Senior Legal Counsel
Muhammad Ali Pasha
In this article, we will focus on early-stage financings which usually range between a few hundred thousand dollars and five million dollars (or more), for a Series A fundraise.
A. HOW MUCH TO RAISE?
How much should an early-stage company raise? The simple answer is: as much as is required to reach profitability and avoid the need to raise further capital in future. But the practical reality differs – most companies go through multiple rounds of fundraising, seeking to raise as much money as needed in each round to get to their next “fundable” milestone.
In deciding how much money to raise, founders and management teams should consider the following:
- how will the money be deployed to maximise progress;
- how many months of operation do you want to fund;
- what are the key expenditures are over the next 12 to 18 months;
- how competitive is the market is (a company should raise more money if it operates in a highly competitive market where its competitors have raised a lot of capita)l; and
- how much credibility do the company, founders and management have with investors and how much equity they are willing to give up.
The amount of capital raised by companies in Southeast Asia varies widely. In this article, we will focus on early-stage financings which usually range between a few hundred thousand dollars and five million dollars (or more), for a Series A fundraise.
B. FINANCING OPTIONS: EQUITY v DEBT
The two primary financing options available to a company are debt and equity. Most seed rounds, at least in South East Asia, are now structured as either convertible debt, or as convertible note (eg, the Simple Agreement for Future Equity (SAFE) and Convertible Agreement Regarding Equity (CARE)). In contrast, most Series A rounds involve equity.
Equity financing involves issuing a company’s shares to investors. An equity round means setting a valuation for the company and then issuing and selling new shares in the company to investors. Equity financing is more complicated, expensive and time consuming than using a convertible note (eg, SAFE/CARE), which explains why debt financing is popular for early fundraising rounds.
Early stage companies often raise their seed round by issuing convertible debt (in the form of a SAFE/CARE) instead of equity because debt is simpler and cheaper. Founders and management teams that choose to raise capital by way of convertible debt should focus on negotiating simple and short documents, closing quickly and cheaply, and maintaining options for a future Series A round.
(a) Convertible note
Convertible notes are unsecured debt instruments that convert to equity at a future date, usually when a company completes its next equity raising. The convertible note will have a principal amount (the amount of the investment), an interest rate and a maturity date. While the investment amount typically automatically converts to equity on the date of a qualifying capital raise at a discounted price to the next round price, it is often subject to an overall valuation cap. If not already converted, the debt may be repayable or convertible at the investor’s discretion.
In addition to the above, certain Southeast Asian countries impose limits on the amount of investment a foreign investor can make in certain types of businesses or industries. For example, Indonesia has an “Investment Negative List” which determines the maximum shareholding a foreign investor may have in a particular business line. One way to mitigate the above restrictions, which has become quite popular for investors, is to invest through debt instruments (such as convertible notes), instead of owning equity in the company. However, a thorough assessment from a legal, finance and tax perspective is required. In particular, one should consider whether it is beneficial to hold only a convertible note (instead of shares), how to align the interests between shareholders and note holders, whether there is any tax leakage (due to the nature of debt compared to equity), etc.
A SAFE/CARE are types of convertible notes that convert on a future equity financing or an exit. However, unlike a convertible debt instrument, a SAFE/CARE (i) does not have a maturity date; (ii) does not impose interest; and (iii) does not require repayment. The negotiable terms of a SAFE/CARE will almost always be the investment amount, the cap and the discount (if any). Due to the nature of the document (for example, unsecured, simple form, no maturity date, etc), a SAFE/CARE is usually reserved for very early stage start-ups, such as seed rounds or pre-Series A funding.
(c) Equity v Convertible Debt
There are various reasons why a company would prefer to issue convertible debt instead of equity:
- If the founder believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it to equity at a later date.
- The transaction costs are usually lower when issuing debt rather than equity, with less documentation, simpler terms to negotiate.
- Founders will retain more control, as it is uncommon for noteholders to obtain extensive negative control rights or director appointment rights.
However, founders and management teams should be careful when using convertible notes, with different valuation caps, for multiple rounds of fundraising. This can often lead to complexity and uncertainty regarding ownership and/or dilution when the convertible notes convert into equity.
For an investor, the preference for debt over equity is less clear. Sometimes investors will use a convertible note if they are unable to set a valuation for the company. This approach allows follow-on investors to set the valuation – when the company is more developed. In addition, debt is senior to equity in a liquidation scenario, so there is some additional security in receiving debt rather equity. However, for early stage companies, the seniority of debt over equity is not particularly valuable given that if a start-up fails, there is often little or no liquidation value.
C. THE “IDEAL” INVESTOR
Before a founder or management team begins its search for early stage financing, it should set out what it considers to be the most important values that it is looking for in an investor, whether they are capital resources, mentorship, branding or the investor’s network, etc.
Founders and management should also ask themselves what value an investor can provide to the company (other than just funds to grow the business). For example, a good investor will bring:
- Expertise: whether it is because they have invested in many successful companies and can bring unique insights or because they are a “specialised” investor with industry specific knowledge.
