An ideal investment agreement is one that enables a start-up investee company to thrive.
The key is finding the right balance of rights and obligations between the investor and the promoter. Overly onerous obligations on the promoter can suffocate the freedom, nimbleness, risk-taking ability and ingenuity required by the promoter to make a start-up successful. On the other hand, obligations that are too modest on the promoter, could result in the company rapidly burning cash.
First and foremost, promoters must understand the difference between ownership of shares in a company, and the management of it. These are distinct aspects, and promoters must carve out their roles as shareholders and as managers accordingly. Their shareholding gives them rights to be on the board of directors, and in turn, control over the management of the company.
The investor and promoter should endeavour to constitute the board in a manner that allows the exercise of co-adjuvant control on the company- by both the investor and the promoter. While investors will typically not enjoy majority on the Board, they can exercise the requisite control with differential voting rights or affirmative voting rights on reserved matters.
Much thought must go into devising the list of reserved matters. For the protection of the investor, care must be taken to include those matters in the reserved list, which limit unbridled spending of company funds in areas not strictly meant for the objects of the business, and restrict the decision making power of the promoter on aspects that could significantly dilute the return on investment to the investor. The promoter on its part, must ensure that the reserved matters do not significantly dilute their freedom to operate. This is a fine and difficult balance to achieve.
To a savvy investor, the expressions drag, tag, call, put, rights issues, dilution, exit, preference in liquidation are familiar terms. Although it is fairly standard to have these clauses in some form in an investment agreement, they have vastly different connotations for the investor and the investee/promoter. The investor sees these clauses as a shield of protection for its investment, but can end up costing the proverbial arm and leg to the unwary promoter. Promoters entering into an investment negotiation must make the effort to familiarize themselves with these terms, and their significance on themselves and the investee company.
Promoters looking for investment must remember that investors are looking for avenues to grow their money. The transaction is purely commercial and not personal. They are not god-fathers to the promoter, and want the freedom to be able to liquidate their investment at a time of their choosing, to a party of their choice and with the number of shares that the third party buyer decides. It would serve the promoter well to understand this when they enter into a negotiation.
Drag/Tag rights, in a sense, epitomize the investor’s interest in the maintenance and growth of their investment. Simply put, ‘drag’ means the investor has the right to drag/force the promoter to sell its shares to a third party buyer of the investor’s choosing, if such third party buyer wants to purchase more stake in the company than the investor has to offer, at the price negotiated by the investor with the third party buyer. Conversely, the investor shall have the rights to ‘tag’ along with the promoter, in the event the promoter has negotiated a sale with a third party buyer for its shares, provided the investor is satisfied with the price of the shares being offered by such third-party buyer. To what extent the investor can tag along, depends entirely on what has been negotiated between the promoter and investor. This could be in proportion with the promoter’s sale shares or could even be to the extent of the investor’s entire shareholding. Importantly, tag rights usually come into play only after the ‘lock-in’ period has expired. Mostly, promoters will be bound by a lock-in period during which they will not be able to sell, transfer or alienate their shares.
Promoters must watch out for a dilution of their investment, as and when more money is required in the company. The investor must have the freedom to capitalize the company as and when funds are required. While this is also in the interest of the investee company and the promoter, this should not be used as a tool to dilute the promoter to the extent that s/he loses control of the company. One mechanism to protect against dilution could be providing for anti-dilution on voting rights for the promoter. However, the early investor will demand anti-dilution protection qua subsequent rounds of investments in terms of price and rights. The investors would typically bind the promoter and company from selling shares below the original price of purchase by the investor, and from granting rights more favourable that those the investor is entitled to. The investor will also typically demand pre-emptive rights, rights of first refusal and preference over the promoter and other subsequent investors/shareholders in case of a liquidation event. Albeit, these protections are customary, but can, in certain instances, impede future investments.
The real landmines to watch out for, however, are the call and put options. In a call-option, the investor can ‘call’ for the promoter to sell its stake for a pre-determined price to the investor, which price can be a song. Conversely, the investor can ‘put’ its stake to the promoter, requiring the promoter to purchase the investor’s stake at a pre-determined price, which could be the moon. Instances of investment agreements providing for minimum guarantee pay-outs at the end of a fixed term were also not unknown.
I must mention that there has been some back and forth on the legality surrounding pre-emptive rights including drag/tag/call/put options by the SEBI and RBI over the years. The details are not relevant for this article; suffice to say that promoters must beware of call/put options in their contracts, as these provisions can be onerous.
Uncomfortable as the conversation is, it is important for parties to discuss, understand the consequences of, and incorporate a dispute resolution clause that is equitable to both parties, particularly the promoter, because their resources are limited. It is in the interest of both the investor and promoter to opt for arbitration over court proceedings. In terms of the recently amended Arbitration and Conciliation Act, 1996, the arbitral process is time-bound and is required to be completed within one-year, extendable by another six months by mutual agreement. To be cost-effective, it is advisable for the parties to opt for a sole arbitrator. It is also advisable to opt for institutional arbitration over ad-hoc arbitration.
To conclude, I would say that the responsibility of finding the correct parity of rights, in my view, lies on the investor alone. They have access to advisors, which promoters of a start-up (typically) don’t. Secondly and importantly, investors have the negotiating power over the promoter. How an investor wields that power will be a major factor in the ultimate success of the investee company.
This article was first published on Linkedin on 20.03.2018. The original article can be viewed by following the link: