(This post is not about clauses that need to be negotiated or not negotiated. It just tries to analyse how (and whether) past round documents have an impact on future round document clauses).
….before signing on the dotted line, founders need to have full conviction with regards to an incoming investor that – this is a great team that is backing us and onus is on us as founders to be able to work towards having their vote on our side when it matters. And from an investor's perspective the ideal thought needs to be – we are happy to assign this part of our capital to this startup team led by their founders who are best at what they do and shall always have our vote when needed…
During the course of round structuring and documentation process, it's quite common for advisors acting in good faith guiding the company / founders / investors alike to negotiate with their counter parties that a certain set of rights / provisions should or shouldn't be there in the documents. And the reason they cite for this advocacy or pushback is – it will set a precedent for subsequent rounds investors asking for similar rights or we will be able to hold these to our advantage if we have captured them here. Rarity but once in a while – the advisor be it a not so savvy lawyer or any other person is using this as an simple excuse to get his client to toe his line
With the right INTENT (at the end of the day – it's intent that matters), this is a reasonable argument and should be discussed. To enable a transparent discussion and thought process, I have tried to summarise below our experience during follow on funding rounds (Series A and beyond) by Blume portfolio companies. I have counted experiences of only those follow on rounds that Blume companies have gone through, across both of our funds and where we have not been lead investors in that follow on round. The number of such follow on rounds in the portfolio have been high enough to count as a good sample size in making these observations. The follow on lead investors include a wide range of investors including Indian and foreign financial investors / VCs, strategic investors as well as larger family office (funds) and angel investors.
When an investor is evaluating a company and has nearly made up his mind, he would talk about the commercial terms with the founder(s). Amongst the terms discussed, round size, % stake expected by the investor and his / her cheque size are the most common terms agreed. This means that by and large even valuation is a derived number basis the quantum to be invested by the incoming investor and his expected stake %. For example – if a VC (let's call him Lead VC) is inclined to invest ₹20 Cr in a startup and their desired % stake to be held is 25%, the POST MONEY VALUATION is implied at ₹80 Cr. I repeat – This factors only the amount that will be brought in by Lead VC and his % stake.
Now, if the founder has other existing investors (let's call them Seed round investors) and they have their Pro rata rights to invest at similar terms, founder may get them and dilute over and above the 25% to Lead VC under the same Post money valuation. So if Seed round investors have a pro rata right of 20% of the round they are entitled to contribute upto ₹5 Cr in this round. This makes it a ₹25 Cr round on a valuation of ₹80 Cr post money which results in a dilution of around 30%.
Broadly, let me try and answer the question – how far do previous round agreements shape the subsequent round documentation?
Before I give the short answer, here's the long answer.
There are lot of nuances in structuring these and initially bandwidth of most parties is spent mostly on commercial discussions around round size and dilution. At this juncture no one has actually discussed legal terms nor diligenced the documentation of the previous rounds. Yes, Lead investors may opt for discussions of the past terms agreed but by and large the same comes up at a later point in time.
Another equally important point is that if an incoming investor has a certain set of opening terms at which they want to invest, they will put it in their opening term sheet regardless of past round structures. To hope or expect that they will be considerate and not put out certain terms merely because founders have succeeded in not having it on their seed round documents is a myth. Or even vice versa – in terms of future investors putting some liberal terms favouring existing shareholders just because they have been already captured in their past documents.
The best of investors don't need an excuse of a precedent to act or not act in a certain manner – at least in terms of structuring a legal document. So to have or not have clauses in a particular document is best dictated by the needs of the parties comprising that particular round of funding. While most blue chip investors may endeavour to honour the past commitments, the same may at times not be practicable given the size and shape of company and its cap table are now going through a sea change.
Then why did I admit that this is a reasonable argument in the first part of this write up??
Position explained above holds true for most contractual rights between investors and founders as shareholders like ROFR, Tag, Exit, Vesting etc.
Discussions and intent to act becomes crucial when it comes to commercial rights like valuation adjustments or bump up or penal factors leading to share price change due to some events, or clauses that draw out relationship between founders, affirmative rights, right to drag along etc.
Here it becomes critical to discuss threadbare and document with caution not because it becomes a precedent or you will succeed in creating a situation to your advantage. But largely because – the above rights would be those where an incoming investor may have a view and sometimes if the company doesn't need to raise capital soon, it is these set of rights that will pretty much drive the relationships of various sets of shareholders (founders amongst themselves or investors vis a vis founders or investor inter se). How to structure these rights is a separate topic and requires a post which I will work towards and soon post.
The limited point of this short note is to just highlight the point that discussions and negotiation during any round of funding should be driven by needs of the Parties to the document. It's important to set the right precedents early but to have fear of precedents as a guiding post for structuring a relationship amongst people who are ideally expected to work in the same direction, is a bit of a stretch.
Past round documentation gets over ridden during subsequent fund raises anyway. The intent is that – all privileges and obligations of earlier round investors would also get restated in a fresh document which is also going to contain the rights and privileges of the newer investors. So that there should only exist one document that guides all shareholders. Besides it is also a common practice that as larger round investors set in, rights of investors or prior rounds do suffer some dilution but not when it comes to their ability to get an exit, dividends, M&A, liquidation preference on a waterfall basis, etc. Some privilege like affirmative rights, right to appoint board directors and a few others are reserved only for investor shareholders with a certain % of shareholding or clout on the cap table.
In such circumstances, just because the older version of documentation has a right or doesn't have may not make a big difference. If company has diluted in favour of some HNI who doesn't have much of a track record as an angel investor or a quasi strategic investor with certain vested privileges – due care needs to be taken in offering certain category of rights. Reason being – at the time of future rounds, founders need their consent and if these shareholders choose not to cooperate with founders at such occasions, it could easily become an opportunity loss.
Every stage at which the company raises capital is different. Investors coming in at each stage have a different role to play and even different time horizons and return expectations which lead them to make an investment in the company. Pricing is a function of the perceived risk that the company in question poses. Therefore, rights and obligations also should be function of these factors and depend from the nature of investors who are going to hold the right and their track record in such situations in the past.
So while it's not real that investors won't have rights and restrictions – but the best Founders should see to it that rights and privileges are in hands of 1-2 responsible hands (certainly not across a fragmented group) and that there is a fair mechanism laid down on how and when these get exercised such that it is binding on all. You don't need litigation after having built a nice company and at the time of the exit or the M&A.
At the end of the day, before signing on the dotted line, founders need to have full conviction with regards to an incoming investor that – this is a great team that is backing us and onus is on us as founders to be able to work towards having their vote on our side when it matters. And from an investor's perspective the ideal thought needs to be – we are happy to assign this part of our capital to this startup team led by their founders who are best at what they do and shall always have our vote when needed.
If all parties have this representation in their documentation on a best effort basis – guess negotiations will be easier if not extinct.