Kiwis are great at bootstrapping businesses. This is borne out of necessity. On the whole, risk capital is only available in small amounts, so resourceful entrepreneurs have to do a lot with a little.
However, for most New Zealand tech startups, bootstrapping will only take them so far before it becomes a constraint on growth. In order to exploit market opportunities, particularly those outside New Zealand, even the most careful bootstrappers need to raise external capital.
We covered the basics of finding investors in our getting investment ready guide. In this guide, we focus on what happens once you have found some willing investors – negotiating and completing the investment deal.
Because the Kiwi startup scene is relatively young, the vast majority of tech company founders are first timers. This means that raising a seed or Series A round is a new experience for them. First time founders face a steep learning curve in what can be quite a stressful process, and they will often find themselves at a disadvantage when dealing with investors who have past deal experience to draw on.
This guide is intended to help founders bridge this experience gap, both in terms of helping explain the mechanics of capital raising transactions and by providing some guidance on the negotiation of investment terms.
The key thing to communicate, negotiate and agree up front with your potential investors is your company’s ask. Your ask is essentially the amount of money you are raising, your company’s valuation and the form of the investment (either some form of equity or convertible debt). You will commonly discuss this with investors before you start negotiating a term sheet.
As mentioned in our getting investment ready guide, valuation is a key element in your investment deal. You should of course strive to achieve a good valuation, but remember that the harder you negotiate on price the tougher the terms your investors are likely to seek (since this improves the investors’ chances of achieving their targeted returns).
Just as important as your valuation is the amount of money that you are raising. Many founders do not want to raise too much money at the lower valuations typically given to early stage companies. While understandable, we generally recommend raising as much money as possible as fund raising is hard, time consuming, expensive work and the fewer you have to do the better. Also, you are likely to get a higher valuation if you are raising a larger amount of money (since the bigger war chest increases the chances of success).
The large majority of early stage investments into NZ tech companies are equity investments (i.e. new ordinary shares or new preference shares). However, we are starting to see an increased use of convertible debt, particularly for small seed rounds.
Very briefly, convertible debt usually takes the form of a loan where:
- the amount of the loan automatically converts to shares on the completion of a future funding round of sufficient size. The price per share of the conversion is determined by reference to the price per share of that later round, usually at a discount of 10-20% (and subject to a maximum valuation cap)
- if a subsequent funding round is not successfully completed by an agreed date (say 12 months from the date of the loan), the investors can choose to convert the loan to shares at a pre-agreed price (normally quite low to reflect your company’s failure to raise further capital). If the investors do not choose to convert, the loan becomes repayable in cash on demand.
We think that in the NZ context, this type of convertible debt is often well suited to smaller seed rounds (say less than $300k) as it is simpler and cheaper to negotiate, document and complete than most straight equity investments. This is because:
- the often contentious issue of valuing an early stage tech company is deferred until the negotiation of a later funding round (at which point it should be easier to determine a fair valuation for a more mature company). Negotiations on valuation are therefore limited to the valuation cap and discount referred to above
- the negotiation of the investors’ preferential rights is avoided entirely. The debt simply converts to the highest class of shares that are issued as part of the next funding round. The cost of negotiating and documenting these rights is usually far more palatable in the context of that larger funding round.
Once you have communicated your ask, assuming your investors are keen, the next stage will hopefully be the negotiation of a term sheet.
Term sheets summarise the material terms of an investment deal. While not legally binding for the most part, it is pretty difficult to get investors to give ground on anything included in the term sheet. The term sheet is where most of the value in a deal is won or lost, so you need to bring your A game to the negotiation table.
We encourage founders to:
- learn as much as possible about tech investment deals before talking to investors. Brad Feld’s book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist is a good starting point – although the US terminology is a bit different to NZ terminology, many of the underlying concepts are directly applicable here.
- get an experienced, founder friendly lawyer to help with the review and negotiation of the term sheet. First timer founders will have limited experience to draw on regarding current market practice, which leaves them vulnerable to investors who insist that particular terms are just standard. Also, founders may not appreciate the significance of some of the wording in a term sheet since there is quite a lot of shorthand used on important commercial points.
On the topic of lawyers, some investors encourage founders to rely upon lawyers nominated by the investors to draft the term sheet and investment documents. In New Zealand, this is most common in transactions involving NZVIF co-funding, the rationale being that the documents are industry standard. This is dangerous territory for founders – they need to realise that investors will generally be nominating lawyers who are friendly to them. These investor friendly lawyers are not likely to propose amendments to NZVIF’s standard terms to get a better deal for founders.
The term sheet will record your valuation, the investment amount and the investment structure (i.e. your ask).
It will also contain a bunch of other deal terms, the most important being those that give your investors:
- control rights (e.g. board composition and veto rights)
- economic rights (e.g. liquidation preferences and anti-dilution protection).
Generally speaking we think that control rights are more important than economic rights. Control rights determine your ability to run your company and to drive its growth, including via the raising of further capital to fund that growth. Economic rights determine the return that investors (eventually) get on their investment in particular scenarios.
Terms that do not go to control or deal economics (e.g. information rights or board observation rights) are usually of lesser importance and not worth tipping the apple cart over for.
With this in mind, we discuss below the control rights and economic rights that NZ investors commonly seek in term sheets.
board appointment rights
Board composition is one of the most important provisions in your term sheet.
Investors will usually want the right to appoint at least one director to your board to represent them at the board table. Assuming that you are raising money from investors who have relevant experience, expertise and contacts to offer your company in addition to capital, this should be a win-win for you and your investors.
As long as the appointment rights of an investor group are linked to maintaining a minimum shareholding percentage (e.g. 20%), and the investor directors are in the minority at the board table, these rights should not cause significant problems for you.
However, some investors want more than just a seat at the table – they want an equal say in board decisions (i.e. half of the board seats so that no decisions can be made at the board level without their consent). This is often accompanied by a requirement to appoint an independent director or chair, on the basis that this will avoid deadlocks.
We recommend that founders be very cautious when investors seek this level of board representation, since in both situations founders effectively give up control of their company:
- when founders and investors sit on a tied board, the founders (as the management team running the company) effectively need the consent of their investors for all decisions concerning the company and its business. This level of negative control gives investors an extraordinary amount of leverage over founders, which they can use to force founders to abide by their directions
- when an independent director or chair is the swing voter on a board, founders can find themselves outvoted on major issues concerning the business or the company – including on issues that are of fundamental importance to the founders. Investors will argue that this is reasonable because the independent director will vote in the best interests of the company, rather than in the interests of either the investors or the founders. However, what is in the best interests of the company is a subjective matter, and in our experience investors are often more skilled at convincing independent directors that their views are correct than founders are. Also, there is a tendency for neutrals involved in a company (such as independent directors and professional advisers) to align themselves with the views of investors.
There is no cookie-cutter solution to this issue as the appropriate composition of your board will depend upon the nuances of your cap table, both before and after the investment. The only over-riding advice we can give is to try and retain control of your board if you can, and if you are unable to, try not to give control directly to your investors.
protective provisions (veto rights)
Most investors will want veto rights over material actions of your company. From your point of view, minority rights of veto over the conduct of your business potentially limit the commercial freedom of your company and, in a worst case scenario, give the minority a level of negative control over the company.
As with director appointment rights, any rights of veto would ideally cease to apply if the shareholding of the investor group falls below a stated percentage.
The types of actions over which investors may request a veto can vary quite significantly from deal to deal, but some of the more common are set out in the table below, along with our thoughts on each:
|Any issue of new equity in your company (including the issue of any new shares, options or convertible debt).||It is critical that your board has the power to raise further capital when required without any party having a unilateral right of veto, especially since the NZ tech growth company model almost always involves future funding rounds. Investors do not need this right of veto if the term sheet provides for pre-emptive rights on new share issues and anti-dilution protection.|
|The adoption of annual budgets or business plans, and any material departures from them.||As the adoption of budgets and business plans are important operational matters for your business that affect all shareholders, we would normally recommend that the investors are required to act reasonably in respect of any such decision.|
|Any borrowing by your company.||This veto right is normally limited to borrowings over a material amount (say $25,000).|
|Any appointment or removal of the CEO, CFO or similar key employee of your company.||Similar to the annual budget, these are key operational decisions for your company and the investors should be required to act reasonably in all cases.|
|Any significant change in the nature of your company’s business.||This is standard for NZ early stage investments.|
pre-emptive provisions (new shares)
Pre-emptive rights in respect of share issues mean that any new shares in your company must first be offered to all of your existing shareholders (in proportion to their existing shareholding) before they can be offered to any other person. This allows existing investors, and other shareholders, the opportunity to maintain their percentage stake in your company.
