Lifecycle of a tech startup series: VC Investor

The EMI share options which KNow Wear Ltd granted to Aggie and Edith in episode 12 have really worked to incentivise them; and thanks in large part of their efforts, the company is getting lots of advanced orders for the product. In order to ensure that the company has enough bandwidth to keep up with demand, you, Sarah and Chris have started to think about raising more funds. This is to ensure that the company can produce the number of units it needs to fulfil the orders, and then actually physically fulfil them.

You have been having conversations with a few venture capital firms (aka VCs) for a number of months and have been keeping them updated about the progress of the business. One (fictional!) VC called KNow Growth is very interested in investing in KNow Wear Limited, especially now that you have been able to show traction with the number of advanced orders.

KNow Growth is proposing to invest £3,000,000 for 15% of the company on a fully diluted basis and they have sent a you a term sheet on that basis. Most of the concepts set out in the term sheet (such as information rights, investor consent matters and having an investor director on the board) are familiar to you from when you raised your seed round and you are comfortable giving such rights on the basis that KNow Growth is investing such a large sum. However, there are some terms which you are less comfortable with so you send the term sheet to the company’s lawyers for their thoughts.

Liquidation Preference

To date all of the shareholders in KNow Wear Limited have subscribed for ordinary shares. However, KNow Growth is proposing that they invest in exchange for a new class of preference shares which carry a 1.5x non-participating liquidation preference. This has been structured so on any distribution to the shareholders (whether as a result of a liquidation, share sale or asset sale) KNow Growth will receive back 1.5x of the money it invested with the balance then being paid to the holders of ordinary shares. In addition, a non-participating preference almost always means that KNow Growth can choose to either receive a distribution by exercising this preference or, if it means they would receive a higher return, Know Growth can choose to convert its preference shares into ordinary shares and thereby share in the total distribution with the ordinary shareholders pro rata to their shareholdings instead.

You understand from your lawyer that a liquidation preference is a common right which VCs will seek, although there are differences in how they are structured (non-participating vs full participating vs capped participating, and the multiple changes). The preference is intended to protect the VC from its downside risk where a company fails or is sold for less than the VC invested, in a similar way to how angel investors are able to de-risk their investment by claiming SEIS or EIS tax relief.

Therefore, although you are willing to agree with the principle of KNow Growth having a liquidation preference, you are uncomfortable with the level of the preference being set at 1.5x. You propose to KNow Growth that the level of the preference is set at 1x so KNow Growth can receive up to the full amount it invested before any distributions are made to the ordinary shareholders. You expect to have to have a negotiation here.

Anti-dilution rights

KNow Growth have proposed the inclusion of an anti-dilution right so in the event of a down round (meaning KNow Wear Limited issuing shares at a valuation lower then the current valuation at which KNow Growth is investing) KNow Growth will be issued with additional shares at nominal value to compensate them for the decrease in the valuation of the company.

Again, you understand from your lawyer that it is common practice amongst VCs and while you are amenable to this in principle you discuss with your lawyer the best way for the number of anti-dilution shares to be calculated.

KNow Growth have proposed a “full-ratchet” formula whereby the number of shares to be issued to KNow Growth will be calculated as if KNow Growth had originally invested at the lower valuation. This formula is the most punishing of adjustment mechanisms and would lead to the greatest number of shares being issued under the anti-dilution mechanism.

As an alterative you propose to KNow Growth that the formula is based on a “broad-based weighted average”. This formula takes into account equity previously issued and the equity to be issued in the down-round to give a weighted average price per share. It still means that additional shares would need to be issued to KNow Growth on a down-round but this formula would be the least dilutive for the other shareholders.

Leaver Provisions

KNow Growth have proposed that leaver provisions apply to each of you, Sarah and Chris as founders of KNow Wear Limited. They have suggested that if you are a good leaver (meaning you cease to be an employee because of ill-health or death, or you retire or the board agrees that you are a good leaver) you are required to offer up all of your shares for sale and the price that you receive for those shares will be fair value, calculated by an independent accountant. However, if you are a bad leaver (meaning you cease to be an employee for any reason and you are not classed as a good leaver), you are required to offer up all of your shares for sale and the price that you receive for those shares will be the price you paid for them (being nominal value).

Although you understand that leaver provisions are common place, you feel like the structure KNow Growth is proposing is particularly harsh and doesn’t fairly reflect the time, effort and sacrifice you have put into the business. You are also uncomfortable with the definition of bad leaver.

Therefore, as an alternative, you propose to KNow Growth the following changes to the leaver provisions:

1. You can only be classed as a bad leaver if you are dismissed by the company for cause or because you breach your restrictive covenants.
2. The definition of good leaver is amended to include circumstances in which you are unfairly dismissed by the company.
3. If needed as part of your negotiations, you might propose that a new concept of ‘intermediate leaver’ is introduced which is defined as circumstances where you cease to be an employee for any reason and you are not classed as a good leaver or a bad leaver therefore capturing circumstances in which you resign.
4. That a reverse vesting mechanism applies to your shares over a three year period. This means that the leaver provisions only apply to your shares for a period of three years and the number of shares over which the leaver provisions apply reduces over time on a monthly basis. You intend to propose that the leaver provisions and reverse vesting mechanism only apply over a % (anything between 50% and 90%) of your shares, as you will argue have already earned a % of them and should not lose them.

You feel that this alternative structure for the leaver provisions still give protection to KNow Growth by tying you into the business for a number of years but also means, in the event that you do leave, you will be able to retain some of your shares, reflecting your status as a founder of the company and the work you have put into it so far.

Having got through these tricky negotiations, KNow Wear Ltd successfully closed the round with KNow Growth and you now have runway for the next 12 months! You are really pleased and excited about the future, as is Sarah.

Following the round Chris expressed some reservations.   He’s not sure whether he wants to continue with the business, especially now that it is growing, as it is taking time away from his family. The three of you decide to have a meeting to discuss the direction of KNow Wear Limited. Find out what our founders choose to do in the next episode.

ABOUT THE AUTHOR

Emer Hughes joined the Corporate and Commercial team in May 2016. She works on a broad range of corporate and commercial transactions including advising on commercial contracts and shareholder agreements, corporate governance, company restructuring, asset and share acquisitions, VC investments and listings on junior stock markets.