4.2 CAN WE SAFEGUARD OUR LONG-TERM FREEDOM WHEN ENGAGING WITH A CORPORATE?
STRATEGIC CORPORATE VENTURE CAPITAL
In this section we limit strategic venture capital investments to minority investments by a corporate in a startup or scaleup, coupled with a strategic alliance covering a commercial collaboration which can take any of the forms of non-equity partnering models as described in Section 3.
Of course, corporate venture capital can have different objectives, from taking minority equity stakes in emerging purely to reap financial returns, gaining an early understanding of new markets or technologies, expanding strategic M&A options, or a combination thereof.
The startup may have the following objectives while accepting an investment by a corporate:
• Obtain additional equity capital funding from a well-capitalized corporate able to support it over an extended period of time.
• Leverage the corporate and its clients to increase the market reach for the products and services of the startup.
• Increase its revenue stream through fees (subscription, license, maintenance and support).
• Retain the flexibility to raise capital from financial investors and other corporates and obtain the highest price in an M&A transaction.
The corporate may have the following objectives while making an investment in a startup:
• Secure a strategic learning advantage, by identifying and procuring access to new technologies and business model, as well as outsourcing part of its research & development.
• Expand its strategic options by increasing its chances of acquiring innovative companies and accelerate its market entry.
• Increase demand for its own technology and innovative products and support development of new applications for its own products.
• Generate high returns on a financial investment.
Strategic Corporate Venture Capital Best Practices
In our experience, nearly all corporate venture capital investments are driven by strategic, rather than purely financial objectives.
Successful corporate venture capital investments require the strategic alliance to be structured at arm’s length and to be judged on its own merits separate from the equity investment. In other words, it is not acceptable for a corporate to argue that by reason of the investment itself, it should obtain certain commercial advantages from the startup.
Whether the corporate intends to integrate the standard or custom developed products and services of the startup into its own product suite through value added licensing, requires the startup to develop a unique customized module, or desires to obtain exclusive distribution or reseller rights, the best practices described in Section 3 for purposes of designing, structuring and negotiating partnering transactions are equally applicable.
A number of important structuring aspects for such strategic alliances are described below:
• Scope: as alliances are undertaken by partners with different objectives and interests, it is crucial for each partner to identify the scope of the alliance, the tasks and responsibilities of each partner, the expected commercial benefits for each partner, and the treatment of any knowledge, know-how and other intellectual property rights which may originate from the alliance.
• Exclusivity: if the corporate desires to obtain exclusive distribution or reselling rights with a certain functional, sectoral or geographical scope, there should be performance targets associated to such exclusivity arrangements, leading the corporate to forfeit such exclusivity rights in the event the performance targets are not met. An alternative can consist of an obligation to procure a minimum level of products and services from the corporate during a certain period of time or up to a determined absolute number.
• IP ownership: in order not to compromise the ability of the startup to resell its products and services to other potential clients, it is crucial for ownership of the intellectual property rights underpinning the products and services to remain with the startup. Usage rights should be carefully defined and not be structured as a de facto ownership transfer, making the corporate a competitor in the process.
• Funded development: in the event development does not take place with equity funding but within a strategic alliance, it is much more difficult to argue against a corporate that the startup should retain all IP rights related to software or deliverables which have been developed at the expense of the corporate within a strategic alliance. The startup will need to offer something substantial in return for the retention of IP ownership:
•Discount as compensation for funding development: a significant discount compensates the corporate for funding the development and incurring the development risk, while allowing the startup to retain the opportunities to resell or license the software or deliverable.
•Exclusivity as compensation for funding development: exclusivity arrangements may serve to compensate the corporate for funding development, with such exclusivity limited in duration, scope and/or geography.
•Royalties as compensation for funding development: one manner to avoid having to (heavily) discount upfront license fees can consist of offering the relevant clients who funded the development a royalty arrangement, which entitles such client to certain royalties on the funded product sales to other clients until the client which had funded the development had recouped the development cost.
• Co-creation: if the corporate and startup engage in co-creation, it should be as clear as reasonably possible from the pre-defined co-creation purpose, the contributed background and the agreed upon co-creation efforts what the expected co-creation outcome will be.