Ideally your company would not have pre-emptive rights as they add time and uncertainty to any fund raising process. When a capital raising needs to be completed under time pressure, pre-emptive rights can be particularly problematic since a waiver of these rights will be needed from each investor. This can give individual shareholders an effective right of veto in these circumstances.
Despite the problems that pre-emptive rights can cause, NZ investors usually insist on them. However, your investors may agree to:
- limit the application of pre-emptive rights to down rounds (i.e. funding rounds undertaken at a lower price per share than that paid by the investors)
- allow a majority of the investors to waive the pre-emptive rights, avoiding the need to get a waiver from every investor no matter how small their shareholding; and/or
- limit the pre-emptive rights to material investors only.
In all cases, share issues under an employee share or share option scheme that is approved by the board should be exempted from the pre-emptive rights provisions.
tag and drag along rights
Drag along rights apply where a supermajority of shareholders wish to sell their shares in your company. Those selling shareholders are able to force any of the remaining minority to also sell their shares in the company, on the same terms and to the same buyer.
A sale of at least 75% of all shares is the usual starting point for the application of a drag along right. This is because 75% is the approval threshold under the Companies Act 1993 for major transactions (i.e. 75% of shareholders can approve a sale of the entirety of the business and assets of your company, so it makes sense that they can also force that same outcome in the form of a share sale). It may still make sense to vary this percentage of course, depending on the particular shareholdings of your company (60% is not an uncommon position).
You will generally want to set the drag along threshold high enough so that as founders, you cannot be compelled to sell your shares until you are ready to do so. However, keep in mind that when you want to sell your company, if you have set the drag along threshold too high, you may not be able to compel a minority shareholder to sell, which could stop a potential exit transaction in its tracks.
Tag along rights entitle minority shareholders to sell their shares (on the same terms and to the same buyer) if a large enough shareholding in your company is being sold. The starting point for triggering a tag along right is often 50% of all shares, on the basis that a change in control is the logical trigger for providing minority shareholders with a right to exit a company.
tranches and milestones
If possible, avoid your investment funds being paid against milestones. Early stage companies rarely develop according to plan, and milestones that make sense today are quite likely to become less relevant or in some cases even pointless as circumstances change over time.
The worst case scenario is that you are faced with a choice of pursuing milestones that no longer make commercial sense, or to go cap in hand to investors seeking the waiver of a milestone. It is not uncommon in the latter scenario for investors to require concessions from your company in return for the requested waiver, e.g. a reduction in the valuation of your company for the purposes of that milestone payment or the granting of additional preferential investor rights.
If your investors insist on milestones, make sure they are realistic and achievable, and do your best to ensure that they will continue to be relevant, even if your business plan changes over time.
A liquidation preference is intended to provide investors with some downside protection if your company is either sold or wound up. On the occurrence of either of these liquidity events, the investors are entitled to receive an agreed amount of the proceeds before any money can be paid to any of the other shareholders.
There are a number of different ways to structure a liquidation preference but (to the extent that that they are provided at all) it is most common in NZ to provide a 1x non-participating liquidation preference only.
Under a 1x non-participating liquidation preference the investors are (in effect) entitled to receive the higher of:
- the original amount of their investment (before the remaining proceeds from the liquidity event are shared amongst the other shareholders); or
- their pro rata share of the proceeds from the liquidity event (according to their percentage shareholding in your company).
The next most common form of liquidation preference in NZ is a 1 x non-participating preference with an additional preferential return based on a cumulative dividend rate. We recommend avoiding this type of liquidation preference unless your company has a very short route to exit. Otherwise, even at something like an 8% cumulative dividend rate, these types of provisions can make it hard for founders and early investors to get a return on their investment following an exit.
