Morrison & Foerster
Morrison & Foerster
Morrison & Foerster
This article seeks to explain market practice for certain key VC deal terms in other markets and how they have developed, helping founders and investors to make an informed choice on how they can position themselves in in this region.
A. MORE TO VC TERMS THAN PRE-MONEY VALUATION
The conditions are right for venture capital (“VC”) investment in Southeast Asia to reach new heights. Numerous regional VC funds have now been targeting investments in Southeast Asian early stage companies, and promising companies from this region are also attracting investors from overseas or from industry. What results is an interesting mix of experienced VC funds that factor the high risk of this asset class into their valuations, and angel investors, family offices, corporate venture capital and traditional industrialists, some of whom may have less experience in VC investing.
Pre-money valuations understandably form the headline term of each financing round. The terms and conditions of a company’s early rounds of equity financing can be complex, but they carry significant and long-term implications on a company’s ability to operate nimbly and achieve value creation for all shareholders.
Founders and investors tend to bring their desired market terms, shaped by their diverse geographic, risk profile and deal-making backgrounds. Yet, the small transaction sizes in early stage investments can constrain both sides from bringing in experienced legal advisors. This can result in a perfect recipe for time-consuming, inefficient, and potentially divisive negotiations between founder and investor, which unnecessarily diverts the parties’ attention away from value creation.
This article seeks to explain market practice for certain key VC deal terms in other markets and how they have developed, helping founders and investors to make an informed choice on how they can position themselves in in this region. This will also explain some of the various drafting options found in VIMA, allowing parties to use VIMA more effectively to achieve their objectives.
In particular, this article considers the United States’ National Venture Capital Association model documents (“NVCA”), which have (since 2003) served as an influential standard set of provisions for negotiating VC financings in the United States. The practice in other markets is also considered, such as in China, where the sheer volume of VC investments in recent years has created a body of “market practice”.
Set out below are five key terms when negotiating early stage VC investment terms:
(1) founder liability,
(2) reserved matters (also known as protective provisions),
(3) pre-emption rights,
(4) lock-ups, and
(5) liquidation preference.
More background is provided as to why investors or founders request them, what the market trends are for them and how to incorporate them into your VIMA documents.
B. THE FIVE KEY TERMS: WHYS, WHATS AND HOWS
1. Founder liability
(a) Scope of warranties and representations
The scope of warranties and representations to be provided depends on various factors, such as how developed a company is, the nature of its business operations, and the background and preferences of investors. Founders of companies still at an early stage will often seek a very limited scope of representations and warranties, given its short operating history, relatively light assets and liabilities, and limited budgets. Traditional US-style venture investors tend to be sympathetic to these constraints. However, investors with other backgrounds may seek a more robust scope of representations and warranties, especially if they are more used to conducting later stage mergers and acquisitions deals or if the company’s business sector or investor’s due diligence highlights potential risk areas.
(b) Founders’ personal liability
Whether founders are held personally liable for such warranties and representations varies widely in practice. Under the NVCA, founders are not personally liable. In China, founder liability is more customary, given the perceived challenges of enforcing warranty claims against an offshore holding company (as the most valuable assets are typically held several corporate layers below in one or more Chinese operating companies).
The practice in Southeast Asia VC investments is evolving. Many VCs recognise that subjecting a founder to personal liability will instantly create misalignment of interests between founders and investors, bringing about a chilling effect on the founder’s willingness to take disruptive, and sometimes higher risk actions, that may be needed for innovative breakthroughs. On the other hand, to the extent a start-up has local operating subsidiaries with an asset-light Singapore holding company, investors may not be comfortable with having recourse limited to the holding company. A number of middle ground approaches are possible such as introducing a limit on founder liability, requiring an investor to seek recovery from founders only after it has exhausted its remedies against the company, and/or creating a direct warranty between an investor and the operating subsidiaries.
See Item 1 of the Appendix for selected VIMA provisions and drafting tips.
2. Reserved matters (also known as protective provisions)
The scope of reserved matters requiring an investor’s special approval varies from region to region.
US transactions based on the NVCA tend to include a fairly short list of reserved matters, focusing on corporate actions with a direct impact on investors’ economic or governance rights, such as a liquidity event, closing a new round of preferred financing, changes to the rights of the existing preferred shares, dividends and distributions to shareholders, and changes to the board size. Having said that, the scope of reserved matters in the US have increased in recent years.
In China, the list of reserved matters tends to be lengthier and extends to operational matters, such as hiring key employees, incurring material operating expenses or entering into material contracts or strategic partnerships.