To ensure success of the collaboration and avoid ugly disputes at a later stage, the partners should have an agreed upon strategy concerning the ownership and commercialization of the Foreground. Developing such strategy takes significant time and effort.
• Governance: in addition to the governance mechanisms described below under Corporate Investment Aspects, the strategic alliance will require an additional governance level allowing the partners to manage the strategic alliance. The governance structure should be tailored to reflect the needs of the project and the respective organizations, for purposes of ensuring an efficient implementation of the strategic alliance. In view of the corporate venture capital investment, appropriate Chinese walls and conflict of interest management mechanisms need to be put in place.
The strategic nature of a venture capital investment by a corporate has many important implications as the corporate on the one hand and the startup, its founders and financial investors on the other hand, will have significantly different objectives.
The corporate will typically desire to increase its chances of acquiring innovative companies and accelerate its market entry. Such desire will frequently lead to attempts to block similar corporates from investing in the startup or ultimately block any competitor from purchasing the startup.
The startup and its financial investors will insist on retaining the flexibility to develop and expand the business as they see fit, to raise capital from financial investors and other corporates, and to obtain the highest price in an M&A transaction.
In our view this inevitably results in different deal terms than would normally be structured and negotiated with purely financially driven venture capital investors.
A number of important structuring aspects for the corporate venture capital investment are described below.
The structuring and negotiation approach in respect of the valuation to be applied to the corporate venture capital investment should follow the same path as a “standard” venture capital investment. This has the following implications:
• No discount: the fact that the corporate is offering the benefit of entering into a strategic alliance with the corporate in principle should not have a no downward impact on the valuation of the startup at the time the investment is made. It should be observed though that many corporates argue that this strategic alliance provides an additional benefit to the startup and should be factored into the valuation.
• No uptick: likewise, the startup should refrain from arguing that it is offering the corporate the benefit of entering into a strategic alliance which should have an upward impact on the valuation of the startup at the time the investment is made.
In general, the syndication of a round with financial investors and any future fundraising activities are significantly complicated or compromised by applying a different valuation to the corporate investment. Any perceived or expected benefits resulting from the commercial relationship should form part of the strategic alliance discussions and not complicate the capital structure of the startup.
Like a financial investor obtaining a minority stake of a certain importance, the corporate is likely to negotiate the right to delegate a director or observer to the Board. More often than not in our experience, corporate policies and procedures prevent corporates from accepting Board mandates, with a preference to delegate non-voting observers to the Board.
At the same time, they typically desire to have the same veto rights as corporate investors, leading them to push certain decisions which are normally taken at the Board level to be moved to the shareholder level. Such demands should not be accepted as such as it can significantly complicate the governance of the startup by having to disclose highly confidential matters to a (broad) shareholder base, instead of having the discussion at the confidential Board level. From a practical perspective it also impedes swift decision making.
Exclusion of Board Member or Observer
The board should be entitled to exclude the Board member or observer appointed by the corporate from certain portions of meetings or withhold certain information, if the Board believes in good faith that the presence or provision of information would be inappropriate. This is for example the case in matters related to the existing or future contractual (commercial) relationship of the startup with the corporate, its competitors or the unsolicited or planned sale of the startup. The negotiations concerning such exclusions are very sensitive and should be approached with great care.
Veto rights that can relatively easily be conceded to financial investors, require careful consideration for a corporate. From the discussion on the objectives set forth above, it seems quite clear that giving the corporate a veto right over important strategic transactions, such as important commercial agreements, joint ventures, mergers & acquisitions and fundraisings is likely to have disastrous consequences.
A representative of a corporate will have conflicting objectives, with on one hand the obligation to exercise its rights as Board member in the fiduciary interest of the startup and its stakeholders, but on the other hand feeling obliged to pursue the interests of the corporate it represents on the Board.
It stems from such considerations that a corporate should have no veto rights at all for any matters that touch upon the commercial relationship between the corporate and the startup. The commercial relationship should be exclusively governed by the strategic alliance.
In the event a proposal is made to the Board in respect of which the representative of the corporate has a conflict of interest from a commercial perspective, appropriate mechanisms should be put in place to ensure that the legitimate interests of the corporate are preserved (e.g. by requiring consent from one or more of the financial investors which are likely to take an objective view in the best interest of the Company), while also taking into account the legitimate interests of all other stakeholders.
