This article was written by Minh Vu Hong, Investor at Qualgro.
If you’re still here after reading the title — kudos to you as most founders (and some VCs) would walk away just by hearing “legal” in a sentence!
Nonetheless, legal terms are of the utmost importance because they set the nature and the tone of the relationship you will have with your investors for the next 5 to 10 years while you will be busy growing your business (and not willing to re-visit the 78 pages shareholder’s agreement you signed on a Friday evening 2 years ago…).
Below are, in our opinion, the key terms you should be focusing on with our explanations and recommendations. Most of them would be in the term sheets you will receive; some others may be in the long-form documents (e.g. Shareholder’s agreement). This article is split into 2 parts:
– Part 1 covers some general definitions and the key terms for equity investment
– Part 2 covers the key terms for convertible notes and discusses pros and cons of using equity vs. convertible notes
Disclaimer: this article in 2 parts is only our views on what we usually see and use and by no means is a legal advice. Please consult a law firm before engaging into legal discussions/negotiations.
- Common Shares: these are also known as ordinary shares of any company. These are typically the type of shares you buy on the public stock exchanges for public companies. For startups, the common shareholders are usually the founding teams, employees and some early investors (e.g. angels, friends and family).
- Preferred Shares: these are shares issued to institutional investors such as VCs. The differences compared to common shares come from the special rights attached to these shares, which we will cover later on in this article.
- Fully diluted: often goes with shareholding and valuation (e.g. 10% shareholding fully diluted, $10M valuation fully diluted). It means that the valuation/shareholding is inclusive of all the shares of a company including common shares, existing preferred shared, employee option pool (ESOP), conversion of convertible notes etc. This allows to calculate the real shareholding % without any “hidden” dilution.
Key terms for Equity investments
Let us take a simple example: investor A wants to invest $1M in your company against 10% shareholding “Series A”. We will also assume each share is worth $1 so investor A holds 1,000,000 shares out of 10,000,000 shares in total.
1. Investment amount, shareholding, and valuation
These will most likely be the first terms you talk about with a potential investor.
- Investment amount: how much an investor is willing to invest in your company ($1M in our example)
- Shareholding: how much shareholding will that investor hold after wiring you the money (10% in our example)
- Valuation: how much is your business worth. The valuation always comes with the terms “pre-money” or “post-money” which simply mean excluding (pre) or including (post) the invested amount. In our example, the post-money valuation is $10M and hence the pre-money valuation is $10M-$1M = $9M
Once these are defined, you will derive the exact number of preferred shares that the new investor will acquire in exchange for the investment amount.
Note: only 2 terms out of 3 are actually necessary as the 3rd one is calculated from the first 2. For example, your investor can just say he wants to invest $1M for 10% of your company then the post-money valuation is exactly $1M / 10% = $10M. Or she says that she wants to have 10% of your $10M company post-money, then she will have to invest $1M no matter what.
2. Liquidation preference
Here is one of the most important “special rights” that comes with acquiring preferred shares and could deserve a whole article in itself to go into all the details and nuances of this particular clause. The liquidation preference gives priority to preferred shareholders (vs. common shareholders) to get back money in case of a liquidity event (e.g. M&A, liquidation).
This mechanism is made up of 3 components, 1. multiple of the amount invested, 2. participation rights, and 3. waterfall/pari-passu. To illustrate, building on our example, let us assume someone now wants to acquire your company for $3M (still with the current assumptions: you have 1 investor A who invested $1M and owns 10% of your company) — this is a liquidity event and an “exit” for investors.
- Multiple: this is how many times the investor is entitled to get back the amount invested. In the example above, if the multiple is 1.5x, that means that your investor A is entitled to get back 1.5x $1M = $1.5M in priority to the common shareholders (you, your employees). So if your company gets acquired for $3M, after giving back to investor A his required multiple, $1.5M, then only $1.5M is left for the common shareholders. If the multiple is 1x, then investor A gets back his $1M, and $2M is still available to be distributed among the common shareholders. If, as a founder, you still had 70% of the company, then you are entitled to 70% of the remaining $2M = $1.4M.