While investors understandably wish to have oversight of a company’s growth, it is essential for a growth-stage company to be able to move quickly to stay ahead of its fast-moving competitors. A founder that regularly needs to spend time locating and persuading an overcommitted investor over matters that are time sensitive yet mundane is bound to become frustrated.
(a) Subsidiary coverage
If there are operating subsidiaries (as is common in Southeast Asia start-up enterprises), investors will often seek to apply the list of reserved matters to subsidiaries, for example, by having subsidiaries become parties to the shareholders’ agreement so that it is enforceable in relation to those subsidiaries.
(b) Voting threshold – board
For protective provisions applying at the board level, the typical approval threshold is a majority of the board (at a convened meeting), but that majority must include directors appointed by one or more investors. This is generally the position under NVCA. In Southeast Asia, the approach is varied as sometimes every investor requests for a board appointee with voting rights. Founders can try to keep the board to a manageable number by offering observer seats instead of board seats (especially for smaller investors), or require approval by only a majority of the investor directors (especially if there is more than one director appointed per Series of preferred shares).
(c) Voting threshold – shareholders
At the shareholder level, the approval percentage threshold is typically between a simple majority (>50%) and 66 to 75% supermajority of the preferred shares (or a Series of preferred shares).
(d) Separate Series voting v preferred voting as a single class
Since each Series of preferred shares will have a different desired timeframe for exit and valuation target, different Series may not be economically aligned on all matters. A new investor is inclined to request Series-level voting to give it more influence (at a Series-level vote) than amongst all preference shares. However, this means the company will need approval from each Series of preference shares to proceed, allowing any Series to veto the fundraising. For this reason, the company often prefers to have preference shares voting as a single class.
Under the NVCA, combined voting is often acceptable (that is, a certain percentage of all preferred shares voting as a single class is needed) for most of the protective provisions. In China, Series-level voting is present in a significant minority of transactions.
See Item 2 of the Appendix for selected VIMA provisions and drafting tips.
3. Pre-emption Rights over New Issuances and Redemption
(a) Pre-emption rights
Pre-emption rights are customary and provide an investor a right to top up its ownership of the company to avoid dilution. Typically, an investor gets to purchase the percentage of the new offering that is equal to its percentage ownership in the company (calculated based on all preference shares, ordinary shares, and share options then outstanding).
Some investors may request for a “super pro rata” allocation (to increase their existing equity percentage ownership of the company), or to calculate their pro rata portion based only on the outstanding preference shares. Finally, some founders may request to participate in such pre-emption rights. Under each of the above scenario, there could potentially be no shares left to allocate to new investors. This is problematic because different types of investors may specialise in helping companies at different stages of their growth. A company may need the expertise of a later-stage investor to assist with the company’s IPO or a sale to a strategic acquirer, but would be unable to attract them if founders or existing early-stage investors have taken up the entire allocation.
In the US and China, the holders of ordinary shares will almost never benefit from pre-emption rights. In fact, the practice under the NVCA encourages pre-emption rights to be granted only to Major Investors (holding a minimum number of shares), whereas in China it is more common for all investors (holding preference shares) to have pre-emptive rights.
See Item 3 of the Appendix for selected VIMA provisions and drafting tips.
Ordinary shareholders may be subject to a lock-up for a period of time after completion (for example, 3 to 5 years), unless otherwise approved by the board or preferred shareholders. This is to disincentivise founders from exiting, before investors do so in a liquidity event. The straight pre-IPO lock-up is more prevalent in China and Southeast Asia transactions, but much less so in US transactions. In US transactions, the ROFR and Tag-Along provisions are often relied on as a more subtle, “polite” but indirect way to impose a lock-up on founders, since founder shares will be much less marketable if a prospective purchaser needs to run through a full ROFR and Tag-Along process to complete a sale.
See Item 4 of the Appendix for selected VIMA provisions and drafting tips.
5. Liquidation preference
A liquidation preference provides downside protection so that investors receive their investment proceeds before the ordinary shareholders in the event the company is sold for a relatively low valuation. Preference shareholders may exercise their liquidation preference rights upon the occurrence of a liquidity event. The ranking of different Series of preferred shareholders, the value as well as type of liquidation preference are often subjects for negotiation.