Carefully constructed rights of first notification or refusal for the corporate in respect of commercial proposals or partnerships falling within the scope of the strategic alliance are a good mechanism to balance the interests of all partners involved.
Shareholder Veto Rights on Equity Fundraisings
At the shareholder level, the same concerns as applicable to the Board level apply. Veto rights that can relatively easily be conceded to financial investors, require careful consideration in respect of a corporate. Allowing the corporate to block a legitimate equity fundraising from financial and/ or corporate investors is obviously unacceptable from the point of view of the startup and its other stakeholders such as the founders, employees and financial investors. At the same time, it would not be fair nor acceptable for the corporate to be diluted below its agreed upon equity percentage by allowing the startup to unilaterally implement an equity fundraising to which the corporate cannot participate.
Several mechanisms (or combination thereof) can be used to guarantee an appropriate balance:
• Pay-to-play: the corporate has voting rights as any other investor, but it cannot block an equity fundraising which is offered to all investors on a pro rata basis. The fact that the fundraising is open to all investors on a pro rata basis serves as a guarantee that it cannot be diluted against its will, but in the event it decides not to participate to the fundraising, it cannot block the fundraising.
• No super pro rata subscription rights: it is common to provide that any shares offered on a pro rata basis to all investors who have not subscribed to, are offered to those subscribing investors who desire to subscribe to more shares than they would be entitled to on the basis of their percentage of ownership. Shareholders other than the corporate will be concerned about any deep pocketed corporate being granted such super pro rata subscription rights and increasing its percentage of ownership on this basis. It is thus quite common to provide that any portion not subscribed to by investors other than the corporate, is to be offered to all subscribing investors other than the corporate or to a third party, in order to maintain the agreed upon distribution of ownership (and resulting influence) of the shareholders of the startup.
• No veto rights on other corporates: unless it is specifically agreed in the strategic alliance that the corporate has exclusivity in a certain field or domain and should thus be entitled to block competitors from becoming shareholders of the corporate, the corporate should not have a veto right on any competitor becoming a shareholder of the startup. As stated, exclusivity comes at a price in the strategic alliance negotiations and should not result from the mere fact of having invested in the startup. Any corporates active in fields or domains which do not fall within the exclusivity scope should at all times be able to invest without having to consult with the corporate, assuming the appropriate majorities are obtained from the other shareholders.
Shareholder Veto Rights on M&A and Other Strategic Transactions
Financial investors will typically negotiate veto rights on M&A and other strategic transactions involving the startup. As they are motivated in principle by financial returns only, it can normally be assumed that they will not exercise a veto right in the event of transactions they deem to be in their financial best interest. The same cannot be assumed for the corporate who will have a strong interest in blocking an M&A deal or other strategic transaction with a competitor, but also with other potential counterparts in the event it decides not to bid itself to enter into the M&A or other strategic transaction at the relevant point in time, for financial or other reasons.
It follows from the above that giving a corporate veto rights on M&A deals or other strategic transactions is highly problematic and should thus be avoided. At the same time, the corporate has legitimate interests in engaging with the startup and emerge as the winner in an M&A deal or other transformative transactions. It should not be excluded by virtue of being a shareholder of the startup. Below we describe the mechanisms that can be used to reconcile the interests of the corporate, the startup and its stakeholders.
It is standard practice to provide amongst shareholders of a startup that in the event a shareholder desires to sell shares to a third party, it first has to offer them on a pro rata basis to the other shareholders. It is also common to provide that any shares offered for purchase which are not purchased by certain shareholders in whole or in part, are offered to the other purchasers which desire to purchase more shares than they would be entitled to on the basis of their percentage of ownership.
Here again, shareholders other than the corporate will be concerned about any deep pocketed corporate being granted such super pro rata pre-emption rights and increasing its percentage of ownership on this basis. The corporate could be patiently purchasing any shares which become available and acquire control over the startup which would have a significant adverse impact on the ability of the other shareholders to obtain the best price for their shares in an M&A process. It is thus quite common to provide that any portion not purchased by shareholders other than the corporate, is to be offered to all shareholders other than the corporate who have exercised their pre-emption right or to a third party, in order to maintain the agreed upon distribution of ownership (and resulting influence) of the shareholders of the startup.
