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):
- Fundamental founder and company covenants to improve corporate governance and keep the founders committed to the company
- Exit and enforcement provisions to give investors recourse if and when the company or the founders step out of line
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.
Part I: Key Governance Rights and Founder and Company Covenants
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):
- Notice and Quorum. These administrative provisions are often overlooked but can be crucial when there is any disagreement over the company’s direction. You should ensure that (a) the company cannot form a valid quorum if your appointed director, or at least a significant number of investor directors, is not present; and (b) the required notice period for any board meeting is sufficiently long to avoid a board meeting being called in a way calculated to make it difficult for an investor director to attend.
- Delegated Authority. Another frequently overlooked area is that the board’s authority can be delegated to a sub-committee, management, or any other party chosen by the board. Delegation usually only requires a simple majority of the board. A well-drafted agreement should therefore provide the investors a veto right over any such delegation, as well as representation rights at any sub-committees of the board (in similar proportion to their board designation rights). You should pay very close attention to the scope of any delegation of authority by the board — it should only be with respect to specific transactions, and narrowly drafted.
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.
- Entrenchment. Always avoid providing for certain named individuals named as board members in the constitution of the company, as this could give such individuals a perpetual right to be directors even if they otherwise stop being involved with the company if the constitution of the company does not have a mechanism in place to replace or remove such individuals. Board appointment rights should instead be tied to shareholding (and in the case of the founder, continuous employment with the company), and should be suspended upon misconduct.
- Subsidiary Boards. Consider whether the various board-related provisions applying to the company should also apply to each subsidiary within the group. This is not essential if the investor has good governance rights at the holding company level (such as extensive veto and information rights that capture the entire group company) but can act as a safeguard and give better visibility particularly in the case of local operating subsidiaries. Often, an investor will be entitled to these rights but not exercise them fully, for example if some subsidiaries are in jurisdictions where the legal processes for appointment and removal are time-consuming and costly so as to outweigh the benefits of appointment.
Veto Rights over Key Matters
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:
- Business Plan and Budget. From the company’s perspective, this is perhaps the most intrusive veto right. Investors can have comfort that the company’s annual business plan and budget are in line with the investors’ expectations, and any material amendments or deviations will also normally require investor approval.
- The effectiveness of this veto right depends heavily on the level of specificity and details of the business plan and budget. The company needs a certain amount of discretion on implementing the business plan and budget and some departures from them, but investors should be sure that the agreed format for the business plan and budget provides sufficiently detailed guidance to the company.
- Often the company will argue that a transaction otherwise requiring investor’s approval should be exempt if it is contemplated in the business plan and budget. This kind of language needs to be reviewed carefully — any exempted transaction needs to be very specifically provided for, and approved in, the business plan and budget.
- Related Party Transactions. A significant area of risk, whether in terms of non-compliance with laws or misappropriation of company assets, lies in the company and its subsidiaries being able to enter into transactions with management, employees or other related parties. This is not normally a controversial veto matter from the company’s perspective, but care should be taken to make sure the concept of “related parties” is broad enough. For example, you would want to capture the management, their close relatives, and any corporate vehicles controlled by any of them.
- Management Related Matters. Related to the above, hiring and replacement of key management, and terms of employment (including remuneration and share incentives) for key management, or remuneration involving amounts exceeding a certain threshold should all be subject to investor approval. This subjects major hiring decisions to investor oversight and helps to prevent company funds from being diverted through inflated remuneration.
- Loans and Guarantees. Consider requiring a veto right over incurrence of material indebtedness, providing loans or guarantees over another’s obligations (other than for subsidiaries), and creating encumbrances over the company’s assets, since these all have the potential of exposing the company’s assets to risk.
- Capital Expenditure and Asset Disposals. Investors should have veto rights over capital expenditures and asset disposals above certain thresholds. Again, this is aimed at protecting the integrity of the company’s assets and making sure that investors are aligned with the company’s significant acquisitions or disposals.
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.