Whilst your seed investment round may have been done quickly with a convertible note or short form equity financing documentation, closing a follow-on or series A funding round will be a bigger task. It usually involves an equity capital raise with several investors, including one or two lead institutional investors, so the investment documentation inevitably takes longer to agree.
The rapid acceleration of the tech start-up funding environment and the type of international investors involved in Southeast Asia means that entrepreneurs have needed to get up to speed on globally accepted venture capital (VC) investment terms – often heavily influenced by Silicon Valley.
This guide for tech start-ups is based on our experience of advising on many series A and larger follow-on capital raising rounds for companies and investors in Southeast Asia. If you are raising a pre-series A round, check out our guide to raising seed capital in southeast asia.
If you are raising money from investors, you are promoting the issue of securities and must comply with the relevant legal requirements in all jurisdictions where the investors are based. For Singapore issuers, under the Securities and Futures Act (Cap. 289), all offers of securities must be accompanied by a prospectus unless the offer is exempted. Fortunately, that Act provides many exceptions for private placements and other share issues. See our guide to raising seed capital in southeast asia for further information on securities law for the issue of shares to investors. Complying with securities law is just as applicable to a series A round as it is when raising seed capital.
Expect a more structured due diligence process before receiving series A money as compared to seed investments. We suggest setting up a dropbox of documents, ordered with headings and an index (see our template southeast asia due diligence checklist which will help you put together the documents). This will speed up due diligence not only for the current series A deal, but any future financing round.
For businesses operating in more than one Southeast Asia jurisdiction, prepare early for the due diligence process on a series A round. With less publicly available documentation in jurisdictions such as Thailand, Indonesia, Vietnam and the Philippines, investors will want to take local advice and understand the risks. If intellectual property (IP) has been developed by personnel across a group of companies, investors will want to see evidence that the IP has been legally assigned to the parent company. Finally, there may be minimum capital requirements or foreign ownership restrictions to consider at country level depending on local law requirements.
VCs see a large number of investment propositions in Southeast Asia. A recent presentation from Google and Temasek suggested that Southeast Asia has up to 7,000 start-ups. As institutional venture capital money flows into the region, valuations have risen. Some exciting tech companies in Southeast Asia have raised money at big valuations, particularly in the mobile and e-commerce space. But Southeast Asia is still a young market compared to the US. A high valuation in early stage rounds can put off investors because it suggests the entrepreneurs involved are unrealistic and will be difficult to deal with in future capital raisings or on exit.
Term sheets record the investment amount, structure and other material terms of an investment deal. The term sheet for a series A deal is normally non-binding and prepared by the lead investor. Term sheets in Southeast Asia tend to fall into two categories: long form term sheets, which set out in detail the key transaction terms; and short form 1-2 pagers which are more high level. The latter seems more appealing on first glance, but the downside is that you will probably end up spending a lot of time later in the negotiations discussing key issues which could have been addressed at the outset.
Term sheets can contain very broad phrases such as customary warranties and indemnities, founder vesting arrangements and standard exit default rights. If you’re unsure what these mean, it’s a good time to chat to an experienced VC lawyer. These concepts can have a big impact on who carries the risk (the company or you personally) and the level of any liability, the time periods for claims, and the remedies for investors. Whilst term sheets are non-binding, it is difficult to renegotiate an issue in the main series A investment documents if it conflicts with the term sheet. So it pays to put the effort in up front in the term sheet where you can.
Most investors will want exclusivity under the term sheet for an agreed period. Ideally, this should not be more than 45 days from the signing of the term sheet, so you can move on quickly if the deal does not close for any reason.
Our template southeast asia series A term sheet is a good example of the terms for a series A investment round in Southeast Asia.
If your priority is getting on with building a funded business, it pays to focus your attention on the critical investment terms and not to sweat the small stuff.
We suggest that you focus on:
- the economic rights (e.g. valuation, liquidation preference, anti-dilution and share vesting)
- the control rights (e.g. board composition and investor veto rights).
Other terms are usually less important and you shouldn’t spend lots of time negotiating terms that have relatively little benefit overall.
With that in mind we set out below a summary of the issues that you will want to focus on.
investment amount and class of shares
The term sheet will set out the total investment amount and a pre-money valuation for a certain percentage on a fully diluted basis. It is essential that you understand, and the term sheet accurately sets out, the company’s valuation, the cap table and the impact of any new or enlarged employment share option plan (e.g. whether the allocation for any employee share option plan (ESOP) is based on a pre or post-money basis). For clarity, you should attach the agreed cap table to the term sheet.
Investors on a series A round in Southeast Asia will expect to be issued preference shares which take priority over the ordinary shares in several respects (e.g. through a liquidation preference and anti-dilution protection) and carry additional control rights.
If possible, avoid the investment funds being paid in tranches against milestones. Early stage companies rarely develop according to plan. Milestones that make sense today are quite likely to become less relevant over time. If an investor insists on milestones, make sure they are realistic and achievable.
The term sheet will set out the proposed board composition. Investors (jointly or possibly the lead investor alone) typically want board representation. Observer rights (under which investors can attend board meetings in a non-voting capacity) are sometimes offered as a compromise to a director appointment.
Typically, only one investor nominee director is appointed on a series A round.
Occasionally investors 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, to avoid deadlocks. Remember that the board is responsible for managing the company. Given this, founders should be cautious when investors seek equal board representation, since it will see founders effectively give up control of their company:
- when founders and investors sit on a tied board, the founders 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
- when an independent director is the swing voter on a board, founders can find themselves outvoted on major issues concerning the business or the company. Investors will argue that this is reasonable because the independent director will vote in the best interests of the company, rather than in favour of either the investors or founders. However, in our experience there is a tendency for independent directors to align themselves with the views of investors.
Finally, any board appointment or observer rights should remain subject to the appointing investor retaining a shareholding above an agreed percentage (e.g. 10% or 20%). Founders also should retain the express right to appoint either themselves (or a nominee) for as long as they continue to hold shares
Investors will want veto rights over certain company actions, e.g. future share issues, related party transactions, the company incurring unusually large expenses or debt obligations, amendments to the constitution, changes to the board, majority ownership changes, or the sale or acquisition of any new business or subsidiary. In practice, this means you would need investor consent for those actions.
Even with a majority of directors on the board, veto rights and the inevitable investor interference can significantly reduce your control and distract you from the day job. We suggest that you approach this issue in two ways:
- consider streamlining the consent procedure so that only one or two lead investors (or alternatively a majority of the investors) are required to give consent. Ideally, this consent would be given by the investor nominee director at board level. Consent should not be required of all investors as this will stymie the company’s decision making
- limit the items that require investor consent. It is good practice to review the veto rights carefully so that they are fit for your company.
Resist items which might impede the company’s ability to:
- raise the next round of funding. It is critical that your board has the power to issue shares to raise further capital when required without any party having a veto
- change the annual budget, business plan or strategy (unless that change is material). And, for material changes, because these documents affect all shareholders, we think an investor should be required to act reasonably in respect of that decision
- hire and incentivise key people. The ability to hire key personnel and teams is fundamental and should not be unnecessarily restricted (e.g. by investor approval being required for the allocation of options under an ESOP). Any consent right on the appointment or removal of the CEO, CFO or similar key employee are key operational decisions for your company and the investor should be required to act reasonably
- set up in other territories. This is often a key business strategy that Southeast Asian tech start-ups present to their investors, yet the ability to do so remains restricted by investor veto. The investment documents need to align with the plans you have presented to investors.
In short, investors always expect some control over board actions at series A stage. However, investors understand the burden that seeking consent can impose on founders and are normally very open to negotiating the scope of veto rights.
A liquidation preference provides investors with some downside protection if your company is either wound up or sold (a liquidity event). The preference provides that, on a liquidity event, investors will receive a specified amount of the proceeds in priority to the ordinary shareholders. This preferential amount could be equal to the investment amount or possibly a multiple of it (often 1x or 2x). The remaining proceeds are then shared amongst either the preference and ordinary shareholders on a pro-rata basis (called a participating preference) or amongst just the ordinary shareholders (called a non-participating preference).
In terms of a quick analysis of liquidation preferences:
- a participating preference can significantly reduce the amount of proceeds that ordinary shareholders will receive on a liquidity event. As a result, sometimes the amount received by the preference shareholders is capped. The cap is typically set as a multiple (e.g. 2x or 3x) of the original investment. Once preference shareholders receive the fixed amount, they cease participating in further distributions with the ordinary shareholders
- under a non-participating preference, once preference shareholders have received their preferential amount, ordinary shareholders receive the balance of the proceeds. This means that if the proceeds of the liquidity event would return to preference shareholders at least their preference amount, their shares will convert into ordinary shares. In doing so, investors then participate alongside ordinary shareholders on an equal basis
- a 1x non-participating liquidation preference is therefore the best position for founders. This ensures that, on a liquidity event, investors participate on a pro-rata basis alongside ordinary shareholders as long as they receive back their investment amount
- multiple or participating liquidation preferences (or combinations of both) can have a significant negative impact on returns to founders.
As a general rule, most investors in Southeast Asia tend to accept 1x non-participating liquidation preferences on series A rounds.
Investors holding preference shares may convert these shares to ordinary shares. This a general right but there also will be certain events which cause automatic conversion (e.g. IPO or where a majority of the preference shareholders agree). Practically speaking, conversion normally occurs on an exit event.
Preference shares convert into ordinary shares at an initial conversion ratio of 1:1. This conversion ratio will be adjusted in accordance with anti-dilution rights (see below) with the result that investors may receive additional shares on conversion.
Anti-dilution rights protect investors when new shares are issued at a price which is lower than the price at which they invested (a down round). This protection operates to compensate investors for the dilutive impact caused by the issue of shares at the lower valuation. A formula is applied which determines a number of new shares which investors should receive on conversion. Alternatively, the mechanism can require the company to immediately issue shares for a nominal sum as a bonus issue. In Southeast Asia, the anti-dilution mechanism is typically dealt with by adjustment to the conversion ratio.
Anti-dilution protection comes in different forms, each providing investors with different levels of protection. E.g.:
- full ratchet: this re-prices investors’ shares to the lowest price of any later share issue, regardless of the number of shares issued and the reasons for the lower pricing. This is a blunt instrument, potentially providing investors with a windfall, so is generally considered unfair to founders
- weighted average: this amends the price of the investors’ shares to the average price at which the company has issued its shares (including the issue of shares in the down round). This is much more company friendly than the full ratchet
- the weighted average mechanism comes in two forms – narrow based and broad based. The distinction is that a broad-based weighted average provision includes both the company’s shares on issue (including all ordinary shares to be issued upon conversion of the preference shares) as well as shares which could be issued by converting all other options, rights, and securities, including employee share options. A narrow-based mechanism does not include these other convertible securities and limits the calculation to shares currently on issue
- using a broad-based weighted average results in a higher conversion price for the holders of the preference shares. This is favourable to founders because, on conversion, fewer ordinary shares will be issued to investors, causing less dilution.
Our experience is that a broad based weighted average is the standard accepted by nearly all series A investors in Southeast Asia deals.
pre-emptive rights on new share issues
Where a company issues new shares, investors typically want the right to maintain at least their percentage equity stake on the same terms. The term sheet will set out the rights-of-first-refusal that investors and other shareholders will have if the company wants to issue new shares after the series A financing has closed.
If you need to raise capital quickly, pre-emptive rights can be problematic, since a waiver of the rights will be needed from each shareholder with pre-emptive rights.
Despite this issue, series A investors usually insist on pre-emptive rights. However, they may agree to:
- allow a majorityof investors to waive the pre-emptive rights, avoiding the need to get a waiver from every investor no matter how small their shareholding
- limit pre-emptive rights to major investors holding shares above a certain percentage of the total equity
- very rarely, limit the application of pre-emptive rights only to down rounds.
In all cases, share issues under an approved ESOP should be exempted from the pre-emptive rights provisions. We sometime see a further carve-out for shares issued as consideration to sellers on future acquisitions by the company.
Often, the other non-investor shareholders also want the right to participate pro-rata to their existing holdings on future share issues. Be cautious before agreeing to this as this can give an individual shareholder a right of veto on future equity financings.