Change of Control Pre-emption Rights
An overriding concern of founders and financial investors will be the possibility to obtain the best possible price in an M&A transaction. Typically, pre-emption rights will apply as well upon an M&A transaction with each shareholder being entitled to pre-empt a third-party bid and purchase all shares of the startup which are offered to a third party.
From the perspective of the startup and the shareholders other than the corporate, this is highly problematic as it is unlikely for any third-party buyer to go through the effort and expense of negotiating an M&A term sheet with the startup and its Board, conducting a lengthy audit and executing a share purchase agreement, if it runs the risk of the corporate exercising its pre-emption rights and leaving the third-party bidder emptyhanded. Any third-party bidder will require assurance at the start of the M&A process that it is not required to run this risk.
From the perspective of the corporate, it should be sympathetic to these concerns of the other shareholders, but at the same time it is fair for it not to be sidelined or excluded as potential buyer of the startup.
The customary manner to deal with this problem is to provide a specific Right of First Offer procedure which reconciles the interests of all stakeholders. It is advisable for the startup to tie such Right of First Offer to the existence of strategic alliance entered into with the corporate and the performance of its obligations under the alliance agreement.
Corporates often strive to obtain a Right to Match, commonly referred to as Right of First Refusal, which would allow them to match any offer to be made by a shareholder or a third party. The Right to Match prevents the startup from organizing a bidding process as it entitles the corporate to match the offer made by a shareholder or third party in a binding manner, effectively binding the startup and the shareholders other than the corporate and thus foreclosing any further bids and counterbids.
From the point of view of the startup, its founders and financial investors, a Right of First Offer is preferable as it ensures much more flexibility to obtain the best price possible in an M&A transaction through the organization of a bidding process. On the other hand, the corporate may legitimately expect for the strategic alliance and the agreed upon collaboration between the corporate and the startup to be given enough time to develop, certainly if the corporate is incurring significant internal costs and expenses for purposes of developing such collaboration.
Being dragged into a bidding war at such point in time might not be acceptable to the corporate and the startup and its backers may need to concede that during the development phase of the strategic alliance the corporate benefits from a Right of First Refusal, to be followed by a Right of First Offer after the expiration of the development phase.
Right of First Refusal – third-party bid: a balanced procedure can be structured as follows:
• Duration of Right of First Refusal: as explained above, the Right of First Refusal should not be applicable for an indefinite duration but tied to the duration of the development phase of the strategic alliance. After such phase has expired, the corporate would cease to benefit from the Right of First Refusal and instead would benefit from the Right of First Offer described above.
• Notification: the startup is required to give the corporate advance notice of any bona fide offer made by a candidate buyer to acquire control over the startup, which was accepted by a sufficient number of shareholders for purposes of transferring control to such candidate buyer.
In particular, the notification to the corporate should contain sufficient details on the number of shares to be purchased (majority or all outstanding shares) by the candidate buyer, the purchase price in cash, or if the price does not consist in cash, the counter value in money of the offered consideration, and a summary of all material terms and conditions to which the expression of interest is made subject.
• Realization of bid conditions: for purposes of determining the offer price to be offered by the corporate, all reasonable assumptions made in the initial expression of interest regarding the performance of the startup and the determination of the price, should be deemed met for purposes of any counteroffer of the corporate.
• Corporate counterbid: the corporate should then be given a relatively short period of time, e.g. one month, to submit an irrevocable and binding counterbid.
• Full exercise of Right of First Refusal: the Right of First Refusal will only apply in the event it is exercised in full by the corporate. If it is exercised in full, the corporate and the other shareholders are to enter into a share sale and purchase agreement, incorporating the same or equivalent terms as the originally proposed transfer. All shareholders would be obliged to transfer their shares upon consummation of the transactions set forth in the purchase agreement executed with the corporate.
