Kumar Kartikeya Prakash & Nikita Appaswami
Start-up companies seek various forms of funding to help kick-start their operations and, eventually, to scale their growth. Typically, the seed capital ploughed in by the promoters themselves and/or their close friends and kin helps the start-up companies create a workable product prototype and set up the business, before the companies are ready to go into the market to seek further capital infusion from investors (specifically, institution investors, venture capital funds (the VCs), private equity funds, high net worth individuals) for sustainability, growth and expansion.
There are a variety of factors that drive an investor’s decision to invest, such as, the sector, intended customer base and financial eco-system in which the company is operating, ability of the product/service to generate meaningful economic returns and a strong management framework to drive the business forward.
While there have been compelling accounts of how VCs, guided by metrics and other determinants, have gone about making bold investments through various rounds of alphabetically progressive capital infusions, what happens when a start-up (hereafter, the New Co) decides to approach other investors (hereafter, the New Investor(s)) after an investor / a VC (hereafter, the Existing Investor) has made its Series A investment in the New Co?
New Co’s ability to attract New Investor(s) is largely dependent on several factors such as how well the entity could utilize the funds brought in by the existing investor, the amount of investments sought by the New Co, the speed at which the New Co is burning its capital, market trends, investment sentiments in the country at the time of the proposed capital raise.
Based on these factors, often, the New Co may decide to proceed with (or rather, is compelled to select) an investor that is of a relatively smaller ticket size and one that is less sophisticated in comparison to the existing investor. There have been instances in the Indian market, where target companies, after a round of investment from a sophisticated VC, have opted for subsequent round of capital investments from smaller investors.
Usually these small investments are strategically timed to precede another big round of investment from a sizeable VC, to meet immediate capital needs. This article will look up-close the rights of the Existing Investor (being a large sophisticated VC) vis-à-vis the New Investor(s) (having smaller ticket size than that of the Existing Investor) and the give-and-take between them in a predominantly promoter driven New Company.
Rights of the Existing Investor
For the purposes of this article, let us assume that the Existing Investor holds over 50 percent in the New Company and has considerable rights inter alia including (i) lock-in on the promoter shares in the New Company, (ii) right of first offer or refusal and tag along on any transfer of promoter shares; (iii) drag along rights on the promoter shares, (iv) board representation along with affirmative voting rights; (v) anti-dilution protection; (vi) pre-emptive rights to partake in further issuances; and (vii) liquidation preference.
The rights and obligations of the Existing Investor also plays a crucial role in setting up the platform / market for the New Investor(s). In practice, during a further capital raise, the New Co is obliged to provide protection against any reduction in pre-money valuation of the New Company to the Existing Investor. In cases where the New Co is subject to a reduced pre-money valuation for the new round, the Existing Investor is entitled to, depending on the nature of securities held by it, either adjust the conversion ratio of its convertible securities or subscribe to additional securities, to ensure that the Existing Investor does not suffer from the reduction of pre-money valuation of the New Co.
Typically, in case of convertible securities, this adjustment mechanism is built into the terms of the securities. Further, where such securities are held by a non-resident Existing Investor, approval of the Reserve Bank of India or Foreign Investment Promotion Board is not required for reset of the terms of the convertible securities, if the adjusted conversion price per equity shares upon conversion of the convertible security is not less than fair market value of the equity shares of the New Co at the time of subscription of the convertible securities by the Existing Investor (who is a non-resident).
What rights can the New Investor have with a small investment?
In most cases, the New Investor(s) can be another VC or individual investor but of a different investment profile – in terms of size and risk appetite. The New Investor may not have delved into detail into the New Company’s day to day operations, legal compliances, precision and accuracy of financial viability or expansion plans but is encouraged by the confidence of the Existing Investor’s presence in the New Co and would like to piggy-back on the value created by the Existing Investor.
