Digital Futurists Angels. popularly known as DFAN conducted a Master Class session with Varun Sethi, (https://about.me/varunsethi, https://www.fullstacklawyer.com/) a leading legal expert in the start-up eco-system. Varun has conducted the financial and legal due diligence for all DFAN investments to date.
Varun proposed 15 keywords jargons in the sessions to simply this complex legal area to help Angel investors understand the importance of these terms while doing an Angel Investment. The summary of this session is presented for the benefit of larger audience:
Early-stage angel investment is among the riskiest investments in the entire Start-up Investment life cycle. And the lack of knowledge on the part seed stage Angel Investors further aggravates it.
You can also watch the recording of the session here.
The 15 Key words were divided into three categories namely:
A) Deal Maker/Breaker terms – can’t be comprised even at the expenses of walking out from the proposed investment. The key 5 words in this category are:
1. Exit Clause: This should be defined in the SHA as what options founders are planning to provide to Angel Investors. Usual exits routes available to Angels are:
- Secondary sales during subsequent rounds of funding at higher valuation
- Strategic sale: sellingthe start-up to a bigger player
- IPO which is typically long term say 5 to 10 years
2. Pre-Money Cap table: This captures the snapshot of current shareholders in the start-up even before the Angel Investors comes in. In Indian context, this is a public record available in department of company affairs portal.
3. Team or ESOP: Usually about 10 to 12% of ESOP pool as a separate line item is a must in the Cap Table before Angel Investment. This provides a rough idea on the start-up’s potential to scale, reveals the psychic of the founders and whether it is worth taking a bet on the founders or not. In USA, the ESOP pools goes from 15% to as high as 35%.
ESOP provides sense of ownership to key employees and help in attracting and retaining the talent which is key ingredient for start-up to scale.
4. ROFR/ROFO: Right of first refusal or right of first offer is an important clause where founder shall offer first to the current shareholders specially during subsequent round of fund raise or other events.
5. Investment Instrument: In the Indian context, the Angel Investor has two choices namely Equity or CCPS (compulsorily convertible preference shares). CCPS is more advisable as broadly it covers both the rights of equity and gets preference in case of any eventuality like liquidation scenarios etc.
B) Should have terms – significantly impact investors rights:
6. Information rights in the post investment scenarios. Investors right to get the Monthly/ Quarterly information is a must. Any resistance from the founders to share this information is first sign for you as investor to reflect on to your decision to invest in this start-up. Information includes but not limited to MIS of sales, contracts, employees hired etc, P&L and the plan for next one/three months.
7. Founder(s) exit before Investor’s exit. This can be divided into Good Leaver and Bad Leavers. It will depend upon timing of the founder(s) exit and his shares can be purchased by all existing shareholders in prorate proportion their holdings. In case Founder is exiting before the completion of locking period, he can seek for a mutually accepted value (usually at intrinsic value as certified by registered evaluator) for all his unlocked shares only at the time of exit. Any locked shares would be purchased at the par value.
8. Tag along: When founder is selling a part of his own shares to an outsider, the tag along clause gives investors a right to sell their shares in the same proportion to the same buyer. In essence if founder is selling say 5% of his total holding than investors also get the right to sell up to 5% of their holding along with founders sale.
9. Liquidation clause – This clause comes handy in situations of distress sale or liquidation. It gives first preference to all stakeholders holding liquidation preference clause and rest of the proceed(s), if any, will then be divided to left over stakeholders.
10. Secondary Sale: This is the most commonly used exit route in current times and gives investor the right to seek exit in subsequent future round(s) of funding. Investor decides if he want to stay or exit from the start-up .
C) Good to have terms – balances the investor’s rights:
11. Valuation in the early-stage investment is more of game of negotiation based on information like Team, product, problem they are solving, is there a market for scale etc. Though many other methods of valuation do exists like discounted cash flow or valuation certificate from a registered valuator etc.
The start-up should have Start-up India registration certificate to take benefits in Indian context.
12. Board Observer or Director: It is in the interest of the Angel Investors to appoint a board observer to act as a liaison between founders and investors, to help ease out on communication, plus provides his independent view on the progress, how the Investors can help the start-up in managing some the challenges. Note: The Board Observer do not have any voting rights and cannot participate in any decision-making process. He is just a silent observer of the events.
13. Intellectual Property assignment agreement, should have been duly executed by the founders transferring all the IP’s in the company names instead of holding in their individual names. This again reflects on the psychic of the founders in terms of any vested interest or just negligence/ignorance. This can be a deal maker/breaker specially at the series A level funding round.
14. Fees: The fees for conducting the due diligence etc should be clearly spelled out in the term sheet if it is born by the start-up or the investors.
15. Extrapolation of Term Sheet terms to Share Holders Agreement: It is important to ensure all terms from the signed TC are carried over in the SHA. Similarly, in a new round of funding a new SHA is drafted, hence the existing shareholders should ensure that either their previously agreed terms are carry forwarded into this new SHA or they specifically acknowledge that they are agreeing to the new terms which could impact their previously agreed rights.