MoFo PE Briefing Room
Investing in unicorns is a high-stakes game. These companies are often run by strong, charismatic founder teams, with no shortage of willing investors eager to accept their terms. However, it is important to know your bottom line as an investor when it comes to what protections you need in terms of governance, control, exit and enforcement rights when managing downside risk. The press is replete with examples of investors suffering financial and reputational damage due to misalignment of interest between the management and the company, corruption or failure to comply with laws, personal misconduct in the age of #metoo, or simply the founders taking the company in a direction different from the investors’ original expectation. Inevitably, there will be some tension between what the investor requires from a risk-management perspective and allowing the founders and the company sufficient freedom to operate, but conveying your expectations to the company upfront and being creative and flexible when negotiating and structuring these rights will go a long way towards bridging the gap.
In this two-part article from the MoFo PE Briefing Room, we discuss some of the ways you can mitigate the risk of suffering such damage in connection with your investments in Asian unicorns, including:
Part I: Key governance rights investors should negotiate for in order to stay informed of (and to proactively advise on or intervene in if necessary) the company’s business
Part II (forthcoming):
The year 2020 is shaping up to be a year of change and challenge but also opportunity. You should assess the need for these risk-management measures to be part of the terms of your next investment. For your existing investments, now may be a good opportunity to review your rights in your portfolio companies and their compliance with existing obligations. You may want to revisit some of the investment terms, particularly if the company needs additional capital in order to keep it afloat through these trying times, and, thus, any follow-on investment could be predicated upon those terms.
As an introductory comment, this article has been written assuming, for the most part, that your investment will be for preferred shares in the company. However, if you are able to structure your investment as a convertible bond instead, then you would be able to get extra downside protection associated with debt investments (therefore, avoiding the issue with redemption rights outlined above), while most rights normally associated with equity investments, such as governance rights, can also be attached to a convertible bond investment. Sometimes a target company will insist on an ordinary share investment, which would impact the way some of the investors’ rights can be structured, though, again, most of the rights we discuss below can be obtained in an ordinary share investment.
Unicorns and their founders, even more than other target companies, often insist on having complete operational freedom and control over the company’s direction and activities (and by extension, how to use the funds you have invested). Often unicorns have a high level of sensitivity disclosing operational and financial data to even existing investors, due to the concern that the confidential information might be leaked to their competitors.
However, the investors have a real and legitimate need to have adequate information, access, participation and governance rights. This is also an advantageous proposition for the company as, by providing investors a seat at the table, the management team can benefit from the views and expertise of the investor team given their significant involvement with multiple other companies in myriad jurisdictions, not to mention give future investors confidence in the transparency of the governance structure of the company.
Therefore, if you are an investor who is taking up a significant minority stake, you will need to strike a balance between being sensitive to the company’s legitimate concerns, and having the rights that keep you informed and comfortable that you satisfy your responsibility to your LPs by participating in the company’s major decisions and managing your investments meaningfully. Even if your interest is smaller (for example less than 10%) and the company is unwilling to grant you these rights, you can seek some “essential” rights that directly impact the economics of your investment and additionally negotiate for other rights to be exercised by the majority of investors participating in your round, or at a minimum by other financial investors who would be able to act as a safeguard against unfettered management discretion.
In an ideal scenario from the investor’s risk-management perspective, the company’s management should not be able to unilaterally make key strategic decisions without such investor’s approval. In this section, we outline a few key rights investors should have at their disposal during the life of their investment in order to safeguard their interests, including some notes on the practical implementation of these rights and negotiation tips.
In the United States, startups tend to have boards that are more balanced in terms of founders and investor appointees, and it is common for the founders to lose control of the board after a few rounds of financing, depending on the relative bargaining positions of the parties. However, and while there are exceptions and we are seeing early signs of the market moving away from this, in Asia and particularly China, it is much more likely for the founders to insist on maintaining board control for longer, often right up until listing. This is even more likely the case with Asian unicorns.
Generally, a majority of the board is able to make decisions for the company, subject to statutory requirements for certain matters requiring additional shareholder consent. Therefore, if the founders control a majority of the board, or in jurisdictions where each individual director has authority to act on behalf of the company (for example civil law-based jurisdictions), it would be critical for investors to have an approval right over key decisions of the company (see section “Veto Rights over Key Matters” below).
Rather than allowing more investor directors on the board, founders may be more receptive to having independent directors as a way to break the founders’ majority board control. This way neither the founders nor the investors control the board. While often independent directors will side with the management, they nevertheless have fiduciary duties and need to exercise independent business judgment. The presence of independent directors can be critical where a company faces serious issues that may call for replacing the management team. We will discuss this further in Part II of this article.
Assuming you have representation on the board, whether individually or together with other investors, you should also pay attention to the following matters (noting that there may be some differences depending on the jurisdiction of incorporation of the company):
Management often has a more general authority to conduct day-to-day operations of the company. This may be an operational necessity, though again, you should ensure that this kind of authority is subject to restrictions such as caps on amounts, frequency, and periodic review or expiry.
A good practice is to pay close attention to the wording of resolutions circulated for signing during the life of your investment. While everything is under a microscope during negotiations of the investment documents, resolutions proposed during the day-to-day operations of the company may not receive as much scrutiny.
Customarily, there would be a number of key actions specified in the company’s constitution and shareholders’ agreement that the company (and ideally its subsidiaries) cannot undertake without the approval of the investors. Depending on bargaining power, some investors may have an individual right of veto or investors participating in the same round may have a collective veto right.
Veto rights over fundamental transactions affecting share capital, such as mergers and other change of control transactions, repurchases, winding up and dilutive share issuances, are not normally controversial (although the specifics of each may be extensively negotiated). However, investors should expect strong pushback from founders on veto rights over operational matters (with the possible exception of significant disposals and acquisitions). That being said, having veto rights over certain operational matters is crucial from a risk-management perspective, particularly if the founders have a board majority — as otherwise you may be inadvertently giving the management carte blanche to manage (or mismanage) the company’s assets.
Below we briefly discuss some key operational matters over which investors should strive to obtain a veto right:
Note that while an investor having extensive veto rights over operational matters is desirable from a risk-management perspective, the benefit will need to be balanced against the risk of having such rights triggering a requirement to make an anti-monopoly filing if the relevant size thresholds are met. For example, an investor with a unilateral veto right over amendments to the business plan and budget will generally be viewed as having joint control over the company, and thus the completion of the investment by that holder will be deemed to constitute a change in control (from sole control to joint control) for the purposes of anti-monopoly regulations. Having veto rights over multiple other operational matters could also in the aggregate be deemed to constitute joint control.
Veto rights are generally extensively negotiated by founders who are committed to their vision for the company. When negotiating, the founders should be assured that veto rights are a protective measure, and the investor is not intending to meddle with the company’s operations unnecessarily.
As a fall back if the founders reject more extensive veto rights, consider having certain veto rights be “springing” rights that will not apply at the time of the investment but will automatically come into force upon the occurrence of certain triggering events, such as the failure to meet certain economic targets. We will discuss possible triggering events in more detail in Part II of this article.