If all shareholders have pre-emptive rights, we sometimes see smaller holders agree to sign up to limited powers of attorney at series A stage in favour of the board. This at least helps you execute a future capital raise without minor shareholders frustrating the transaction.
restrictions on share transfers
Series A investment documents often prevent founders from selling any shares for a set period of time. Try to negotiate that a small percentage of your shares fall outside of this restriction, (e.g. 10-15%) to enable some liquidity, noting that you will, in any event, be bound by a right-of-first-refusal (ROFR) on share transfers.
These rights require a shareholder wishing to sell shares, to first offer them to the shareholders who have that right on a pro-rata basis. You will need to consider who should benefit from the ROFR (e.g. only investors, or other shareholders too). It is common for founders to receive a pro-rata right alongside their investors. Alternatively, founders may have a secondary right to purchase shares offered for sale which investors do not take up.
The ROFR is usually subject to standard exceptions, including the right of individuals to transfer shares to relatives or for tax or trust administration purposes, or the right of corporates to transfer shares to affiliated companies within their group.
Many institutional investors will refuse to be bound by a ROFR. This is not ideal for a founder as a major equity share of the company could be sold to a non-strategic third party without the founder having a chance to purchase those shares. In those circumstances, a compromise right-of-first-offer (ROFO) can be agreed. This right carries considerably less weight than a ROFR. With this right, the investor is only required to notify the applicable shareholders that it is looking to sell its shares. This, in turn, presents an opportunity for the other shareholders to make an offer for the shares that is acceptable to the investor. However, the investor is not compelled to sell so ROFO is in effect no more than a right of negotiation.
co-sale right (tag-along)
If a shareholder wishes to sell shares that are the subject of a co-sale or tag-along right, the other shareholders who benefit from this right can require that the purchaser buy an equivalent percentage of their shares on the same terms and conditions. On Southeast Asian series A deals, investors expect to receive the right to participate pro rata in any sale of shares by founders to a third party. If founders wish to sell shares which would leave them with less than a certain percentage of the total number of shares (e.g. 20% in aggregate), co-sale rights typically allow investors to sell their entire stake in the company. As a result, these rights make it hard for founders to sell their shares. This is the intention of investors who have invested in your company on the basis of the management team leading the business. You might wish to seek an exception to this so that you can freely sell some of your shares (e.g. 10-15% of your total holding).
Co-sale rights are generally subject to pre-emptive and/or drag-along rights (see below).
A drag-along right requires all shareholders to sell their shares to a potential purchaser if shareholders holding a certain percentage of the shares agree to sell to that purchaser. These rights are important where a potential purchaser is seeking to buy 100% of the shares of the company. The trigger percentage for drag-along is often 75% but could be higher or lower. Sometimes, the exercise of the drag-along right is limited to a third party offer above a certain valuation.
Drag-along rights are not often seen in series A term sheets in Southeast Asia. Most investors do not seek such rights on the basis that they don’t want to be dragged themselves. Otherwise they could lose control over their future exit.
Separately, the board may want to require smaller shareholders to sell if an offer is received which the major investors have also approved. This will help administratively on the future sale of the company. In the absence of a drag-along right, you could ask smaller shareholders to execute powers of attorney in favour of the board covering future sales.
Share vesting provisions can have a big impact on founders. As investors are investing partly on the strength of the founder team, they often require a mechanism to claw back unvested shares from founders if they leave the business. Investors often require that 50%-75% of your existing shares be subject to vesting. Of those vested shares, 25% often vest after 12 months (the cliff) with the balance vesting in the following 2 or 3 years.
Vesting can affect your relationship with investors, but also with your other founders. Make sure that you are comfortable with how it works, including the length of the vesting period, the implications of a founder leaving, the circumstances of that departure, the price to be paid for vested or unvested shares if you depart, and how a change of control affects vesting (e.g. acceleration of vesting). In particular, if you are forced out of the company for alleged poor performance, you may be a bad leaver. This may result in you losing all of your shares for no value.
If a founder leaves, you might want to consider whether the remaining founders should be able to issue new shares up to such amount that has been repurchased by the company from leavers, outside of ROFR, e.g., through an increased ESOP allocation or by issue to the remaining founders.