• No full exercise of Right of First Refusal: the Right of First Refusal will not apply if not exercised in full by the corporate. In such event, the other shareholders will be entitled to transfer of their shares to the original candidate buyer for a price per share equal to or higher than the price offered by the corporate, taking into account all other relevant terms and conditions included in the notification of the corporate. Assuming the drag along threshold to force all shareholder to sell their shares is met, the corporate would also be obliged to sell its shares to the candidate buyer. It is fair to require that the transaction with the original candidate buyer is consummated in a relatively short period of time (e.g. 45 to 60 days), failing which the Right of First Refusal would become applicable again.
Right of First Offer – third-party bid: a balanced procedure can be structured as follows:
• Notification: the startup is required to give the corporate advance notice of any proposal or indication of interest in any transaction which would likely result in an exit. Such expression of interest should be sufficiently serious and interesting for the startup’s shareholders to enter into or pursue discussions with the entity making the bid.
• Corporate counterbid: the corporate should then be given a short period of time, e.g. 10 to max. 15 business days, to submit a counter bid, which the Board of the startup should consider in good faith. In the event the corporate elects not to submit a counterbid, it is deemed to have forfeited any pre-emption rights upon closing of the M&A deal with a third party. It is also obliged to transfer its shares to such third-party bidder on the same terms as agreed with the shareholders.
• No definitive agreements – due diligence: during this period, the startup will not enter into any binding agreements with any bidder and will give the corporate due diligence access which is no less extensive than provided to the original bidder.
• Fiduciary out: the Board should remain entitled to determine in its reasonable judgment that it is not in the best interest of the startup to accept the original or counterbid, and that it is allowed to solicit additional counterbids from third-partners in order to maximize the M&A deal terms. Such deal terms should not be restricted to the price offered only but encompass many other deal terms relevant to the transaction at hand and the long-term future of the company.
• Expiration of the Right of First Offer: it is preferable for the Right of First Offer to be tied to the existence of the strategic alliance with the startup and the achievement of certain minimum revenue commitments in respect of the purchase of products and services of the startup by the corporate.
It is well possible that the corporate is not willing to commit upfront to minimum revenue commitments towards the startup, in which event the inclusion of certain revenue targets to be achieved over a certain period of time might be an acceptable alternative. In the event the corporate would fail to honor the minimum revenue commitments, or would fail to achieve the minimum revenue targets, the Right of First Offer would expire.
A complicating factor would be the emergence of an unsolicited bid prior to the measurement period for achieving the minimum revenue commitments or targets having been completed. In such instance, it would not be fair for the Right of First Offer not to apply as the corporate will not have had the opportunity to honor its commitments or achieve its targets. In such case, the Right of First Offer would normally remain applicable. An alternative can consist of having the Right of First Offer expire unless the corporate would prior to the expiration place orders for products and services to achieve the minimum commitments or targets nonetheless.
Right of First Offer – controlled exit process: a venture backed company will typically be run with a 5 to 7-year exit horizon for the financial investors, providing in procedures allowing the financial investors to start the exit process:
• Notification: in the event the controlling shareholders of the startup desire to sell all their shares, they are required to inform the corporate of all material terms against which they are willing to sell their shares.
• Corporate counterbid: the corporate should then be given a short period of time, e.g. 1 month, to submit a counter bid. If the corporate makes a bid corresponding to the terms and conditions against which the controlling shareholders wish to exit, all shareholders would be obliged to transfer their shares to the corporate at such terms.
• Forced sale – drag-along: if the corporate refrains from making a bid corresponding to the terms and conditions against which the controlling shareholders wish to exit, such shareholders may oblige all shareholders, including the corporate, to transfer their shares to a third party at terms at least equal to the material terms set forth in the initial notification to the corporate, so that a third party is able to acquire 100 % the fully diluted share capital of the startup.
• Expiration of the Right of First Offer: in the event the controlled exit process is started after expiration of the measurement period during which the corporate was able to achieve the minimum revenue commitments or targets and such targets were not achieved, the automatic consequence would be for the Right of First Offer procedure not being applicable anymore. Obviously, nothing would or should prevent the startup and its shareholders to gauge the interest of the corporate and have it participate in the sale process. The only difference would be that the startup would not be obliged to strictly follow the contractually agreed upon Right of First Offer procedure.
Survival of Strategic Alliance
It is standard practice to provide that in the event of a change of control of the startup, appropriate arrangements are made to ensure that the rights and obligations under any commercial agreements entered into between the corporate and the startup survive such change of control.