- Network/mentorship: investors (particularly venture capital firms) can offer early-stage companies access to their network of founders, talent or other investors that may be critical to the company’s future success. This is especially true for venture capital investors. Good investors can also offer opportunities for collaborations between portfolio companies or even with the investors themselves to create synergies and generate growth.
- Branding: investment from a large, reputable investor can help open doors to other investors who may not be willing to invest on their own. In addition, the backing of a large investment firm can raise the profile of the company and signal to the rest of the market that the company is of investment quality.
In addition, founders and management who receive offers of capital from multiple investors, should consider the following issues:
- Who is going to be the most pleasant to work with going forward?
- Who has the biggest war-chest to invest additional capital in follow-on rounds?
- Who is giving the best valuation of the company?
- Who is trying to impose the most onerous terms?
- Who has the most experience in Southeast Asian markets?
- How to maximise value through the investor’s other investments or resources?
Not all early-stage investors are the same. As such, it is important that a company conducts a thorough due diligence before choosing to partner with an investor. Particularly in early-stage financings, the investor(s) that a company chooses to partner with will have a big impact on the future success of the business.
D. CONTROL RIGHTS
1. Board composition
It is common, especially in early-stage financings, that an investor will want the right to appoint a nominee to the company’s board of directors. The main reason for this is control: having an appointee on the board allows the investor to be kept informed of the day-to-day operations of the company (strategy, financials, proposed acquisitions, etc) and be given the right to approve or veto certain actions. In reality, the investor-appointee will represent the investor’s interests and, as far as possible, ensure that the company does not take any actions that may harm the investor’s interests.
Investors often seek equal representation on the board (holding half of the board seats) so that no decisions can be made at the board level without their consent. Founders and management should be cautious, because providing investors with equal representation will mean that they are effectively giving up control of their company. In practice, founders and management should only grant board representation to investors who are investing the largest amount of money in the funding round. As a compromise, smaller investors can be granted “observer rights” instead of board representation, allowing them to appoint a nominee to attend board meetings, but in a non-voting capacity.
Founders and management should ensure that board appointments and board observer rights remain subject to the investors retaining a shareholding in the company, at or above an agreed threshold.
In Indonesia, rather than insisting upon board representation, investors commonly request for a seat on the board of commissioners of the company, which is a separate body to the board of directors. The commissioners are not involved in the day-to-day management of the company. Instead, they have veto rights on significant matters that affect the company (such as those matters listed below). With this approach, the board of directors (usually the founders) will have control over operational matters save for certain specific matters (for example, entering into contracts above a certain monetary threshold) that are subject to the investor’s approval via the board of commissioners.
2. Governance rights (veto/control)
Investors will typically seek veto rights over certain major company actions, such as future share issuances, incurrence of unusually large debt, amendments to the company’s constitution, declaration of dividends, or the sale or acquisition of any new business or subsidiary. In practice, this means a company will need investor approval for taking any of these actions.
The presence of such veto rights can significantly reduce a founder’s or management’s control over the company, even if they appoint a majority of directors on the board. Founders and management should therefore limit the matters subject to veto rights, and simplify the consent procedure so that only one or two lead investors (or alternatively a majority of the investors) are required to provide consent.
In particular, founders and management should resist items which may impede the company’s ability to conduct future fundraising rounds, as it is critical that a company’s board has the power to issue shares to raise further capital when required, without an investor having a veto right. One common approach is granting investors a right of first refusal over any new issuances of shares (in a future fundraising round), rather than a veto. This approach is preferred because it gives the company the flexibility to raise future capital (without needing investor approval), while providing existing investors the opportunity to subscribe for shares before they are offered to new investors.
In summary, investors will expect to have some degree of control over board actions in early-stage financings, but founders should carefully limit the scope and extent of such control. An extensive list of actions that require investor consent will impose a significant burden on a company, and will prevent founders and management from running the business effectively.
3. Lock-in provisions
Investment documents for early-stage financings often contain “lock-in” provisions which prevent founders and other key members of the management team from selling their shares for a prescribed period of time (often two to four years after closing the funding round). Investors insist on these provisions to ensure that the founder and/or management interests are fully aligned with the success of the company.
To balance, on the one hand, the investor’s desire to incentivise the company’s key employees, against the founders’ and/or management’s need for liquidity, founders/management should agree with the investor that a percentage of their shares shall fall outside of the transfer restrictions, in order to enable them to sell a small portion of their overall shareholding (for example, 10-20%) before the lock-in period expires.
4. Information rights
It is common for investors to request for access to certain information about the company (financial reports, management accounts, etc). In general, investors will want the right to:
(a) access the company’s key management personnel;
(b) access the company’s books, records and other financial information;
(c) receive information that the company provides to its board of directors (if the investor does not have an appointee on the board or observer rights); and
(d) request such other information that it requires in order to be kept well informed about the Company.