- Participation rights: this gives the right (or not) to preferred shareholders to keep on “participating” in the distribution even after the multiple was applied, prorate of their equity shareholding in the company. Let’s assume 1x and participating, that means that after receiving his required 1x, $1M, investor A is entitled to receive money from the remaining $2M according to his 10% shareholding = $200k. So in total the investor will get back $1.2M and the remainder will go to common shareholders.
- Waterfall or Pari-Passu: as a founder you might feel a bit indifferent about this one as this relates to the order of priority among preferred shareholders, and the main difference is in case the liquidity event does not provide enough capital to pay all investors back their respective amount invested (which means no proceeds will go to common shareholders anyway). Nonetheless, we think it is important to understand the differences as it can impact how later stage investors will see the terms your negotiated with your existing investors.
In our example, let’s assume you have now another investor B who invested after investor A an amount of $2M for 10% shareholding “Series B”.
- In a waterfall scenario, it’s the “Last-in, First-out” rule, which means the most recent investor will get back her money first. In our example, after investor B gets her $2M back, investor A gets his $1M and nothing is left for common shareholders. If the acquisition price is $2.5M, investor B still gets back $2M but investor A only gets the remaining $0.5M, and again nothing is left for common shareholders.
- In a pari-passu scenario, investors A and B are forced to be at the same seniority and the proceeds are distributed prorate amount invested (and not shareholding). This has an impact only if there is not enough money to pay back all investors. So, for an acquisition at $3M and above ($1M from investor A and $2M from investor B), pari-passu and waterfall have the same result for investors’ payback. However, if the acquisition is only for $2.5M, the proceeds will be distributed 66.6% to investor B = $1.67M and 33.3% to investor A = $0.83M (and not 10% both as it’s the prorate of amount invested). The founders still get nothing in this case as the acquisition price is less than the amount invested.
As you can see Waterfall is clearly better for investor B vs pari-passu if the exit is less than the total raised by the company, and the difference is quite significant (33.3% exactly 😊). While this gap tends to tighten as the company keeps on raising money and early investors prorate on amount invested decrease over time, this is still something that later stage investors take into account in their return scenarios to value a business and negotiate terms.
Note: at Qualgro, we believe that anything else than 1x, non-participating liquidation preference is overly favorable to the investors and detrimental to the founders in the long-run. Keep in mind that once you have accepted terms from early-stage investors, later stage investors are very unlikely to change to less favorable terms, so if you accept 2x participating liquidation preference at Series A it will keep on stacking up at Series B, C etc. and even with a great exit, you might not be able get much money from it — the only exception would be to IPO which we will see in point #3 below.
3. Conversion of shares
The conversion right is also a special right of preferred shares, and it goes hand in hand with the liquidation preference (even if not explicit most of the time). The preferred shareholders have the right to convert to ordinary shares with 1:1 ratio at any point in time.
Why would an investor give up special rights to convert to common shares? It’s of course to make more money! Let’s assume that someone wants to buy your company not for $3M but now for $30M (in this case there’s plenty of money to payback investors A and B so waterfall or pari-passu doesn’t make a difference). If investors A and B are 1x — non participating, they are entitled to get back $1M and $2M respectively then $27M would be available for common shareholders.
However, if investor B decides to convert her shares to common shares (and A stays with preferred shares), then investor A would actually become the most senior holder and get $1M before everyone else, then $29M would be available for common shareholders including investor B who decided to become a common shareholder. Since Investor B owns 10% of the company, he is entitled to 10% of the proceeds = $2.9M vs. the $2M he invested initially. (Investor A would in reality also convert to common shares, but this is for the sake of illustrating).