It is fair for the corporate to expect that the purchase of all shares of the startup by a competitor do not entitle such competitor to terminate such agreements and prevent the corporate from continuing to do business with the startup.
When done at the right time and in a proper manner, corporate venture capital can add significant value to startups, scaleups and their investors. Meticulously selected Corporate VCs can open doors, provide access to new networks and ecosystems, hence reducing time-to-result or time-to-market.
It is key to set the right common goals and targets and create a win-win situation for the company, founders, employees, corporate VCs and other shareholders.
Besides sophisticated arrangements for confidentiality, exclusivity, execution and exits, proper arrangements are needed to deal with deadlocks. Corporates have their own agenda and their own strategy, both subject to change over time, and not necessarily in sync with the future goals of your company.
All in all, corporate venture capital is an important and valuable tool in an innovative company’s toolbox for enhancing shareholder value.
Roald Borré, Head of Equity Investments PMV
Standard Venture Capital Investment Aspects
In addition to the specific corporate investment aspects described above, the corporate will attach as much importance to certain customary venture capital aspects as would purely financial investors.
Certain of those important structuring aspects applicable to any venture capital investments are described below.
Due Diligence and IP Chain of Title
For startups, the protection and enforcement of their intellectual property rights is of paramount importance.
This applies to so-called inbound intellectual property rights, requiring all persons and entities having contributed to the development of the business and technology of the startup to validly assign all intellectual property rights to the startup.
Likewise, the outbound intellectual property rights granted to commercial counterparts through license, funded development, co-creation or any other type of commercial transaction involving the intellectual property rights of the startup should be carefully constructed to ensure that the startup retains the freedom to develop and operate its business in accordance with its product road map and business plan, as extensively described in the previous sections. The protection, enforcement and ability to commercialize the intellectual property rights of the startup is generally referred to as its “IP chain of title”.
Financial investors are extremely focused in their due diligence examination of the startup on such IP chain of title. Corporates are even more focused on such chain of title in view of the strategic nature of their investment and their plans to do business with the startup under the strategic alliance and any other agreement it enters into with the startup.
Any issues with the IP chain of title are likely to have significant adverse consequences and can range from demanding the startup to obtain valid IP assignments from those persons or entities who have not signed appropriate IP assignment agreements to having to re-negotiate commercial agreements with commercial counterparts. Such persons or entities may simply refuse to sign IP assignment agreements. The commercial counterparts may also flatly refuse to re-negotiate the IP arrangements made with the startup or demand an exorbitant price to renegotiate such arrangements.
Such issues are not only likely to lead to a significant value reduction to be applied to a financing round and specific indemnities to be given by the startup and its founders, exposing them to significant liabilities, but might cause investors to simply walk away from entering into a financing transaction. The problem is likely to be even exponentially larger when attempting to sell the startup, as any potential buyer will go through the same due diligence exercise before consummating any M&A transaction.
Founder Warranties and Indemnities
Investors will typically request the startup and the founders to give an extensive set of warranties to the investors covering all aspects of the business. Such warranties typically have a double purpose.
On the one hand, they force the startup and the founders to disclose any issues they are aware of or should have been aware of taking into account their position as founders of the startup, supplementing the due diligence exercise to be undertaken by the corporate. It allows the investor to estimate any exposure associated with potential disclosures against the warranties and factor such exposures into the price. It furthermore allows the investor to demand appropriate measures to be taken, either as conditions for their investment taking place or to be implemented after their investment has actually taken place. Typically, inbound and outbound IP issues as described above are to be dealt with prior to the investment being made.
On the other hand, the warranties and (lack of) disclosures against the warranties serve as a basis for indemnity claims by the investor after the investment has been made. For certain minor exposures the investor may accept them as being factored into their investment decision, but for major exposures the investor is likely to negotiate a specific indemnity, giving it the right to be indemnified by the startup and the founders if such exposure materializes. For any matters constituting a breach against the warranties which predate the investment and have not been disclosed against the warranties, the startup and the founders are typically required to indemnify the investor.
