In a previous guide on raising seed capital in Southeast Asia, we discussed getting investor ready, including where Southeast Asian start-ups should incorporate their company, founder arrangements, and group structure.
In this guide, we talk about how to structure seed investments, the key terms and documentation, and how to go about finding investors.
Many seed investment rounds in Southeast Asia complete using convertible note instruments like the 500 Startups Keep-It-Simple-Security (KISS). These are unsecured debt instruments that convert to equity when a company completes its next equity raising.
The KISS is the most common type of convertible note used in Southeast Asia. If you are contemplating a seed round, we suggest you upskill on this document by downloading a version of the KISS adapted for Southeast Asia from our website.
There are other forms of note in use in Southeast Asia, including US style documents. With these documents, US specific provisions need to be amended, e.g. removing US securities law and taxation language which shouldn’t be relevant for a non-US issuer.
Convertible notes anticipate that the investment amount is drawn down either in a lump sum on one date or, more likely, over a period of time. The investment amount typically automatically converts to equity on the date of a qualifying capital raise at a discounted price to the next round price, but subject to an overall valuation cap.
If not already converted, the debt may be repayable (potentially at a multiple of the outstanding amount) or convertible at the noteholder’s discretion:
- on the occurrence of a liquidity event, i.e. the sale of your company
- at the maturity date for the note. This is often at least 18 months from the initial drawdown.
Convertible notes have been successful in Southeast Asia partly due to the availability of series A money. This gives noteholders comfort that you are likely to raise follow-on capital quite quickly, which triggers conversion of the note into equity.
key features of convertible notes
|Investment Amount||The amount to be invested by the investor (noteholders)|
|Series||Notes of a particular series are issued on the same terms. Typically, you may have a period of time to issue further notes on the same terms without seeking the consent of existing noteholders. The total investment amount is sometimes drawn down in a lump sum on one date or over a period of time with multiple closings|
|Interest||This is the annual rate at which interest accrues on the note whilst it is outstanding. In Southeast Asia, the rate varies, but usually is a low amount, e.g., 1% or 2%|
|Maturity Date||This is the date on which the debt is due for repayment. This should be a reasonable period of time from the date of the note, so that the company can achieve the qualifying capital raise (see below) to trigger conversion. In Southeast Asia, periods to maturity are generally set at 18 months and can be longer. Usually, if the company is unable to raise money before maturity, the majority of noteholders can elect for the debt to convert to shares rather than demanding repayment|
|Qualifying Amount||The investment amount of the notes will automatically convert into shares at the time of the company’s next capital raise. There is normally a minimum amount that must be raised to trigger conversion (called a qualifying capital raise), which is set to ensure that the raise is a legitimate company financing, not a device to trigger conversion|
|Discount||Assuming the company’s next financing round is a qualifying financing, the notes will automatically convert into shares often at a discount to the share price paid in that financing. The discount is intended to compensate investors for the risk they take on by investing at an early stage. In Southeast Asia, this discount is typically 15-25%. This follows Silicon Valley norms|
|Valuation Cap||This addresses an initial concern that investors had with the KISS style and other convertible notes – that the company’s valuation could increase significantly and they would only have the protection of the discount to the price of the next funding round. The valuation cap effectively caps the price at which investors pay for their shares when the note converts. If your company raises a financing round at a $5 million pre-financing valuation but the convertible notes have a $2 million valuation cap, your note holders will effectively receive a 60% discount to the price that the new investors are paying. So consider a valuation cap carefully as it can have a significant dilutive effect on the next round of financing if set too low|
|Majority-in-Interest||This term simply means those noteholders holding a majority of the total investment amount of the series. It is useful to incorporate this concept into the document so that key decisions are taken, or rights waived, not by individual investors but on a majority rules basis|
convertible notes vs equity
There has been a lot written on this topic. For a founder’s take on the debate, have a look at the blog Seedinvest: Pros and Cons of Convertible Notes or 500startups KISS blog post. For an investor point of view, Jason Lemkin’s SaaStr blog post An insiders’ guide to convertible debt vs equity is good read.
From a founder’s perspective, the biggest benefit of convertible notes over an equity financing is speed. The note is generally a single document with simpler terms to negotiate, and without lots of conditions, representations and warranties. In addition, the KISS and other most convertible notes are designed to be executed by individual investors, so it is possible to receive funds without closing with all investors simultaneously.
Other benefits of convertible notes include:
- postpones the difficult discussion about the company’s valuation. It is hard to value start-ups early on. Deferring the valuation until a larger equity round is raised is one way to address this. Also, if a third party is prepared to invest at a particular point in time and valuation, it provides some level of market evidence of the valuation for the notes.
- lower cost to execute. Convertible notes are simple and flexible. It involves a single document, whereas even small equity investments can involve a subscription agreement, shareholders’ agreement and a new constitution
- fewer representations and warranties. Subscription agreements often include multiple representations and warranties which are inappropriate for an early stage start-up. A convertible note generally includes only a handful of very focused warranties, avoiding protracted negotiations and unnecessary time spent on disclosure by the company
- concedes much less control. Noteholders typically receive little (if any) control over the company, e.g. no veto or director appointment rights. This works well with the need for start-ups to pivot and to raise the next round of funding without investor interference. Because notes provide this flexibility, there has been good success rate of note financed companies raising a series A follow-on round
- less administrative burden. The fewer shareholders you have, the less shareholder notices and other company secretarial formalities you have to deal with.