To a great extent, it may also rely on the due-diligence conducted by the Existing Investor and the pre-money valuation determined by or for the Existing Investor. By not conducting another due-diligence, the New Investor makes the process of fund raising, both time and cost-efficient. By participating in a new round of investment of the New Company and subscribing to a portion of the next series of securities (for instance, Series B convertible preference shares) the New Investor(s) will not necessarily be entitled to rights similar to those of an Existing Investor.
However, the New Investor(s) can seek liquidation preference on account of being a holder of the subsequent series of the securities i.e. Series B shares. While the rights of the New Investor(s) is dependent on how the negotiations pan out, factors such as: (i) ticket size of the New Investors’ investment vis-à-vis investment ticket size of the Existing Investor; and (ii) amount of capital infused by the New Investor and the resultant shareholding (if less than 5 percent), play a compelling role in determining the rights and obligations of the New Investor.
Fear of dilution is high even for a small investor, as the worth of its shareholding can be wiped off by the combination of a down-round (for example) and the issue of shares to a protected shareholder (being the Existing Investor, in this case). Therefore, it is very likely that the New Investor will insist on anti-dilution protection.
The New Investor(s) may not be interested in staying invested in the New Co should the Existing Investor decide to exit as the exit may negatively impact the growth in the New Co’s value or profitability, or business model. While the New Investor may have the right to participate in the New Co’s qualified IPO, it may not always have the ability to cash in on the New Co’s qualified IPO. In that event, a tag right with the Existing Investor, instead, assures exit at a reasonable price.
Further, in case the New Investor has for a proposed shareholding ranging from 0.5 percent to 5 percent, it is unlikely that it will be granted a say in the day-to-day running of the business. Hence, while the right to a board seat may be given up, the New Investor may negotiate for information rights, to be aware of the New Co’s financial health. On a similar note, the affirmative voting rights of the New Investor is, typically, limited to matters which relate to any modification in the economic interests of the New Investors.
In case there are many new small investors participating in a further round of capital raise, for operational convenience, such investors are requested to provide a power of attorney in favour of one of the investors or one of the promoters. Operationally, this reduces the interference of several investors in the further fund raises or operations of the Company.
How to raise this capital effectively?
Fund raises are usually completed by way of a preferential allotment or a right issue. Typically, the New Company invites all its existing shareholders for a rights issue where most of the existing shareholders waive their right to subscribe to the rights shares and these shares are then offered to the New Investor. In many cases, the Existing Investors participate in these rights issuances to boost the confidence of the New Investor and to avoid any dilution of their shareholding.
Multiple rounds of capital raise also enable the New Company and the Existing Investor to gradually increase the pre-money valuation of the New Company and move forward on the path of becoming a start-up unicorn.
Further, where there is more than one non-resident subscriber to the rights issue process and where the subscription price is in USD, minor adjustment to the rights issue price due to forex fluctuation is an acceptable practice (for example, if one non-resident subscriber remits USD 100 on Day 1 and another investor remits USD 100 on Day 2, then there will be slight difference in conversion of the said USD subscription amounts due to forex fluctuations and hence, the rights issue price per share will vary slightly).
However, the New Company should ensure that the rights issue offer letter explicitly makes a mention of the said adjustment in the per share price, resulting from forex fluctuations which especially in the case of non-resident investments.
In light of the above, we see that the first big round of capital brought in by an early-stage investor often sets the tone for a company’s future rounds of investments. The terms of a convertible instrument offered in subsequent rounds (such as in Series B, Series C etc., offered to existing investors and/or new investors), such as conversion and liquidation preference, will borrow their flavour from the terms of the securities held by the existing investors.
The new investors participating in future rounds of funding (even with a smaller investment), are comforted by the priority in liquidation preference at the time of liquidation events.
A mixed bag of investments (of big and small ticket sizes) is often in anticipation of the next big round of investment from a highly coveted investor, which may serve as an excellent platform for the existing investors to cash out or redefine their the rights and obligations going forward.