Another event where conversion happens is when a company goes public (listing on a stock exchange). In this case, all preferred shares get automatically converted to common shares, with the same rights as the ones traded for the public. So if you have investors with predatory terms, one solution can be to IPO to convert them to common shareholders and remove all their special rights 😊
4. Anti-dilution mechanism
The purpose of the anti-dilution mechanism, as the name implies, is to protect investors from being diluted too much (i.e. that their shareholding would decrease significantly) in case the company goes through some troubled times — mainly raising money at a lower valuation than their entry point, a so-called “down round”. While there are 2 main types of anti-dilution mechanism, only broad-based weighted average is and should be used as full ratchet is very punitive towards founders:
- Full ratchet: as investor A bought her shares at $1 per share, if in the following round the price decreases (lower valuation by the next investor) to $0.5 per share for example, that means that investor A is entitled to have all of her shares adjusted to the new price — so for the same $1M, instead of getting 1,000,000 shares she will get 2,000,000, and the subsequent dilution effect of investor A shares for founders is basically doubled without any new cash from investor A. Full ratchet is very punitive for founders and employees and we strongly recommend not to use it.
- Broad-based weighted average: the conversion price is calculated with the formula CP2 = CP1 * (A+B) / (A+C) where:
- CP2 = Share price of down round
- CP1 = Share price of entry round (“Series A” in our example so $1)
- A = Total number of shares in the company (fully diluted) before the down round,
- B = Cash received by the company in the down round divided by the entry round share price
- C = Number of shares issued in the down round
While the formula looks complex and your lawyers will enjoy doing the calculation for you, in a nutshell the adjusted share price for investor A will be a weighted average between the entry price and the down round price (so between $1 and $0.5), so less detrimental for the common shareholders.
5. Right of first refusal (ROFR), Drag-along, Tag-along
We will not go too much into detail for these ones as they are quite straight forward with only little room for nuances or negotiation, but they are nonetheless very important for VCs and founders should understand the implications.
- Right of First Refusal (ROFR): this is basically the right for preferred shareholders to protect their shareholding in case of new round of funding, allowing them to invest up to the prorate of the current shareholding they have. So investor A can keep on investing to maintain his 10% shareholding in the company in subsequent funding rounds.
- Drag-along: this clause enables the major investors (usually VC funds who have put the most money in your company) to literally drag along smaller shareholders (including common shareholders) in case of a sale, with the same terms (e.g. price) as the larger shareholders. This is to prevent small shareholders from blocking an exit (e.g. a sale) when majority of shareholders agree to sell the company (especially when the buyer wants 100% control).
- Tag-along: this clause is the mirror of the drag along as it enables:
- Smaller shareholders to sell along major investors if they sell above certain thresholds (e.g. 25% of the company). This is to protect smaller shareholders to not be stuck with new major shareholders they have not vetted
- Investors to exit if the founders sell a significant portion of their shareholding (e.g. 10% of their shares). For early-stage investors, the founding team is critical in assessing the potential of the company. Having founders selling some shares is completely OK, but above a certain threshold it might be signs of lack of commitment or potential stepping-back from the business, hence VCs want the ability to exit if case may be.
Nuances for Tag-along clause are mainly around proportionate tag-along (you can sell prorate of your shareholding) or tag-along in full (if triggered, you are allowed to sell all of your shareholding, irrespective of how much % the other party is selling). At Qualgro we usually use a tag-along in full above a certain threshold of shares being sold by founders. Our rationale is that founders are one of the key reasons why we invest in early-stage companies in the first place, so them starting to sell a significant part of their shareholding may signal a lesser commitment in the long run to the company, hence potentially triggering our exit from the company.
We hope that this 1st part has enabled you to have a clearer understanding of the main equity terms that you will come across when discussing with potential investors. While you should always rely on a law firm to help you navigate the intricacies of legal documents and their implication, we feel that founders should have at least this basic knowledge to be able to discuss toe-to-toe with VCs and protect your own rights. In our 2nd part, we will cover convertible notes terms and will compare the 2 instruments.
Qualgro is a Venture Capital firm based in Singapore, investing mainly in B2B companies in Data, SaaS, and Artificial Intelligence, to support talented entrepreneurs with regional or global growth ambition. Qualgro invests across Southeast Asia, Australia/NZ, primarily at Series A & B.