At Point Nine, when wrapping up the legal side of a seed round, we focus quite keenly on a small number of contractual terms while we’re much more flexible on others, even those that many other investors consider essential and negotiate passionately. For instance, you will generally not see us marking up the guarantee section of an investment agreement or pushing for personal founder guarantees.
Why this “selectiveness”? Well, it’s not because we are a charity or consider the beer after signing more important (although of course it is important :-)). Rather, we see the agreements concluded in a seed round as the legal basis for a hopefully long and close cooperation of founders and investors. Since what counts most for this relationship to develop its full potential is mutual trust, there is little to gain from one-sided contract optimisation (this contrasts with one-off transactions such as the complete sale of a business, where the parties part ways before the ink has dried). In the big scheme of things, “winning” a certain clause that is of marginal importance to us quickly turns into a Pyrrhus victory if it leaves even the trace of a sour taste with those people who are the main reason for our investment in the first place.
So how do we decide which (few) provisions in the agreements to focus on and where we are happy to compromise? For us, in a nutshell,
IT’S ALL ABOUT THE UPSIDE (STUPID :-))
Since venture capital returns tend to follow a power law, a small number of investments usually generates 80–90% of the returns of a fund. The incremental returns that we can generate on these investments by, for instance, increasing our investment along the way vastly dwarf the potential gains achievable with elaborate contractual protections in case things go awry (which, by the way, also often pale in comparison to the value of a close and trustful cooperation with the founders when it comes to maximising value in a difficult situation).
Sounds all a bit abstract? Here is what we mean specifically:
The left column of the table lists the (few) provisions commonly agreed in seed rounds that are important to us because they either ensure that we can put more money in or sell when the founders/key operators are selling. In contrast, the clauses on the right generally only become relevant if things are not going well — they protect investors on the downside. The column in the middle is — obviously — the middle ground, where we don’t see a particular bias in either direction.* Below we’ll look at some of these provisions in more detail to give you a better idea of what we are talking about.
The pro rata right, i.e. the right to maintain one’s percentage shareholding by participating pro rata in subsequent capital increases, is possibly the most important contractual right for us. While normally the pro rata right as such is uncontroversial (in fact it is a general legal principle in many jurisdictions), shareholder agreements often contain a provision that entitles the majority of investors to waive the right on behalf of all investors. Facilitating such a waiver is not necessarily a bad thing as it may speed up the fundraising process or help accommodate legitimate ownership requests or new high value-add investors without additional dilution of the founders. Since the investor majority will hardly do something that is against its own interest, we generally accept a waiver clause IF it applies to all investors equally and does not allow the company to invite some investors (e.g. those that previously waived the pro rata on behalf of all others) to participate in the round anyway. Sounds strange? Well, this setup is actually quite common in the US and the UK. Not surprisingly (and reducing our headaches substantially), it is also not unusual to clarify in the transaction documentation that in case of a waiver of the pro rata right all investors are to be treated equally.
Similar to the pro rata right, we view the right of first refusal (RoFR), i.e. the right to purchase the shares which another shareholder wants to sell, as another key means to potentially increase our investment. The flip side of the RoFR is that an existing shareholder who (at times laboriously) organises the purchase of shares from another shareholder must share the fruits of his or her efforts with other shareholders who can simply jump on the ticket by exercising their RoFR. Still, this is OK as the alternative would be a potential bidding contest amongst investors or attempted “closed door transactions” that are in nobody’s interest.
The tag-along/co-sale right ensures that investors are able to (partially) exit their investment in parallel to the founders. It’s generally uncontroversial as the founders are a key reason for the investment in the first place, so if they exit, investors should be entitled to exit in parallel. The co-sale right is particularly important where the founders sell a majority of their shares and/or the sale leads to a change of control. In these cases, it’s not unusual that the selling parties are obliged to ensure that investors can sell their entire holding if they request it.