In NZ it is uncommon for investors to receive a participating liquidation preference, i.e. where investors have a preferential right to the original amount of their investment and then also share proportionally in the rest of the proceeds of a liquidity event. It is also rare for NZ companies to grant anything other than a 1x liquidation preference (where a 2 x liquidation preference would grant investors the preferential right to receive twice the original amount of their investment).
Anti-dilution rights are a mechanism for protecting investors from later down rounds. There are different types of anti-dilutes, but all involve the issue of additional free shares to the investors in accordance with a formula.
Many NZ early stage investors require anti-dilution protection, and it is a requirement of any investment deal that NZVIF participates in.
If your investors want an anti-dilution provision, we recommend you focus on ensuring that:
- it is based on a weighted average ratchet rather than a full ratchet. A full ratchet re-prices the investors’ shares to the lowest price of any later share issue, regardless of the number of shares issued and regardless of the reasons for the lower pricing, whereas a weighted average provision makes the number of free shares issued to the investors in a down round proportional to the number of new shares being issued in the round
- the provision does not apply in the case of rights issues (i.e. share issues where all shareholders are able to participate in proportion to their existing shareholding in your company) as investors are able to protect their investment by participating in the rights issue and taking advantage of any discount offered (this principle is sometimes referred to as pay to play)
- the provision does not apply to shares issued under an employee share or option scheme.
The difference between a weighted average anti-dilute provision and a full ratchet provision is discussed in our blog on anti-dilution provisions. The short version is that you should avoid a full ratchet like the plague as it can result in investors being materially overcompensated, and can effectively wipe out the founders, even when undertaking a tiny down round.
Investors may request that a percentage of your shares (and the shares of any other founders that are key to the business) become subject to founder vesting.
The effect of founder vesting is that you and the other key founders must remain employed by your company for the full vesting period (often around 3 years) if you are to retain ownership of all of your shares. The idea from the investors’ perspective is to encourage key people not to leave the employment of your company in the short to medium term.
In an ideal world founder vesting is something that founders will have already considered and, if necessary, addressed between themselves (for an example co-founder agreement with vesting arrangements see our template short form co-founder agreement).
Whether or not investor driven founder vesting is reasonable depends upon the level of investment the founders have made in the company (in terms of money, IP and time) up to the date of investment. If the company has been operating for some years, or if the founders have already invested a significant amount of money in the company, introducing founder vesting at this point could be pretty harsh. On the other hand, if the company is relatively young, introducing founder vesting may well be in the interests of the current team of founders as well as the investors.
A compromise that is often reached between founders and investors who require founder vesting is to exclude a percentage of each founder’s shares from the vesting arrangements. The percentage of shares excluded from vesting should be greater for companies that have operated for longer, or to which founders have contributed more cash.
Be aware that there is a potential ugly side to founder vesting (regardless of whether it is driven by founders or by investors). These arrangements can create an incentive for a group of founders and/or investors to push out unpopular founders during the vesting period, since this increases the percentage shareholdings of the remaining founders and investors.
Your term sheet will often state that the final investment documents are to contain usual warranties for an investment of this type (or similar wording). We don’t think it is worth getting too hung up on warranties, particularly with early stage companies, since it should be relatively easy for you to ensure that the warranties are accurate or appropriately disclosed against.
We do, however, think it is worth addressing the following points at the term sheet stage:
- aim to have the warranties given by your company only and not by the founders. This is accepted by many investors. If your investors insist that the founders give warranties alongside the company, limit the liability of each founder to an amount they can afford to pay without jeopardising their financial stability (e.g. $10,000)
- state that the warranties will be subject to usual limitations and exclusions of liability.
transaction fees and legal costs
If you are receiving investment through an angel group the proposed term sheet may include a transaction fee. The transaction fee sought by angel groups is up to 6% of the funds raised, although this percentage can be negotiated down depending on the circumstances.
It is also not uncommon for investors to request that your company reimburse their legal and professional costs relating to the investment. If you accept this arrangement ensure that the costs are limited to a reasonable maximum amount ($10,000 plus GST is common for angel deals), and are payable only if the investment is completed.
Once you have negotiated, agreed and executed your term sheet, the next step is the preparation of the detailed, legally binding, formal investment documents. Those documents will usually include a subscription agreement, a shareholders’ agreement and a new constitution.