One of the complicating factors in any venture capital investment is the requirement of investors for the founders to indemnify the investor for any breaches of warranties. Assuming the founders have not sold any existing shares to the investor, the founders could theoretically be liable for the entire investment which has been made in the startup. The investor will argue that the startup has been run by the founders from the beginning and that they are best placed to indemnify the investor in the event of breaches of warranties.
In order to limit the exposure of the founders in multi-million euro claims, it is commonly agreed that the cash exposure of the founders is limited to a relatively small amount, not to exceed their annual base salary, with any remaining damages to be covered by call options on their shares in the startup. The exercise of the call options and the transfer of shares to the investors having suffered damages is economically equivalent to a valuation reduction as it increases the relative stakes of the investors vis-à-vis the founders.
Indemnification obligations are typically limited in duration and amount, except for any indemnities resulting from fraud or willful misrepresentation by the founders which are uncapped.
Employee Incentives and Retention
Talent attraction and retention are key in any startup. In view of the limited financial means available, such companies must be able to offer an additional form of remuneration to attract talent. Both financial investors and corporates will attach great importance to an equity incentive pool being available, to ensure the startup can offer new hires and existing employees equity incentives under the form of stock option or restricted stock.
The typical size of an equity incentive pool is between 10 and 20 percent of the fully-diluted capital of the startup. It is recommended to provide in the shareholders’ agreement that this percentage is to remain stable after each financing round, requiring the company to issue additional equity incentives pro-rated to the dilution caused by any new financing round.
Startups, founders and investors typically argue about the persons who should suffer the burden of the dilution of stock option grants. From the perspective of the founders, such equity incentives benefit all shareholders and should thus be issued after completion of the financing round, ensuring that all shareholders are diluted on a pro-rated basis. From the perspective of the investors, it is often argued that the founders should bear the dilution of the equity incentives prior to the investment taking place. This effectively reduces the valuation against which the investment is made and dilutes the founders on a disproportional basis. Often a compromise is found by splitting the dilution burden between the existing shareholders and the shareholders, including the new investors.
Founder Incentives and Retention
The continued active professional presence of the founders in the startup is paramount for any investor. Investors typically equate the startup with the founders and want to ensure that they remain fully committed to building the activities of the startup.
From the investor’s perspective, their investment only gives them a minority stake in the startup with certain rights and privileges as described above. If all founders would terminate their professional relationship with the startup following the investment, the investor would be in a disastrous position. The company would be majority owned by founders who have ceased to be active in the startup, with no ability for the investor to actively control and run the startup itself or attract other persons to take over the company’s management.
The founders should therefore understand that to a large extent the valuation applied by the investor to the startup depends on their active professional presence in the startup. The investor is thus perfectly entitled to demand for ownership of shares of the startup to be linked to the professional activities of the founders within the startup. Contractual arrangements concerning these matters are referred to as “Good leaver – Bad Leaver” arrangements.
In our view a fair manner of structuring Good Leaver – Bad Leaver arrangements takes into account the identity of the party terminating the professional relationship, the timing of such termination and the specific reason applied to such termination.
Below we include what we consider to be a fair and balanced Good Leaver – Bad Leaver arrangement:
• Time commitment: the founders agree to dedicate their full professional attention for a period of three to four years to the startup following the investment.
• Bad Leaver: is a founder whose professional relationship is terminated by the startup for any of the following reasons: material and willful breach of his obligations towards the company, fraud, deceit, embezzlement or any other serious criminal offence, gross negligence and any other act which would justify a dismissal for urgent cause.
• Early Leaver: would be restricted to a founder who voluntarily terminates his professional relationship with the startup other than because of death or permanent disablement.
• Good Leaver: is a founder who does not fall within the Bad Leaver or Early Leaver definition, e.g. because of death, permanent disablement or upon termination by the startup for reasons other than the Bad Leaver grounds of termination.
• Vesting: investors often insist on all shares held by founders to remain subject to leaver arrangements for an indefinite period of time. Consequently, the founders would at all times be obliged to offer all their shares for sale to the other shareholders upon termination of their professional relationship with the startup. From the founders’ perspective such arrangement is unfair as they will consider their shares to have been earned over the years. Therefore, the application of a vesting arrangement based on the time dedication is often agreed with only the unvested shares being subject to the leaver arrangements, with the exception of a Bad Leaver termination where all shares at all times remain subject to a call option. The vesting percentage can be freely determined but should be related to the time dedication agreed to, e.g. 100 % in the first year after the investment, 75 % the second year, 50 % the third year and 25 % the fourth year.
