In the world of venture capital funding, it’s easy for the role players involved (lawyers included) to make the mistake of losing sight of the other party’s objective in an intended funding transaction. There are a myriad of fears and expectations that need to be balanced and measured in order to formulate a funding and capital structure that speaks to the parties’ bespoke needs. It is therefore fundamentally important for investors and investee companies alike to appreciate the main objectives of the party on the other side of the term sheet. In this article we look at investors’ main aims. Hint: it’s not to get a free T-shirt with your company’s logo on it.
Some investors are genuinely driven to expose their cash and commit their expertise (at least in early-stage funding) by an interest in the business they are investing in and a desire to see the economy flourish as investee companies grow and generate economic welfare. This might be true in most cases, but even the most start-up friendly investor has one primary objective: to realise returns from their investment that matches the relative risk associated with the investment. Your uncle who waived his morning coffee to crowd-fund your potato salad (https://www.kickstarter.com/projects/zackdangerbrown/potato-salad) wants to know when he is getting his bite of the salad. That’s just how life works.
While this may be obvious to some, parties often fail to think “exit” when they start a journey together. It is important for both the entrepreneurs and investors as they seek to get a return on their investment (whether time, money or other resources) to understand and manage their exit strategies in order to strike a balance between their own aspirations and motivations on the one side and the stark commercial realities on the other. It is therefore crucial to determine and negotiate the best exit strategies well in advance. In light of the above, this article will aim to provide an overview of the exit strategies commonly found in later stage Seed Round investments or Series A investments.
Difference between Seed and Series A investments
Seed Round (Series Seed)
A Seed Round is an early round of investment into a start-up entity which is meant to support the business until it generates its own cash or until it is ready to receive further investments as soon as it is cash-generative. Terms associated with Seed Rounds are usually still fairly simple and exit strategies are still relatively low priority in most of these transactions, although investors typically aim to be protected from negative events and benefit from positive events.
However, investors would typically subscribe for a different class of shares, which gives them certain preferential rights (senior to that of ordinary shareholders) when a liquidation event occurs in the company.
Series A investments are mostly made by astute and experienced venture capital firms. They are less flexible on their funding terms – for good reason. Venture capital firms are mostly structured as funds managed by persons or a separate entity (called a managing partner) on behalf of various investors in the fund (called limited partners). Limited partners can include high net worth individuals or institutional investors. The managing partners have a very clear and limited investment mandate and have an investment committee that are obliged to ensure that the firm invests on specific terms and has a clear exit strategy as to how the investment may be realised. For this reason, Series A funding is provided on more strenuous terms and includes various provisions aimed at securing and advancing the return on investment for the firm and eventually, the limited partners. All of these usually activate on an exit event occurring.
Like Seed shareholders, Series A shareholders subscribe for preference shares, but their shares will rank senior to ordinary shares and Seed shareholders when a liquidation event occurs. So if a liquidation event occurs, the liquidation preferences are paid first to Series A shareholders, then to Seed shareholders and then only will all the other shareholders participate in the balance on an as-converted basis.
Basic liquidation events
An exit on equity investments (such as Seed and Series A investments) will see the parties cashing in on the equity they own and receiving monetary reward (and hopefully some upside) for taking the initial commercial risk. The following methods are referred to as “liquidation events” in funding documents:
- transferring ownership of the investee company, business or other assets owned by the investee company to a third party (by way of sale of business, mergers, acquisitions or management/employee buyouts);
- listings or other offers of shares to the public by way of an Initial Public Offering (IPO); or
- by liquidating the company.
There are various ways in which each of the methods above can be applied to realise a return for shareholders. Liquidation is very rarely a feasible option, as there is simply too much value lost on liquidation costs. It therefore falls beyond the scope of this article.
