference, the most important element for founders to be mindful of is the type of liquidation preference being demanded by the VC fund – participating or non-participating? Also, how many times of the investment is being demanded as a liquidation preference?
In a 1X non-participating liquidation preference, the VC fund may choose to either receive its liquidation preference OR share in the proceeds of the sale in proportion to their equity ownership (on a converted basis). Participating liquidation preference indicates that the VC fund will be paid back their 1X liquidation preference and then will partake in any additional proceeds in proportion to their equity ownership (on a converted basis). Similarly, if the investor demands a multiple of its investment as a liquidation preference (e.g.: 2X), then the equivalent of such value has to be received by the investor.
The market trend in India is to offer investors a 1X non-participating liquidation preference, i.e., the equivalent of their original investment amount or participation on an as converted basis. All subsequent investors usually assume the same liquidation preference rights, without any difference in priority. Any indication in the term sheet of a participating liquidation preference or a multiple in excess of their original investment amount is a red flag and must be negotiated.
The logic for a liquidation preference is to essentially provide a downside protection for the investors given the risks associated with investments by VC funds. This is a useful concept to understand. Usually, VCs will attempt to get the best form of protection for their capital. There are instances where founders may have to negotiate and push back the terms towards a balance.
Exit rights
All VC funds have an exit horizon. Exit rights are sought by VC funds to give them a route to sell their shares if the founders have not been able to conclude a liquidity event (e.g., IPO or a sale of business) within a predefined period. Broadly speaking, the key areas for founders to negotiate are the exit period; the exit process i.e., the waterfall mechanism; and the obligations of the founders to provide an exit.
The waterfall mechanism sets out the step-by-step processes through which the founders are required to provide an exit to the VC fund. First recourse is an IPO – listing of the shares of the startup on a stock exchange. Next comes a secondary sale – the founders and startup must find third-party buyers for the VC fund’s shares. Third option is a buy-back – the startup needs to buy-back the shares held by the VC fund to provide them an exit. Lastly, a drag sale – the VC fund sells its shares to a third-party and forces the founders and other shareholders to sell their shares to such third party.
Founders should ensure that the document does not contain any personal obligation on them to provide a monetary exit to the VC fund. The market standard is to provide an exit to the VC fund after 5-7 years from the date of their investment as per the waterfall mechanism described above. A VC fund normally has a limited fund-life, and it has to return the investment amount with appreciation to its limited partners by the end of its life. In this context the exit requirements sought by a VC fund are justified to some extent.
Governance rights, Reserved matters / Affirmative voting matters
It is often seen that VC funds require certain governance rights in a startup. A seat in the board of directors, an observer on the board of directors (an observer is a non-voting participant in meetings of the board of directors), and certain reserved matters. While it is fair for VC funds to demand a board seat or an observer seat, founders will do well to ensure that all matters concerning the day-to-day affairs are controlled by them. Simple fix for founders; give the VC fund a board seat but ensure that the founders (and their nominees) make up majority of the board composition.
Apart from the board seat, it is standard for VC funds to ask for certain reserved matters. Reserved matters (or affirmative voting matters) are a set of limited items which the startup and the founders can only action once they receive the VC fund’s approval. How long is that list? What are the items in that list? Founders should run a microscopic lens on the list; negotiate the ones which seem unreasonable or impractical and retain the rest. Most often, the exhaustive list of reserved matters is not provided in the term sheet. A VC fund will only ask for customary rights in the term sheet or only include certain material ones as an indicative list.
The logic for a VC fund demanding certain governance rights is to protect their investment by monitoring the material decisions taken by the startup. In this regard, only material aspects that have a significant financial impact on the business or rights of the VC fund should be provided as reserved matters.
ESOP pool
An ESOP pool is generally carved out from the founders’ shareholding. What is the permitted post-money size of the ESOP pool? Does that size of ESOP pool fit well with the plans the founders have in mind vis-à-vis hiring of talent and allocation of options? Do they need to increase it? Who takes the dilution if the founders need to expand the ESOP pool later? And what happens to the unused options lying in the ESOP pool later? Founders need to agree on these points prior to signing the dotted line on the term sheet. Generally, after the first VC round, the founders prefer to have a larger ESOP pool, around 7.5-10%, to grant to potential talent and key employees. Founders should ensure that they are not required to take approvals from the VC fund each time they desire to grant options.
VC funds will insist on a fair allocation in the ESOP pool since the business will need to retain talent at senior levels who need to be compensated appropriately. But the decision for allocation to individual members should be retained with founders.
Founders’ lock-in and general restrictions
There will be requirements in the term sheet for the shares held by the founders to be locked in for a certain period. In simple words, the founders cannot sell off their shares and generate liquidity for themselves. In addition to that, there are other restrictions placed on the founders. It is standard for the initial shareholding of the founders to be locked-in for a period of 4-5 years with consequences of forfeiture of shares in certain situations. These situations usually deal with the founders leaving the company or being terminated from their roles due to some material concerns.
VCs would need to keep such an arrangement in place since they are largely relying on the founding team to build the business. If a founder exits the business in the early years, the business may need to find another person to take their place as a founder or as management. In either case, there needs to be an appropriate pool of stock available to incentivize the new person who is brought on board.
Approach
As we had mentioned earlier, founders should strive towards having an in-principle agreement with the VC fund on all material items. Once the meeting of minds has happened, founders can go ahead and sign the term sheet. It should be a paramount objective for the founders to sign the term sheet at the earliest, for reasons discussed in the previous article. To that extent, rather than negotiating the nitty gritty of each specific provision, they should agree to reflect the broad principle and save the detailed negotiations for the agreements. Next up would be commencing the investment process as agreed in the term sheet. We will discuss the investment process, other legal jargons and their implications in the subsequent parts of this series.
Arun Mohanty | Principal Associate, Veyrah Law; Ajay Joseph | Partner, Veyrah Law
Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.