(a) Front end multiple
A “1x” liquidation preference is fairly customary and will allow investors to receive 100% of their investment proceeds before sharing the remaining proceeds with the ordinary shareholders. However, some investors (for example, private equity) need to produce higher consistent returns for their own investors and may seek to increase the front end multiple accordingly. At that point, the nature of a liquidation preference changes from downside protection to being a tool for obtaining a fixed income return. The problem with increasing the front-end multiple is that it will encourage future rounds of preferred shares to seek similarly high returns. Since future rounds are likely to be at a higher price per share, this takes more off the table for founders and employees holding ordinary shares. If the future round investors are able to negotiate a seniority over earlier rounds of preferred shares, this adversely impacts not only the founder, but also investors that came in before them.
In the US, it is rare to see more than 1x multiples, with each Series of preference shares given the same priority (also referred to as pari passu rights). The multiples tend to be higher than 1x in China (1.25 to 1.75x), with later round investors receiving seniority over the earlier rounds. Thus far, 1x liquidation preferences in Southeast Asia remain fairly customary, but it is more common for later round investors to seek seniority over early round investors.
(b) Participating or non-participating
Liquidation preference rights can be classified as non-participating and participating. For non-participating preference, preferred shareholders will choose either to exercise their liquidation preference rights (that is, receive an agreed multiple of their initial investment amount) or toforego their liquidation preference, in which case their preference shares will be converted to ordinary shares (according to the prevailing conversion ratio) and receive a share of the proceeds according to their equity ownership of the company. Non-participating liquidation preferences are consistent with the notion of this being downside protection.
Participating preferences allow the preferred shareholders to receive their front end liquidation preference and to continue to sharing in the remaining proceeds with ordinary shareholders. This results in preference shares receiving a disproportionally greater return per share than an ordinary share, even if the company is sold for a high valuation.
In the US, the market standard is generally for all preferred shares to have non-participating liquidation preferences. In China, participation is more common. Thus far in Singapore and Southeast Asia, participation is less common.
See Item 5 of the Appendix for selected VIMA provisions and drafting tips.
VIMA Selected Provisions and Drafting Tips
Selected Clauses from VIMA Documentation
VIMA Long Form Term Sheet – Clause 11, Liability Basis
Unless otherwise agreed by the Parties, all representations and warranties, covenants, agreements and obligations given or entered into by the Founders and the Company pursuant to this term sheet or the Definitive Documentation shall be given and entered into on a [several and not joint] / [joint and several] basis.
Such representations and warranties will be given by the Company and the Founders [and subject to limitations on liability] .
1. Consider deferring this issue until the definitive investment documents, once the scope of the representations and warranties being requested is better known and investors have had more time to diligence the Company’s condition. Founders can refer to the VIMA documents to consider what these warranties and covenants may be ( see Clause 3 (Post-Closing Undertakings), Clause 4 (Warranties) and Clause 5 (Limitations on Warranty Claims) of the VIMA Subscription Agreement ).
2. Delete references to “Founders” in relation to representations and warranties, if Founders would not give warranties and representations.
3. The “several and not joint” option should be used if Founders are only responsible for or are intending to give only certain warranties, with the Company being responsible for or giving the others, independently.
4. The “joint and several” option is pro-investor.
VIMA Long Form Term Sheet – Clause 26, Reserved Matters
Prior to an underwritten public offering of shares of the Company in a Qualifying IPO: (a) the approval of a simple majority of the Board of Directors (and including the approval of [all or at least [●] of] Investor(s) Director[s]) shall be required for the actions set out in Part 1 of Appendix III; and (b) the consent of the Series A Majority shall be required for the actions set out in Part 2 of Appendix III.
1. The Reserved Matters are appended to the VIMA long form term sheet as Appendix III. Depending on deal dynamics, the parties may decide to defer the detailed negotiation of the scope of warranties and the approval thresholds until the definitive agreement stage, as these negotiations can become protracted. It may be useful for all parties to reach alignment on the spirit of these before proceeding to the definitive documents ( eg, whether they will be more “US-style” or include more operational matters).
2. If the Company group consists of other operating subsidiaries, an investor may wish to include a general reference in Appendix III that the same Reserved Matters will also apply to the Company’s subsidiaries.
3. For item (a) board reserved matters, the founder should consider whether all or a subset of investor directors must agree to these matters.
4. For item (b) shareholder reserved matters, the default definition of “Series A Majority” is 75% of the Series A shareholders – ie, Series or class voting. Founders may wish to consider whether it is worth trying to negotiate at this stage for combined preferred class voting and the percentage approval threshold required. While referring to “Preferred Majority” rather than “Series A Majority” in the first round of financing are one and the same during a Series A financing, there may be value in calibrating party’s expectations that future rounds are expected to vote as a single class.