Series A vesting arrangements in Southeast Asia typically involve the buy-back by the company of shares of a leaver. For Singapore registered companies, under the Singapore Companies Act, there are certain restrictions on company share repurchases. E.g.:
- the constitution must expressly permit repurchases
- a buy-back agreement must be approved in advance and the directors must be satisfied that, at the date of that agreement, the company is solvent
- no more than 20% of the total issued share capital can be repurchased in any 12 month period.
representations and warranties
Investors will want a full set of corporate and business warranties for the company and any subsidiary, to be set out in the subscription agreement. We suggest that you avoid:
- broad warranties which require you to confirm the accuracy and completeness of allinformation that you have provided
- forward looking representations and warranties, e.g. don’t warrant the accuracy of a business plan or an information memorandum which you have presented to investors.
Generally the subscription agreement will include an indemnity covering breaches of the representations and warranties and other obligations. Indemnities are fundamentally different from warranties. To bring a claim for a breach of warranty, investors would need to show that their shares were now worth less because of that breach. That is not required for an indemnity claim. This makes it easier for investors to recover from the company for breaches of indemnities so consider their scope carefully.
Most series A investment deals involve founders taking on some personal liability for claims. If liability is stated to be joint and several as between the company and the founders, investors can pick and choose who they take action against. E.g. if the company doesn’t have the resources, the investors can recover the full amount of the claim against any individual founder. As a protection, we suggest that investors be required to bring claims against the company first. Also, claims should ideally be brought only with the consent of the lead investor, to avoid one disgruntled small investor from creating trouble.
Investors may also seek remedies against founders personally if the company materially defaults. Get advice on this – it is important that you understand the risks of this and that you negotiate sensible limitations.
Investors tend to be open to including limitations on liability (including for breaches of indemnities and warranties). These limits might cover:
- monetary caps for both the company and the founders individually. We think a cap is especially reasonable for a founder as this is personal risk
- time periods to bring claims. In theory, investors should have discovered any claim after the first financial audit of the business, so try and limit the claims periods to 18 months
- representations and warranties being subject to disclosure.
Warranties are usually qualified by information that is fully and fairly disclosed in a schedule to the subscription agreement or a separate disclosure letter. This is a great protection for founders but is a key element of the transaction which is often forgotten about until just before closing. Our advice is to get on top of this as soon as you can.
During due diligence, you will provide piles of documents to investors. Don’t assume that this means all of those documents are deemed to be disclosed. Make sure the disclosure letter or schedule formally records disclosure of these documents and provide carve outs to the warranties.
Disclosures are either general, (e.g. referring to accounts, publicly available searches, or the contents of your datasite) or they are specific, (i.e. individual items that, if not disclosed, would breach a warranty). An example of a specific disclosure is a pending claim or if you know a key customer is about to terminate its contract. All founders and key management staff should review each warranty carefully and consider whether they are aware of specific issues to disclose.
The term sheet may provide for investor rights if the company or founders default, e.g. drag-along rights, forced share repurchase, and/or investor control imposed over the board. Default provisions are onerous so only agree to them if the term sheet is clear on scope.
Sometimes the company and even the founders are obliged to buy-back shares from investors in the event of default. This is not realistic for most founders and, if such a right is agreed, it should be limited to material breaches of pre-agreed key terms.
Series A investors often want founders and companies to agree to achieve an exit within a stated period of time. Term sheets often include rights if any exit is not achieved before that time. These rights can be adverse to founders and include drag-along rights, compulsory share repurchases, and/or investor control imposed on the board. If investors insist on exit rights, then confirm what remedies they will have if an exit is not achieved, and don’t agree to an unrealistic exit date (the period should not be earlier than 7 years from closing of the series A round).
Often term sheets require the company to reimburse investors’ legal and professional costs relating to the investment. If you agree to this, cap the costs to a reasonable amount (US$20,000 -$30,000 is common for series A deals in Southeast Asia), payable only if the investment is completed.
Be sure to read part 2 of raising series A capital in Southeast Asia where we discuss closing the deal, follow-on and venture debt financing.