Trapped! Overlooked snares in startup investments

By Peng Cheng and Li Danning, East & Concord Partners
0
340

Startups often negotiate for private-equity or venture-capital investment when they are experiencing dire capital needs, pushing them to accept harsh terms. This often contributes to the departure of the founders. Is there an alternative? This article looks at several.

彭程-PENG-CHENG-天达共和律师事务所合伙人-Partner-East-&-Concord-Partners
PENG CHENG
Partner
East & Concord Partners

PRE-EMPTIVE RIGHTS

The idea of pre-emptive rights derives from article 34 of China’s Company Law, which stipulates that, “where a company increases capital, the existing shareholders shall have priority in subscription for new shares”, unless the shareholders agreed not to assign such a priority. Pre-emptive rights effectively prevent shareholdings from being diluted by follow-up financings, in order to protect the founders’ position within the corporate structure.

A startup founder recently came to realise that, after several rounds of introducing new investors, the series A investor has amassed nearly 30% of the equity, having exercised the pre-emptive rights at every subsequent turn and effectively becoming the second-largest shareholder. If the investor continues to exercise pre-emptive rights, control of the company may change. Sensing a momentum shift in this tug of war for control, the founder was left with few options but to negotiate for partially repurchasing the series A investor’s equity or to seek to act with other investors.

When negotiating terms on pre-emptive rights, for the purpose of maintaining founder control, the authors recommend that the following be made explicit:

  • The calculation of the proportion applicable to the pre-emptive rights, represented in a formula, in order to avoid any future confusion over the capital-increase ratio.
  • The pre-emptive rights shall not be applicable in share issues related to employee share incentive schemes, corporate share reform, etc.
  • Investors’ shareholding shall not exceed a certain percentage (e.g. their shareholding prior to the current series) when exercising pre-emptive rights in follow-up financings.
李丹宁 LI DANNING 天达共和律师事务所律师
LI DANNING
Associate
East & Concord Partners

RESTRICTED EQUITY OF FOUNDERS

This refers to the arrangement where all or part of the founders’ equity is restricted at the time of financing, and a lock-up period is set out under which a fixed percentage of equity is unlocked annually. If the founder departs during the lock-up period, the locked-up portion of his/her equity may be repurchased by the company or investors at nil or the minimum price permissible by law.

When reviewing financing agreements for the financing parties, we noted that investors often set out a shareholding clause in the investment agreement, but the applicable circumstances when it comes to founder departure can be exaggerated. For example, if the clause describes it as “the founder terminating his/her employment with the company for any reason during the lock-up period”, it would mean that even if the founder did not depart voluntarily, his/her equity may still be repurchased.

The development of a startup is closely linked to its founders, whose R&D capabilities, resource contribution and time commitment are often more essential to nascent startups than even capital. In essence, the above-mentioned clause locks up the term of office of the founder and serves to prevent the founder from leaving without the consent of the investors. It also protects investors’ interests from any serious adverse impact caused by any material error on the part of the founder.

However, this one-size-fits-all approach to founder departure may be an encroachment to his/her interests, as all scenarios of departure, even for health reasons, will trigger equity repurchase for nil consideration. In addition, under such financing agreements, investors generally could veto the appointment of senior management with one single negative vote, which makes the continued service of founders that much more uncertain.

When negotiating terms on restricted equity of founders, for the purpose of protecting founder interests, the authors recommend the following be made explicit:

  • The scenarios of founder departure, which we suggest be limited to the likes of “voluntary departure for non-health reasons, investing in and/or operating similar businesses, or dismissal due to causing serious damage to the company via deliberate action or gross negligence”.
  • Dividing the founder’s equity into paid-in and unpaid capital. For paid-in capital, the founder would have paid capital consideration for the equity, so he/she may request that the paid-in portion be free from the “unlock by installments” restriction.

EXCESSIVE FIRST ROUND

If, due to a lack of funds, the proportion of first-round financing is excessively large for the company and the founder, it may lead to future instability in the company’s control. For the purpose of maintaining founder control, we recommend startups to set out in investment contracts their rights to compulsorily repurchase equity when conducting first-round financings of large proportions.

For example, in the next round of financing within three years after the completion of the first round, if the company’s valuation has grown by certain multiples by comparison, the company or new investors will be entitled to repurchase a certain percentage of equity from the first-round investors at the current price. Such a preventive clause does not normally appear in investment agreements prepared by the investors, so founders usually have to raise them and negotiate in full with the investors.

Founders are at the core of startups. From establishment to introducing external investors, founders must devote a great deal of energy, resources and time to the startup, as well as focusing their attention on business operations. First-round financings, where the initial external investors are introduced, are therefore vital.

East-&-Concord-Partners-qr-code
“Welcome to follow East & Concord Partners account”

Startups should engage the service of law firms and other professional institutions as early as possible, so founders could head into preliminary term negotiation with clarity and avoid being backed into a corner in investment negotiations or should any dispute arise.

Peng Cheng is a partner and Li Danning is an associate at East & Concord Partners

Reform

East & Concord Partners
20/F, Landmark Building Tower 1
8 East 3rd Ring Road North
Chaoyang District, Beijing 100004, China
Tel: +86 10 6590 6639
Fax: +86 10 6510 7030
E-mail:

pengcheng@east-concord.com

lidanning@east-concord.com

www.east-concord.com