Investor Education: Shareholder Terms

We have previously discussed the investor-led and entrepreneur-led types of equity crowdfunding  and there is some concern that the entrepreneur-led equity crowdfunding capital raises will lead to higher valuations. This assumes that the “crowd” does not have nous to understand the offering. We believe this to be inherently untrue. Nonetheless, it’s a good idea to look at the terms found in investor-led equity crowdfunding (sponsored by VCs, Angels and professional investors) and determine their relevance to entrepreneur-led equity crowdfunding campaigns.

The Common Shareholders Agreement Provisions

The purpose of the shareholders agreement for venture capitalists is to provide as much downside protection, which can be somewhat daunting to the entrepreneur. Here we discuss the nature of some of the most important terms and why professional investors often insist on their inclusion.

Dividend Rights

What are they: No dividends to other shareholders without equal dividends to investors’ equity

Why are they used: All shareholders having equal rights to the company’s distributions

Liquidation Preference

What: If the company goes broke, investors’ equity is paid out in full before Founders get their share

Why: Investors provide actual cash into the business

Mandatory Redemption

What: The company must buy back the investors’ shares if the company is not listed or sold within a prescribed timeframe

Why: Ensures that investors have an exit after an agreed prescribed time

Conversion Rights

What: The investors’ equity can convert into ordinary shares at any time at the investors’ option, and automatically on certain events (IPO, trade sale)

Why: Based on providing investors’ preference shares, but converting to equal rights with all other shareholders (generally required under an IPO or trade sale).

Anti-Dilution Provisions

What: If the share price goes down at the next capital raise, the investor receives additional shares for free

Why: Because the initial investor made their contribution at a higher price than the true valuation based on the next capital raise valuation

Voting Rights

What: Investors have veto rights over many board and capital raising issues

Why: more for professional investors, but the veto rights on board decisions that affect the valuation e.g. founders salary, 12 month budget

First and Last Rights

What: If shares are being sold by the company, investors get to participate first and last

Why: so the business control doesn’t pass to an external without the opportunity for investors to participate

Pre-Emptive Rights

What: Founders cannot sell additional shares without first offering them to the investors

Why: Because investors may wish to invest further to maintain the relatively share ownership

Drag-Along Rights

What: Under certain circumstances, if the investors want to sell the company, all shareholders must sell the company

Why: Usually under mandatory redemption circumstances, investors find an exit after considerable time and “drag along” the Founders

Tag-Along Rights

What: If the Founders want to sell their shares, they must ensure the buyer makes an offer for the investors shares (at least at equal price)

Why: Not really fair to the investors if the entrepreneurs walk away from the business after selling just their shares

Information Rights

What: Investors receive monthly management reports and can ask for additional information

Why: More for professional investors to keep updated, but the smart entrepreneurs will keep their shareholders informed, and happy.

Warranties & Indemnities

What: If misrepresentations were made, the ordinary shareholders agree to compensate the investors

Why: Because you lied

Clawback / Ratchet

What: These are used to bridge the gap between the Founders valuation (generally higher) and the investors’ valuation (generally lower). A ratchet is made at the Founders valuation (higher), but if the company does not meet certain pre-defined hurdles, the price per share is reduced. A clawback is made at the investors’ valuation (lower), with extra shares provided to the Founders if it exceeds certain pre-defined hurdles.

Why: The experience with clawbacks / ratchets can been interesting. Valuation is often the most negotiated part of any investment in startups and yet, the easiest to resolve. The simple question to ask each entrepreneur is: do you stand by your forecasts? The answer will inevitably be yes; then a ratchet (at the Founders higher valuation) based on pre-defined hurdles should not be an issue. If these hurdles are not met, then the investor acquired shares at an incorrect (higher) valuation, and should be issued additional shares to reflect the true valuation of the company at the time of the original investment. If, on the other hand, these forecasts are surpassed, both the investor and the entrepreneur are in a better position.

 

Implications for equity crowdfunding

The majority of shareholders agreement provisions utilised by venture capitalists and professional investors alike, come from their previously held monopoly on investing in startups. Equity crowdfunding changes the investment landscape and allows entrepreneurs to have more ‘reasonable’ terms in their capital raising endeavours.

However, investors and entrepreneurs need to be cognisant of a ‘win-win’ scenario. If the terms and valuation are too much in favour of the entrepreneur, the investors won’t feel and act like a partner. And too much in the investors’ favour and the Founders become demotivated.

Nonetheless, there are a number of terms above that should be considered. Namely, pre-emptive rights, anti-dilution provisions and tag-along rights should be part of a shareholders agreement for crowd investors. This is to protect investors whilst still allowing the Founders the control of their business, given they know it best.

Each of these provisions should not concern the Founder in an undue way. Pre-emptive rights are especially important given the ability of the Founders to issue new shares at any time. It’s not meant to be draconian, but does allow for the necessary protection of your crowd investors.

As entrepreneur-led equity crowdfunding campaigns are public, investors will have the opportunity to compare and contrast not only the offering, but the entrepreneurs’ implied attitude to investors via the shareholder agreements provisions. After all, democratised capital should be exactly that – democratic and merit-based.

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