Last time round, we saw how liquidation preference and participation can combine to affect the entrepreneur’s prospective exit liquidity. I realised I missed out one important point after a reader emailed me to ask about it afterwards. There are indeed liquidation preference clauses where investors end up choosing to convert their preference shares into ordinary shares in order to get a better payout (i.e. 20% of $20M sale = $4M) instead of choosing to go with their liquidation preference & participation rights. This is actually a much fairer way to implement liquidation preference, and would be phrased differently, i.e. “HIGHER of (i) liquidation + participation, OR (ii) conversion of preference into ordinary to receive pro-rata proceeds“, but is most definitely not what the Term Sheet from Hell had asked for.
Today, I’d like to show you the term sheet’s Redemption, Put Option and associated clauses:
Redemption – The Company shall be obliged to redeem the A RCPS for the full/partial Redemption Amount when so requested by the Investor at any time on any occurrence of the following event(s):
- There is a material breach of any of the warranties and undertakings of the Company in the Investment Agreements;
- The Company fails to secure approval for a public listing on a recognised stock exchange by [T+3 years];
- The Company can achieve a public listing on a recognised stock exchange by [T+3 years] or after, but all shareholders other than the Investor elect against the listing. In this instance, the investor shall be entitled to an Exit Premium in addition to the Redemption Amount;
- The Company fails to sell Investor’s shares through a trade sale by [T+3 years]; or
- Should for any reasons the Company and the Investor have irreconcilable differences concerning the interest of the business, the Investor has the option to request the Company to redeem the A RCPS. In this instance, the Investor shall be entitled to an Exit Premium in addition to the Redemption Amount.
Subpoint 1 is pretty standard. I’m surprised to find subpoints 2, 3 and 4 in a seed-stage term sheet as it is more typical on later-round term sheets. This makes me think the Investor is reaching the end of its fund life and wants to be able to force some sort of exit. I’m also unsure why the Investor would ask for the Exit Premium only for themselves and not for the minority of A RPCS holders who voted in favour of the listing. It’s bound to give the entrepreneur grief if he raises more capital from other investors in the same round or down the road and has to re-negotiate this clause with this Investor. And there’s subpoint 5 which imo really takes the cake; agreeing to this vague and subjective clause is tantamount to a blank cheque for the Investor to yank your chain around.
Let’s take a look at the Redemption Amount and Exit Premium:
Redemption Amount - An amount which would give the Investor a rate of return of 25% per annum compounded on the aggregate issue price of the A RCPS to be redeemed, calculated from their respective dates, taking into account any dividends paid or bonus shares issued by the Company on such A RCPS.
Exit Premium - An independent investment bank acceptable to the Investor shall be appointed by the Company to value the Company on the basis of its listed value had a listing proceeded. The premium represented by the listed value above the Redemption Amount shall be the Exit Premium. This Exit Premium shall be payable by the shareholder(s) who decide against the listing in proportion to their shareholdings in the Company or the Company in the event of a Redemption.
The Redemption Amount of 25% compounded annually after T+3 years is 1.953 times of capital, which at least tracks its 2X Liquidation Preference. The Exit Premium, when considered along with Redemption subpoints 2, 3, 4 and 5, is the final nail in this diabolical coffin. I don’t even want to get started on the scenarios in which these 3 clauses can combine to subject the entrepreneur and his Company to premature Purgatory.
In closing, investors in Southeast Asia have gotten drunk on investment terms with a ton of control. When push comes to shove, entrepreneurs tend to give in on key control clauses in order to have a shot at realising their dreams. A friend of mine who runs his family office told me he would never invest in something he has no control over. I’m not against having proper control, but I believe control clauses need to be keenly balanced with entrepreneur motivation. The clauses above feel more like money-lending clauses than venture capital clauses, and hint of an investor with little faith in the team that he’s backing.
I’ve also met many “investors” who are actually seasoned entrepreneurs that claim they’re investing, when what they’re really doing is parallelised portfolio entrepreneurship. They shake their heads (and fists) at what they consider cavalier fund managers who aren’t investing their own hard-earned money, and thumb their noses at the 2% management fees and 20% carried interest. There’s a lot more than the 2-on-20 to being a good VC, and it’s not a given that a successful entrepreneur can make the cross-over to the VC profession.
In the end, I think entrepreneurs need to develop better taste for what makes for good VCs, and give them their respect. I also think investors need to respect entrepreneurs more and shy away from levying senseless clauses on them and thinking that they can get away with it.