Exit strategies: the good, the bad and the ugly
When considering liquidation events, it is important to consider who controls the occurrence of a liquidation event. In other words, who needs to approve an event before it can occur? This is often referred to as a “drag along” right. If the preference shareholders have the drag along right and can force an event without the ordinary shareholders’ approval, this might, on face value, seem like an effective exit strategy for the investors. However, in reality, this means that founders will not be motivated to grow the value of the company as investors can simply force a liquidation event that merely repays their liquidation preference. If the founders of the company (who usually hold ordinary shares) have the drag along right, this means that the Seed shareholders and Series A shareholders will be forced to accept a liquidation event if the ordinary shareholders approve it. This is not an ideal scenario either, as the preference shareholders are unlikely to receive any returns until the company has grown in value to such an extent that the ordinary shareholders receive a favourable return after payment of the liquidation preference to preference shareholders.
A good balance to strike is to require a high percentage of ordinary shareholders to approve a liquidation event (i.e. considerably more than majority), but then to give the preference shareholders the right to convert their preference shares to ordinary shares and vote accordingly. This means that there is no possibility of a sale at low value if the company is doing well as the drag along right is not held by the shareholders who have the liquidation preference rights. If the company is not doing well and raises funding at a lower valuation at some point (also called a down-round), the anti-dilution rights will enable the preference shareholders to convert to more ordinary shares in any event. This means that if a sale is done after a down-round, the preference shareholders will enjoy a higher participation in the liquidation event if they convert to ordinary shares.
If investors insist that provision is made for the approval of a majority of preference shareholders before a drag along is triggered, then you may want to provide for the liquidation preference to fall away once the company reaches a certain valuation. This still forces the liquidation event and allows Series A and Seed investors to get a return on their investment, but removes the hurdle of the liquidation preference. This ensures that founders are adequately incentivised to grow the value of the company and get the company to a favourable liquidation event that promises returns for all shareholders.
Other ways in which exits are achieved (especially in Series A funding) are as follows:
Co-sale rights: if a founder intends to sell his/her shares to a third party on favourable terms, he/she has to provide the opportunity for the Series A shareholders to convert a proportionate number of its Series A shares to ordinary shares and then tag along on the founder’s sale. The Series A shareholder has a put option to sell any portion of its converted tag along shares to the founder before the founder can proceed with the sale to the third party. This enables the Series A shareholders to exit when a key founder exits the company and forces the company to negotiate exit terms for the Series A shareholder. Depending on the circumstances this can be very restrictive to founders and founders should aim to negotiate a right for them to sell their shares to third parties by means of a gradual earn-out without triggering the co-sale right.
Registration rights: this is a right provided to Series A shareholders in Series A funding documents and is essentially a right (based on the registration of securities in terms of Rule 144 of the Securities Act of 1933 – USA) to either force the company to register the Series A shareholders’ preference shares (convertible to ordinary shares) if the company undergoes an IPO (called demand registration rights). An alternative to demand registration rights are “piggyback” registration rights, in terms of which a Series A shareholders have the right to register their shares with other shares if the company or another shareholder registers its securities. Both options have the effect that Series A shareholders will be entitled to sell their shares when the IPO is done. In the absence of that, they will have to wait at least a year before shares may be sold. Registration rights are usually quite standard and Series A investors are not upon for material negotiation. However, the cost of registering securities can be fairly significant, so from the company’s perspective the less severe “piggyback” registration rights are favourable.
Put option/redemption right: this is when the preference shareholders have a put option to sell their shares back to the company or force the company to redeem the shares and get their invested funds back if certain negative events occur. This is a good example of a provision that should be avoided at all cost. There are various reasons for that, one being that redemption rights for preference shares should always be handled carefully, as they may cause the preference shares to be classified as debt rather than equity, which may render the company insolvent in certain scenarios. It will also cause any dividends or other returns on the capital invested to be taxed as interest in the hands of the investor.
Exit rights are found in various shapes and sizes, especially in Series A transactions. It is very important to formulate an exit regime that strikes a healthy balance between the interests of all stakeholders in the company. This ensures that all the role players are incentivized to drive the company to a healthy exit with favourable returns for all involved.