The requirement to provide extensive information and updates to investors can be extremely burdensome on founders and management, taking up time and resources that could otherwise be spent on running the company and growing the business. As such, founders should therefore limit the amount of information required to be provided to investors, with the parameters clearly defined.
Founders and management should also ensure that investors are contractually obliged to keep information provided to them confidential. This is because investors owe no duty to keep company information confidential, unlike directors. As such, it is crucial to either incorporate a confidentiality provision within the company’s shareholders agreement, or require investors to sign a standalone confidentiality or non-disclosure agreement.
E. ECONOMIC RIGHTS
1. Liquidation preference
In early-stage financings, founders and employees will typically receive ordinary shares in the company, whereas investors will receive preference shares. Preferred shares rank above ordinary shares (which means that preferred shareholders will be paid first), and usually have special rights attached (that ordinary shares do not have).
One such special right is a liquidation preference, which refers to the amount preferred shareholders (ie, the investors) must be paid, before distributions may be made to ordinary shareholders (ie, founders and employees). The liquidation preference means that the investor will have the option – when a liquidity event occurs – either to receive an amount equal (or a multiple) to their liquidation preference, or to convert their preference shares into ordinary shares (such that the investors’ returns are reflected through their overall shareholding in the company).
In effect, a liquidation preference provides investors with downside protection when a liquidity event occurs. A liquidity event could occur if, for example, the company is sold or wound up. The value of the liquidation preference (often 1x or 2x of the initial investment amount), as well as the type of liquidation preference, are usually subject to negotiations between founders and investors.
The two types of liquidation preference are:
(a) Non-participating liquidation preference: investors can choose to either:
(ii) convert their preference shares to ordinary shares, in which case they receive a share of the proceeds through (and in proportion to) their equity ownership.
(b) Participating preference: investors will first receive their preferential amount, and thereafter, receive (in addition) a share of the proceeds together with the ordinary shareholders, as if the investor had converted the preference shares. Under a participating preference, the amount that other ordinary shareholders (ie, founders and employees) receive upon a liquidity event, will be significantly reduced. As a result, the amount received by the investor (as preference shareholder) is typically capped, so that they do not participate in any further distributions, once they have received the capped amount.
In Southeast Asia, most investors tend to accept between 1x and 2x non-participating liquidation preference on Series A rounds. While a 1x non-participating liquidation preference is most fair for the company and investors, other formulations would be appropriate in certain circumstances.
Anti-dilution rights protect investors in the event of a down round (a subsequent round where new shares are issued at a lower price, compared to the price the investor invested at).
This protection is achieved either by adjusting the conversion ratio from preference to ordinary shares, or requiring the company to issue new shares as a bonus issue (for a nominal sum). The former is more commonly applied in Southeast Asia.
Anti-dilution protection comes in different forms, each providing investors with different levels of protection, as follows.
(a) Full ratchet
The full ratchet mechanism works by adjusting the conversion price of existing preference shares, to the reduced price at which new shares are issued in a later down round.This is the simplest type of anti-dilution provisions, but it is also the most burdensome and detrimental to founders and ordinary shareholders.
Introducing a full ratchet mechanism can make it more difficult to conduct future fundraising rounds. For example, if the company needs to undertake a Series B round at a lower share price, there is little incentive for the Series A investors to participate because they will receive a full conversion price adjustment – they will receive more shares in the company without needing to put money in the Series B round. In turn, the amount that Series B investors will be willing to pay will be reduced because the full ratchet results in there being more shares outstanding on an “as converted” basis. For this reason, founders and management should avoid full ratchet provisions.
(b) Weighted average
This form of protection adjusts the conversion ratio to offset the dilution in implied value of the shares caused by the down round. This adjustment involves a formula that compares (a) the number of shares that would have been issued to the new investors, if they paid the same price as the earlier investors, against (b) the number of shares actually issued to the new investors at the lower price.
Most commonly, a “broad-based” weighted average formula is used. This is much more founder-friendly than the full ratchet. A broad-based weighted average mechanism results in a higher conversion price for the preference shareholders (investors), which is favourable to founders because, on conversion, fewer shares will be issued to existing investors, resulting in less dilution.
While most Series A (and later) financings include weighted average anti-dilution protection, Series Seed financings may or may not include that protection. Full ratchet provisions are not commonly seen in early stage financings in Southeast Asia.
Robert is a Senior Legal Counsel at Gojek, where he focuses on capital raising, strategic M&A, partnerships and corporate transactions, as well as the expansion and operation of the international business in Singapore, Vietnam and Thailand. Before joining Gojek, Robert worked for Simmons & Simmons in London and Singapore, advising large corporates, investment banks, asset managers and venture capital funds.
Muhammad Ali Pasha
Pasha previously led the transactional team in Gojek's legal team, specialising in M&A, joint ventures, strategic investments and partnerships. Prior to Gojek, he worked at Baker McKenzie’s Jakarta office (Hadiputranto, Hadinoto & Partners / HHP Law Firm) specialising in foreign investment and M&A in the Finance and Projects Practice Group.
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