Angel investing in startups? Then, familiarise yourself with these!

Startups continue to be the buzz word and it is a flavour of the season which is not likely to fade out soon. Everyone is looking at opportunities to get a toe-hold in the startup space, either by launching their own startups or some like me who are excited being mentor-investors, thus getting an opportunity to take this roller-coaster ride of creating a business, many times over!

If you are evaluating angel investing in a startup seed round (Pre-Series A), then it is important that you familiarise yourself with the key terms and clauses normally used in the seed round fundraising agreements and may want to even insist that these are included to protect your interests. Some of the key ones are:

Pre-money and Post-money Valuation: This is the reference valuation of the business at which the new investors come on board. Simply put, pre-money valuation is the valuation of the business without considering the current round being raised, while post-money valuation is the valuation, including the funds being raised in the current round. E.g. if a business valued at $ 1 Million is raising $ 0.5 Million in the current round, the Pre-money valuation will be $1 Million, while the Post-money valuation will be $1.5 Million.

Vesting: It is quite common to see a vesting period of 36 to 48 months for shares held by the Promoters (or Founders), which means that these shares will vest with them after or over an agreed period in smaller tranches. Vesting means that the Promoter will be free to deal with their shares as they like, only after these vests with them, though this freedom may still be subject to other covenants. The vesting protects the interests of the non-promoter investors since this ensure that the Promoters stay with the business, at least for certain foreseen time.

Anti-Dilution Protection: This clause specifies that if the Company for its subsequent rounds (after the current round) raises money at a price lower than the ones paid by investors in the current round, then the investors shall be entitled to weighted average anti-dilution protection. Hence, in such an event, the Company shall ensure that it issues such number of additional shares to the current Investors or adjusts the conversion ratio of the securities (in case of Compulsorily Convertible Preference Shares), as necessary to nullify the effect of such dilution.

Besides financials, the clause can also specifically relate to the rights of the Investors. In that case, it would mean that if the rights provided to subsequent round investors are more favourable than the rights of the current investors, such subsequent round rights shall be deemed to be given also to the current investors.

Tag along: This clause is to ensure that if Promoters decide to sell their shares, the other investors are not left high and dry, since the decision to invest in a start-up is as much driven by the faith that investors have in Promoters as by the strength of the business model. This clause stipulates that in the event any of the Promoters decide to sell their shareholding in the Company to a prospective acquirer, then the other investors shall also have the right, but not the obligation, to sell their shareholdings in the Company to the prospective acquirer, on the same terms and conditions as the Promoters. Hence, investors tag along with the Promoter.

Exit: Normally the intention is to provide an exit for the investors within a certain period, e.g. through a subsequent Series round or IPO or a strategic sale say within 48 or 60 months. In the eventuality that an exit cannot be facilitated for the Investors, there is normally a clause requiring the Promoters and Company to provide an exit, by way of buy back at a certain specified IRR, within a certain stipulated time.

Drag along: If the Company is not able to provide an exit to the investors, then investors (if agreed by majority) have the unilateral right to sell their securities to any third party and in such a case, the investors may also require all the Promoters to sell all or part of their shareholding in the Company to such third party if required by such third party, which is normally the case since the acquirer is usually looking to acquire full management control. This clause enables the Investors to find an exit in a foreseen time and hence effectively the Investors have the right to drag along the Promoters to get that exit.

Liquidation Preference: In view of the fact, that investors typically invest at valuations substantially higher than the Promoters which may have invested at much lower valuations or could have the shares by way of sweat equity, investors look for some downside preference. Even if liquidation is a remote possibility, it is normally agreed that upon the occurrence of a liquidation event, the Investors shall be entitled to receive in preference to distribution to any Promoters of the Company, an amount which shall be equal or even higher (say, 1.5x times of the investment amount).

Affirmative Voting Rights on Reserved Matters: In addition to any voting requirements under regulations, it is usual to stipulate an express unanimous written approval (or majority approval) from the investors at a shareholders’ meeting or the investor nominee director through an affirmative vote in a board meeting for reserved matters. These could include matters relating to but not limited to, issuance of capital, changing of investor’s rights, changes in the nature or scope of business, establishing any new business, related party transactions, transfer of IP/intangibles, hiring/firing senior management employees or changes in their employment terms, any material changes in the company’s business plan etc.

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