VIMA Long Form Term Sheet – Clause 27, Pre-Emption Rights over New Issuances
[Option 1(a)] [Holders of Series A Shares shall have a pro rata right (determined on an as-converted basis) to participate in any issue by the Company of new equity securities or securities convertible into equity securities, other than the Excluded Issuances (the "New Shares"). /
[Option 1(b)] [Such holders of Series A Shares who have subscribed for the full amount of New Shares that they are entitled to shall have the further right to subscribe for any remaining New Shares that remain unsubscribed for on a pro rata basis.]] /
[Option 2] [Holders of Series A Shares shall have a pro rata right (determined on an as-converted basis) to participate with the holders of Ordinary Shares in any issue by the Company of New Shares, other than the Excluded Issuances.]
1. Option 1(a) is customary and generally in line with practice in the US and China compared with Option 1(b) or Option 2.
2. The priority in which the shares are offered and the definition of shareholders forming the denominator when calculating the pro rata basis are sometimes adjusted to give a certain Series of preferred investors a super pro rata right.
VIMA Shareholders AgreementClause 9
9. Restriction on Founder Transfers
9.1 Each Founder severally undertakes to the Company and the Investors that he shall not, and shall not agree to, transfer, mortgage, charge or otherwise dispose of the whole or any part of his interest in, or grant any option or other rights over, [insert proportion] of his Shares to any person within [•] months from the date of Completion except:
9.1.1 with Series A Majority Consent; or
9.1.2 where required so to do pursuant to the Constitution or this Agreement.
We typically see a full lock-up for 3 or 4 years following the date of the Series A financing in Southeast Asia, but this depends on how long the Company has been established and whether it is fair that Founders should be able to obtain (limited) liquidity from their holding of Company shares whilst remaining incentivized to seek longer term up-side from a Liquidity Event.
1.1 Liquidation Preference
VIMA Subscription Agreement Schedule 6 paragraph 2.1 :
“2.1 Upon the occurrence of any Liquidity Event:
2.1.1 firstly, out of the assets and funds of the Company available for distribution, the Company shall pay to the holders of Series A Shares then outstanding, on a pari passu basis, prior to and in preference of any payments to holders of Ordinary Shares and all other holders of shares in the capital of the Company, an amount per Series A Share held by them equal to the aggregate of: [(i)]  per cent. of the Initial Subscription Price Per Share (as appropriately adjusted for any subdivisions, consolidations, share dividends or similar recapitalisations) in respect of each Series A Share [; and (ii) any accrued and unpaid dividends in respect of each Series A Share] ; and
2.1.2 secondly, if there are any assets and funds of the Company legally available for distribution after the payments referred to in paragraph 2.1.1 above, all holders of [Series A Shares and] Ordinary Shares then outstanding shall be entitled to participate pro rata in the residual assets and funds of the Company [on an as-converted basis] .”
1. (2.1.1(i)) For early stage financings in Southeast Asia, it would be unusual for the multiple to be more than 100% ( ie, a more than 1x).
2. (2.1.1) In a future financing round, if the intention is that preferred shareholders should have the same priority on their front end liquidation preference, then they should all be listed together with the holders of Series A Shares in the first limb of the waterfall ( ie, paragraph 2.1.1).
3. (2.1.2) If the bracketed wording in the second limb of the distribution waterfall is included, this will give the Series A shareholders participation rights on an “as converted basis” – ie, investors can receive the front end liquidation preference and still participate on the distribution of the remaining proceeds.
Thomas Chou is a partner in Morrison & Foerster LLP’s Hong Kong office and co-head of our Asia Private Equity Practice. Highly ranked as a leading individual in China for Corporate/M&A and Private Equity: Buyouts & Venture Capital Investment by Chambers Asia Pacific and Legal 500, Thomas’s practice focuses on cross–border mergers and acquisitions (inbound and outbound), joint ventures as well as private equity and venture capital financings. With over two decades of experience, he is particularly known for his global expertise in private equity and venture capital investments, especially in US and Asia.
Cecile Yang is an associate in Morrison & Foerster LLP’s Hong Kong office. Cecile advises startups and investors through the various stages of the company life cycle. Her practice spans across cross-border M&A, and joint ventures as well as private equity and venture capital financings.
Champ Charernthamanont is an associate in Morrison & Foerster LLP’s Singapore office. Champ helps various regional funds on their investments and acquisitions. He is also experienced in working on general corporate advisory and regulatory matters.
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