In a perfect world, where you have a well drafted term sheet that covers all of the material terms of your deal, it would be a largely mechanical exercise for the lawyers to prepare the full investment documents.
In reality, there is often a reasonable amount of additional negotiation at this stage around:
- additional rights or obligations in the detailed investment documents that were not agreed at the term sheet stage
- mechanical matters – e.g. how the pre-emptive rights process is to work in practice (best to just let the lawyers sort this out as efficiently as possible!)
- details that were specifically left for drafting and negotiation at this stage, typically the full set of warranties and sometimes the full list of investor veto rights.
The amount of time (and cost) required to get to final investment documents will vary significantly from investor to investor and deal to deal but you should at least plan for the drafting and negotiation of the documents to take weeks not days.
Conditions precedent is a term used to describe all of the actions that need to happen after the signing of your investment agreements but before you can complete the deal and receive the funds. A list of those conditions will usually be included in the term sheet and (in more detail) the investment agreements. They are often tidy up matters, so the cleaner your company the fewer conditions precedent you are likely to see, and the smaller the gap between signing and completion.
Conditions precedent can include:
- the final approval of each investor’s board of directors (or other governing body)
- the completion of the investors’ due diligence review of your business, and the investors being satisfied with the results
- the agreement of a business plan for your company with the investors
- key employees and contractors executing documentation confirming that they have transferred any relevant IP that may have been held by them to your company
- the execution of employment agreements with your key employees (including non-compete provisions)
- the conversion of any outstanding shareholder loans to shares in your company
- agreement on the implementation and scope of an employee share option plan or similar.
Most investment agreements will include a long stop date by which the conditions precedent are to be completed. If that is not the case, the person for whose benefit the condition was inserted (usually the investors) can elect to waive the condition, extend the long stop date, or cancel the investment. A typical long stop date is 30 days following the date of the subscription agreement but a different time period may be appropriate depending on the nature of the conditions precedent.
In most cases the completion date for an investment will be determined by reference to the satisfaction or waiver of all of the conditions precedent (often taking place 1 to 3 business days following such satisfaction and/or waiver).
The investment documents will set out the actions to be taken by each party in order for completion to occur. A typical list of completion requirements for each party would include:
Delivery to the investors of:
- all board and shareholder resolutions, certificates and/or consents required to authorise the issue of new shares to the investors. For a full breakdown of the various resolutions, certificates and consents you may require, see our template directors’ resolutions to approve share issues and shareholders’ resolutions to approve share issues
- a resolution of shareholders adopting the company’s new constitution, see our template resolution to amend a constitution
- the new shareholders’ agreement, signed by your company and all existing shareholders
- a certified (i.e. signed by a director) copy of your company’s share register recording the investors as shareholders in your company, see our template company share register.
Payment of the investment funds into the nominated account of your company, and delivery to your company of:
- the new shareholders’ agreement, signed by the investors
- the written consent of the nominated investor (or other person nominated by the investors) to act as a director of your company.
Post-completion you will usually need to update your company registers and your records on the companies office website to reflect the issue of the new shares to the investors, the appointment of any investor nominated director, and the adoption of the new constitution of your company.
All offers of equity in New Zealand (including offers of shares, options or convertible debt) are regulated by the provisions of the Financial Markets Conduct Act 2013 (FMCA).
The disclosure requirements of the FMCA relating to offers of equity are substantial and come with material responsibilities and risks for both your company and its directors. The disclosure requirements automatically apply to all equity offers unless one or more of the exclusions in Schedule 1 of the FMCA apply.
Due to the cost and risk associated with complying with the FMCA’s disclosure requirements, early stage companies will only make offers to investors who fall within one or more of the exclusions categories. The good news is that professional investors will almost always qualify (although in some cases you will need to ensure that the documentation and/or disclaimers prescribed by the FMCA are in place in order for a particular exclusion to apply). The bad news is that the exclusions are a muddle and hard to apply in practice, so you can expect some pain as you work through the process of ensuring that each of your investors meet the requirements of a particular exclusion.
A detailed summary of the relevant FMCA exclusions, and any associated documentation required, is set out in our guide to securities law private offer exclusions.