Three rights to really think about in investment deals

Rights of first offer or rights of first refusal? With rights of over-subscription? Drag-along or tag-along threshold amounts? Broad-based or narrow-based anti-dilution rights?

There are a variety of investment terms that can sometimes over-complicate the fund-raising process for investors and founders. We always want to be practical in every transaction, so it is worthwhile trying to understand some of these intricacies to really understand what may not really matter. While some of these terms are relatively benign and have generally become standard market practice, there are three investment terms founders should deeply consider before coming to an agreed position.

1.      Most favoured nation (MFN) rights

The name gives a clue as to what this is – in the kingdom of your company, the investor enjoys the right to always be the “most favoured nation”. This generally means that if other investors in subsequent rounds are being offered more favourable rights (Eg. a better anti-dilution clause), the “most favoured nation” investor must automatically be offered equal or more preferential terms, at no further cost.

Why this needs to be thought through carefully. MFN rights are usually frowned upon by subsequent investors, because most of the time they are coming in at higher valuation, and naturally, they may expect to be given more preferential rights. For example, it is relatively standard for a subsequent round of investors to enjoy their liquidation preference rights in priority to previous investors. Giving an investor MFN rights may therefore deter future investors from coming on later. This is especially significant for earlier-stage companies who are likely to have more fund-raising rounds in the future.

To deal with this, assuming that this cannot be negotiated away, consider offering a middle-ground compromise, where the investor enjoys MFN rights only be specific selected rights. In most cases, these can be negotiated down to only economic rights (eg. in relation to the payment of dividends), which will leave other more significant rights out of play.

2.      Redemption rights

While this has become less market in South-east Asia, some investors sometimes still ask for a right of redemption for their investment – this allows the investor to, usually after a specific amount of time, to withdraw their investment from the company at a certain pre-agreed formula. Usually, this will either be the investment amount put in, or the then current market value of the shares, whichever higher.

Why this needs to be thought through carefully. Redemption rights place investors in a highly advantageous negotiation position vis-à-vis the company, especially in situations where the Company may be running low in cash and moving towards its next investment round. In essence, an investor has the leverage to negotiate for extremely favourable terms in the event of a cash crunch, as future investors will generally be very wary of investing in a company which may be facing a severe depletion in cash as a result of such redemption rights.

To deal with this, try to offer a different investment structure. One of the only legitimate reasons to request for redemption rights are if an investor wants to mitigate his risk, or to create a potential exit strategy. If the former, structuring the investment in terms of a convertible note may be more appropriate since most convertible note structures account for a maturity period following which an investor can redeem his investment.

3.      Ratchets

There are many variations of a ratchet, but it generally involves the awarding of additional shares to an investor in the event certain conditions are met. These conditions are usually a proxy of the valuation of the Company. For example, a ratchet could work such that an investor is awarded an additional 10,000 shares for every $100,000 shortfall from project annual revenue targets.

Why this needs to be thought through carefully. Mainly, unplanned dilution. Founders need to maintain a certain level of shareholding in order to continue fundraising, because investors in subsequent rounds need to ensure that founders are still motivated to make things work. Having a ratchet risk means that you risk having “unplanned” share issuances, and founders may see themselves getting over-diluted too quickly.

To deal with this, be extra cautious and conservative with the conditions upon which the ratchet can be exercised, or reconsider the valuation upon which you are raising funds at. Ratchets are usually put in place because of certain assumptions which cannot be agreed upon, one good example being annual revenue projections. There needs to be a balance between the potential upside of equity and the risk of loss, and ratchets, if not properly structured, may give one party too much of an advantage.

I’m on a journey to try to make knowledge and education more accessible and affordable, and to sieve out the noise in an age saturated with information. Practicing lawyer by day (I specialize in working with clients in the technology industry), and aspiring technology educator by night. I’ve advised both companies and venture capital funds in their investment rounds with a combined total transaction value of more than US$500m. I am also an active limited partner in a venture capital fund, and sit as an advisor to various startups.