However, there are some downsides to convertible notes from a founder’s point of view:
- convertible notes are debt. The clock starts running towards repayment on the maturity date. If you have not completed a qualifying capital raise by that date, the debt needs to be repaid. While it is uncommon for investors to enforce that right and force the winding up the company if the debt cannot be repaid, you may have to renegotiate some form of refinancing with note holders
- preference shares generally issued on conversion. Most convertible notes convert into the class of shares issued to the investors on the next round of financing. In Southeast Asia, this means preference shares. As a result, convertible note investors have the double protection of both a price discount on conversion plus the liquidation preference negotiated by the lead follow-on investors
- disenfranchised investors. Convertible notes have valuation caps and often don’t include information or participation rights in later financings. This means convertible note investors are not as involved in the business as they might be by owning equity. But, start-ups need all the help they can get, so make sure that your note holders are real supporters of the business and can potentially help bring in the next round of funding
- additional protections. Finally, convertible notes can sometimes include additional protections for noteholders, such as participation rights, additional reporting from the company, and a most-favoured-nation provision (which gives noteholders comfort that they will receive a replacement convertible note if one is subsequently issued on better terms). Avoid these if possible, but if investors insist on them, ensure that they can be waived by a majority of the note holders.
Notes carry some uncertainty, particularly if follow-on money is unavailable, But in Southeast Asia, they remain a very effective tool, predominantly due to how quickly deals are closed – we have seen convertible note financing rounds closed in Southeast Asia in a few days. For start-ups looking to raise money fast and get on with growing the business, this remains a key factor.
Convertible notes are not always an option since some investors prefer the certainty of equity even on seed rounds.
If the amount being raised is not significant then it is in everyone’s interests to keep the documentation simple and get the round closed quickly. Try to avoid “Series A” terms and documentation as this is likely to be overkill and is likely to limit your flexibility both in terms of how you grow your business and how you raise further capital.
Keep the following tips in mind:
- issue ordinary shares – as soon as companies start issuing preference shares, the deal becomes more complex with discussions on liquidation preferences, conversion mechanics, and anti-dilution rights
- aim to keep the subscription agreement (which sets outs the mechanics and terms of the investment) simple. Ideally, include only a limited set of representations and warranties covering items such as compliance with reporting obligations, IP ownership, and confirmation of no claims
- put in place only a simple shareholders’ agreement which contains fundamental rights and obligations for the governance of your company (e.g., information rights, pro-rata participation rights in future financings, and non-competes). Avoid any investor consent rights so that investors do not need to be consulted except for significant capital expenditure or a material change in the direction of the company
- avoid amending the company’s articles of association or constitution (as applicable) – this should be possible as long as you avoid issuing preference shares
- aim to have the company’s lawyer prepare the documents as this usually ensures reasonable first drafts can be presented.
All seed capital raising transactions in Southeast Asia require corporate authorisations which your company secretary will need to complete.
E.g., in Singapore, directors’ and/or shareholders’ resolutions will need to cover:
- approval of all the transaction documents, including any convertible note or the subscription and shareholders’ agreements (as applicable)
- adoption of the new constitution or articles of association of the company (if required)
- the issue of the subscription shares to the investors
- the appointment of any investor director(s) to the board of directors
- an obligation on the investors to pay the subscription monies to the company’s bank account
- approval and execution of any service agreement if founders are to become executive directors of the company.
Aside from the transaction documentation, ACRA requires that Singapore based company secretaries carry out stringent know-your-client (KYC) checks on new shareholders.
You should plan for this early in the process to ensure that this investor KYC documentation does not hold up closing the deal.
There are now over 25 active venture capital funds based out of Singapore focused on the Southeast Asia region. Many of these funds have participated in seed investment rounds as well as larger follow-on capital raisings.
Tech-in-Asia have provided a useful directory of VC firms and angel investors with a presence in Singapore that have been investing in start-ups in the last few years. Some of these funds were supported by the Singapore government through the National Research Foundations Technology Incubation Scheme (NRF TIS) and the Early Stage Venture Fund (ESVF). The NRF continues to evolve with the future ESVF initiatives being announced in early 2016. Further information can be found on the NRF’s website.
In addition, you can meet potential seed investors through various accelerators and incubators in Singapore, e.g. SPH Plug and Play, Joyful Frog Digital Incubator, Muru-d and Startupbootcamp, the latter of which focusses in the area of fintech. e27 have compiled a more complete list of Singapore accelerators and incubators.
LaunchPad, also known as Block 71, is a start-up cluster in Singapore that the government plans to become home to up to 1,000 start-ups. Aside from incubators, accelerators, and other start-up support services, you may find some potential seed investors as part of that cluster.
Finally, Singapore has a significant density of high net worth individuals (HNWs). However, many of these HNWs have made their wealth from traditional industries or property, and have never worked in tech. Working with investors who are new to the tech industry can be difficult, both before and after completing an investment transaction.
Companies raising money from investors are promoting the issue of securities and must comply with local securities law in the jurisdictions where the investors are based. For Singapore issuers, the Securities and Futures Act (Cap. 289) requires that all offers of securities be accompanied by a prospectus unless the offer is subject to an exemption. Fortunately, the Act provides for many exceptions for private placements and other share issues.
These exemptions include (amongst others):
- small personal offers where the total amount raised from such offers within any 12 month period does not exceed SGD5m or such other amount prescribed by the Monetary Authority of Singapore (MAS)
- an offer to no more than 50 persons within any period of 12 months and under certain conditions
- certain offers of securities of an entity made to existing members or debenture holders of that entity
- an offer to qualifying persons like employees of the corporation or its related corporations under the specified conditions
- an offer to institutional investors
- an offer to specified persons, including accredited investors
Further information can be found at: