We covered interesting tips on negotiating the ‘commercials’ of a termsheeet - http://novojuris.wordpress.com/2013/08/27/term-sheets-negotiation-and-tips-part-1/ and http://novojuris.wordpress.com/2013/09/03/term-sheets-negotiation-and-tips-part-2/.
Negotiating commercial aspects of the termsheet is kind of expected unlike ‘controls’ (please see Part I of this series). Most investors would give a standard response of ‘style of investment’ and ‘these are minimum controls to retain our investment in the company’ and shy away from negotiating. They do have a point here.
If you take a loan from a bank, there is a requirement of an asset guarantee, corporate guarantee and/or many a times, a personal guarantee. Banks also have monthly information and reporting requirements. There is an interest that is paid, on the loan which is the ROI the bank works on. If the loan is a large one, there will be certain matters which require the bank’s prior approval. Compared to the bank loan, an early stage investment does not require such guarantees. What they do believe in is the founding team and the scalable idea, with no guarantee of getting back their investment amount. With this perspective, you could negotiate the ‘control’ aspects. No, we aren’t trying to be philosophical, but suggesting that you prioritize your list of things to negotiate.
Here’s how the mechanics work: In a company, the decisions are made at two forums, meeting of board of directors and shareholders’ meeting. The powers that vests with the board, is then delegated to the CEO and others in the company.
In a board, one director has one vote. While in a shareholder meeting, one share gets one vote. (This is where a majority (51%- ordinary resolution) and (75% - special resolution) voting requirements matter). When an investor takes a 26% stake, she gets a veto voting right on important matters, without which, special resolution matters cannot be decided by the company.
Also, in a limited liability company, the investor gets a control by having a representation in the board and having veto rights on a list of really important matters called ‘Reserved Matters’. This means that without the investor’s consent, the agenda items listed in Reserved Matters cannot be decided upon by the rest of the board, though the rest of the board form a majority.
Before you think it is very prestigious to be a Director of the Board, let me quickly add that it does come loaded with liabilities, duties, responsibilities under various statutes (labor laws, tax laws, economic laws, securities related laws and Companies Act.) When there are non-compliances, it is the directors who are held responsible. So, you also have a few institutional investors who do not take a director’s position but opt for a ‘board observer’s position’ which is not a legal position and does not carry voting rights.
Board Composition or the size of the board, determines the ratio of the founder-to-investor representation on the board. The number of board seats for the investor should be relative to the size of the investment.
In India, we typically see that more 15 – 26% shareholding calls for one board seat, in early stage investments (the range covers angels, angel networks, micro VC's, seed stage, series A). We also see that the investor gives away the right should their shareholding fall below 5%. This is limited only to board seat and others, such as right to receive information or veto on shareholder related Reserved Matters continue.
Some tips: (most of it is common-sense do you say?)
- The lead investor gets a board seat - This payments company with a really soft spoken founder: We witnessed a not-so-fun round of negotiation, when 3 institutional investors, totaling to about Rs.1.5 crores of investment, each asking for a board seat and each investor having a really long list of Reserved Matters. It was quite a task to trim it to one board seat and one common Reserved Matters list.
- If in a large network of individual investors, get the decision making done through one person, so that the investor group dynamics are minimized and the founder can focus on business - This feedback company founder thanks us quite a bit for this tip.
- If co-investment, the decision making can be as a group. But, it does come with its challenges during ‘exit’ scenarios.
- It is suggested to have an odd number (as opposed to an even number) of individuals on the board, so that there is no ‘tie’ in the decision making.
- It is ‘nice’ if the founding team has a majority of directors, the dynamics of the number should work in their favor. But, if the Reserved Matters (typically a list of about 25 to 30 items, which covers nearly all important aspects of business decisions) require an investor’s affirmative consent, then, do you think it helps?
- Ensure that the Independent Director is indeed independently appointed and takes independent decisions in the interest of the company. - The investor in this deals company said, ‘Oh, we’ll get you an independent director who adds tremendous value to your business.’
We enjoy many discussions with entrepreneurs. But this one comes to my mind when I write. It was a majority stake sale (51%) that we recently completed and the BITSian founder, true to his engineering (as in, logical thinking) background comes up with an entire working of 49%:51% stake and is adequately represented with a 25 member board seat. You get the point :-) .
Keep the board size small + meaningful.
Disclaimer: This is not a legal opinion and should not be construed as one. Please speak with your attorney for any advice.