The provisions listed in the column “neutral” in the table above all merit separate blog posts (e.g. check out our post on founder share vesting), but are less relevant in the context of upside optimisation vs. downside protection. With one exception: The right of a certain majority of shareholders to drag-along other shareholders in a sale of the company can obviously be important to make an exit happen (both in an upside and downside scenario). Hence, we do look at the drag provisions in the shareholders’ agreement, but only to ensure that a) small shareholders do not have undue leverage over a sale (i.e. can be dragged if necessary), in particular if the founders want to sell (as in most cases they know best when it’s time to let go — which we are generally happy to follow), b) proceeds are distributed in line with any applicable liquidation preferences (see below) and c) investors cannot be forced to accept overly onerous terms (esp. a potential liability for warranties that exceeds the proceeds actually received).
Last but not least a few words on the right-hand column of the table above, which we generally consider least important as this is mostly about downside protection. Many investors will be surprised to find liquidation preference (often shortened to “liq pref” in investment lingo) in the “not so important category” (if you are new to the concept of liq prefs have a look at this post by Pawel for an excellent overview on our thinking here). The most contentious points with liq pref clauses are generally whether there is a so-called waterfall, which means that the later share classes (e.g. the series B shares compared to series A shares and those compared to seed shares) get a higher ranking preference, and whether proceeds exceeding the preference go to common holders first so that they eventually catch up with the preferred holders (then the liq pref is “non-participating”) or are distributed pro rata, so that the preferred holders will always receive a higher payout on their shares even in a successful exit (“participating”). The problem with elaborate waterfalls and participating preferences is that they misalign interests, complicate discussions and frustrate founders. At Point Nine, we are therefore keen to keep the liq pref as simple as possible: all investors are on the same level (i.e. no waterfall) and there is a full catch-up for founders (non-participating). Such a liq pref will become irrelevant as soon as there is an exit at the highest entry price previously paid by the investors (i.e. it’s really only about downside protection) and therefore keeps interests of all parties as closely aligned as possible.**
We hope the above provides a rough-and-ready framework on how we (and many other investors) think about certain seed transaction terms. You may wonder why we would do this, de facto “let down our pants” and disclose our “giveaways”. But that’s the thing: we don’t see the shareholders’ agreement in a seed round as a classic negotiation situation where each side thinks tactically about ways to build leverage to appear generous on some points in order to win on as many others as possible. We rather seek to start from a draft agreement that doesn’t need much editing in the first place. Based on our experience this is the best starting point for a long and productive relationship with the founders (and a boon for the legal budget too :-)).
* For good order 1: The categorisation shown in the table is of course a bit of a simplification. E.g. a pro rata right can also be important in a down round to prevent heavy dilution (“wash-out”). And reserved matters, i.e. the rules that govern which measures may only be consummated with approval of the investors, have a different (only indirectly related) purpose altogether, which is to ensure a minimum of visibility and control for the investors.
- * For good order 2: We’ll spare you with details on anti-dilution provisions, the complexity of which (and pages filled in a shareholders’ agreement) tends to be disproportionate to their practical helpfulness from our perspective. Just two remarks: Simply spoken anti-dilution means that in case of a down round the investors get some free shares as compensation for having paid a higher price in the preceding round (or alternatively the “conversion price” of their shares is lowered). Anti-dilution clauses are standard (we also ask for them to avoid being disadvantaged vis-á-vis later-stage preferred share classes), but as a founder you should never accept more than a so-called “broad based” anti-dilution, where the weighted average price used to derive the number of “free” shares is calculated by using ALL shares outstanding after the earlier round. Down rounds can and do happen of course, so anti-dilution clauses do become relevant at times. However, their impact is generally either quite limited (if the down round is not significant price and/or volume-wise) or, if it is, can (even if broad based) mean massive dilution of the founders/management who then need to be “re-upped” to keep them sufficiently invested. Especially if there are different preferred share classes this unfortunately can lead to huge complexity and drawn out discussions — which are often counterproductive when the company needs money urgently and the founders/management should be focused on the business rather than fundraising.