• Bad Leaver Call Option: a Bad Leaver would upon first demand of the Board of Directors be required to transfer all his/her shares against a purchase price per share equal to the lower of (i) the original subscription price, and (ii) the fair market value, often with an additional steep discount applied to the price to reflect the serious reason for his/her departure. The option should remain exercisable at any time.
• Early Leaver Call Option: assuming the shares are subject to a vesting arrangement as described above, the relevant founder would upon first demand of the Board of Directors be required to transfer the unvested shares against a purchase price per share equal to the higher of (i) the original subscription price, and (ii) the fair market value, potentially with a variable discount depending on the timing of termination, e.g. 50 % in the first two years and 25 % in the latter two years of the vesting period. The option should be exercised within a reasonably short timeframe following the termination, e.g. 6 months.
• Good Leaver Call Option: assuming the shares are subject to a vesting arrangement as described above, the relevant founder would upon first demand of the Board of Directors be required to transfer the unvested shares against a purchase price per share equal to the fair market value. In the event no vesting arrangement would apply, all shares would remain subject to a call option. Again, the option should be exercised within a reasonably short timeframe following the termination, e.g. 6 months.
• Beneficiaries: an investor will often argue that it should be entitled to purchase the shares of the leaving founder, while the founders often argue that they should be entitled to purchase the shares of the leaving founder with any remaining shares to be offered to the other shareholders. A typical compromise will consist of offering the shares of the leaving founders to all shareholders on a pro-rated basis.
• Purpose: as the stated purpose of leaver arrangements is to create room to attract new founders and/or executives, it should be explicitly provided that the shares purchased from a leaving founder are made available for sale to new founders and/or executives. The price at which those shares should be made available cannot be lower than the price paid for them, unless otherwise agreed by the holder.
Evaluation and Termination of Relationship with Founders
A distinction needs to be made between the evaluation and termination of professional relationships of founders in function of the Board composition of the startup. The termination of the professional relationship with such founders falls within the competence of the Board. We distinguish the following main situations:
• Founders holding a minority of Board seats: the Board of Directors of a startup which has completed several financing rounds will typically be composed of representatives of the investors, the founders and one or more independent directors, with the founders holding a minority of the Board seats.
In such constellation, the termination of the professional relationship with one or more founders represented on the Board of Directors can be decided by a simple majority without the founders being able to block such decision. Typically, the investors will have a veto right in respect of any decision to terminate the professional relationship with a founder serving as executive or employee of the startup. When leaver arrangements apply in all circumstances of termination of the relationship, it is often required for more than one representative of the investors and/or one or more independent directors to approve such decision.
• Founders holding a majority of Board seats: it is also possible that the majority of the Board seats is held by the founders, which puts the investors in an uncomfortable position. It will most probably have negotiated a veto right for the appointment and termination of the professional relationship with a founder but will be unable to obtain the required majority unless other founders switch allegiance and vote to terminate the relationship with one of their co-founders.
A good way to resolve this dilemma would be for the representatives of the investors to be entitled to serve a warning notice against a founder of whom it deems the performance unsatisfactory, setting forth in reasonable detail the facts and reasons why the founder fails to meet the minimum proficiency standards which may be expected from such founder. The founder would then be given a remediation period of e.g. 3 months to address any performance issues. It is recommended to involve a professional, independent expert to objectify the assessment exercise.
At the end of the remediation period, the Board of Directors will assess whether the performance has sufficiently improved. If the answer is negative, it should be assumed that the co-founders on the basis of a professionally conducted assessment, will not simply protect their co-founder and vote against a termination of the relationship. The alternative would be for the investor representatives to be unilaterally entitled to terminate the relationship by forcing all founders to recuse themselves from decision making. This is likely to meet strong resistance from all founders as they might all be subject of this procedure. In general, this issue is a temporary one, since there are few startups where founders keep holding the majority of the Board seats after having completed several financing rounds.