10 July, 2015
As Singapore shapes itself to become the “Silicon Valley” in South East Asia, renowned venture capital firms such as Sequoia Capital, Rakuten Ventures and Fenox Venture Capital have started investing in interesting local start-ups in the vibrant tech scene in Singapore. In addition, the Singapore government has lined up various funding initiatives, most notably its Early Stage Venture Funding Scheme, a co-investment equity scheme between the National Research Foundation and selected seed venture capital funds, to fund technological innovation. In light of the ample funding opportunities available, this article seeks to point out four key things to help gear up founders of start-ups when raising capital in the early stages.
Types Of Investment Structures
Investors can invest in start-ups through equity, debt or a combination of both. Investors invest in start-ups through equity by subscribing for shares in the start-up company. These shares can be ordinary shares but the more usual form is preference shares. As the name connotes, preference shares normally confer some preferential rights to their holders. Such preferential rights can take the form of priority over the other shareholders when it comes to payment of dividends or return of capital upon liquidation of a company. If an investor subscribes for preference shares, the rights attached to such preference shares will be set out in a subscription agreement and the memorandum and articles of association of the company. A couple of other features of a preference share are: (i) whether the preference share is redeemable at the option of the investor or the company, or non-redeemable; and (ii) whether the preference share is convertible into ordinary shares or other securities of the company upon the occurrence of certain trigger events (e.g. a trade sale, or initial public offering (“IPO”) of shares, of the company), or non-convertible. Founders of start-ups wishing to adopt this investment structure should consider which of the foregoing features they would like attached to preference shares to be issued to an investor.
Investors can also invest in start-ups through debt by extending a loan to the start-up company. It is common for the loan to have a convertible characteristic whereby it can be converted into shares or other securities of the company upon the company’s next round of financing (which then makes it a hybrid investment instrument of equity and debt). Investing through debt is less complex than investing through equity thereby resulting in lower legal fees and a shorter time frame to close the funding round. This would logically appeal to bootstrapped start-ups but if the start-up is unable to repay the loanwhen the repayment date arrives, this may force the start-up to sell its business at a distressed price to repay the loan. On the other hand, if the preference shares in an equity investment structure are structured such that they are non-redeemable or only redeemable at the option of the company, start-ups will be able to avoid running into this problem. Founders will need to weigh out the pros and cons of the different types of investment structures to see which structure is best suited to meet their needs at that point in time.
Shareholding In The Start-Up
Founders and investors will naturally be concerned about their level of shareholding in a start-up throughout the duration of the investment. The following are several protective mechanisms that are available to shareholders:
(a)Pre-emption right: A pre-emption right is a contractual right to prevent shareholders’ ownership interest from being diluted by a fresh issuance of shares or other securities by the company. This right entitles the shareholders to participate in any subsequent offering of shares or other securities by the company on a pro rata basis in accordance with their respective shareholding percentages. However, as investors have deeper pockets than founders, the founders may wish to further protect their shareholdings in the company from being diluted by agreeing with the investor that where the company requires additional funding, such funding shall first be raised via applications for government start-up grants or schemes or shareholder loans before equity subscriptions by shareholders or new investors.
(b)Right of first refusal: Under this contractual right, shareholders who wish to sell their shares to third parties must first offer the opportunity to purchase such shares to the other shareholders on the same terms and conditions as those offered by the third party. Founders should consider whether the selling shareholder must first obtain a bona fide offer from a third party before offering the other shareholders the first right of refusal, or limit the time period to conclude the sale with a third party (after the other shareholders have declined to exercise their right of first refusal) to a prescribed time frame. A lock-in period where selected or all the shareholders are not allowed to sell their shares in the company should also be considered.
(c)Drag-along and tag-along rights: It is also common for shareholders to push for additional protection via drag-along and tag-along rights. A drag-along right protects a majority selling shareholder by giving it the right to compel the minority shareholders to sell all their shares on the same terms and conditions when required by a buyer. A tag-along right on the other hand protects a minority shareholder by giving it the right to sell its shares along with the sale by a majority shareholder of its shares on the same terms and conditions. However, this is not cast in stone and if the founders take the view that an investor (although holding a minority stake in the company) is in a far better position than them to find a buyer, and the founders do not have a tag-along right, giving the investors a drag-along right may work in their favour. This drag-along right should however have a floor price attached to it so that the founders are only “dragged-along” to sell their shares when there is a good offer on the table.
Vesting Arrangements
In the early stages of fund raising, investors will consider the founders as crucial to the success of the start-up. Investors may therefore require that a vesting arrangement be put in place to incentivise the founders to remain employed with the company during the tenure of their investment. In a typical vesting arrangement, the shares of the company held by the founders will vest over a period of time (e.g. three years). In the event a founder leaves his or her employment before the expiry of the vesting period, the company has the right to re-purchase4 the unvested shares at cost. Founders should negotiate for a percentage of their shares to vest immediately at the start of the vesting period to take into account their contributions to the business of the start-up thus far. Founders should also consider negotiating for accelerated vesting in certain instances such as when their employment is being terminated by the company without cause or when there is a trade sale, or IPO of shares, of the company.
Control Of The Company
Another important factor for founders to consider when raising capital is retaining control over the management of the start-up’s business. By bringing in outside investors, founders are essentially giving up partial control over the company in exchange for funds. Strategic investors tend to play a bigger role in the management of a start-up’s business than financial investors so if a start-up is bringing in a strategic investor, be prepared to give up board seats and control which are commensurate with such investor’s shareholding percentage in the company. One way to water down such control is by keeping the list of decisions requiring the investor’s approval (also known as reserved matters) as short aspossible. The usual important decisions, such as any change in the nature or scope of the business and any amendment to the articles of association of the company, can be kept on the list. However, decisions relating to the day-to-day running of the business should as much as possible be kept off the list altogether or be kept off the list if they do not exceed a certain threshold. However, having an investor involved in the management of the business may not be a bad thing. They can bring invaluable advice and guidance to the table from their experience with other start-ups and investments. Investors can also be mentors and accelerators to start-ups and start-ups can leverage on the investors’ network of contacts. Therefore, if it is a requirement of the investors that they be involved in the management of the business, the founders might as well take the opportunity to draw on the investors’ wealth of knowledge and experience.
Conclusion
More can be said about the many other pointers and considerations that start-up founders should take into account when raising capital.
However, it is worthy to note that a good working relationship between the founders and the investors is at the heart of a good fund-raising experience.
At the end of the day, an agreement may contain terms and conditions running over one hundred pages long but if the relationship between the parties is a good one, things will probably run more smoothly than a bad relationship with a ten-page agreement. Hence, if circumstances permit, picking the right investor is just as important as coming up with disruptive products.
For further information, please contact:
Azman Jaafar, Partner, RHTLaw Taylor Wessing
