Negotiating Anti-Dilution Clauses in Venture Capital
Negotiating Anti-Dilution Clauses
The anti-dilution clause in any share purchase agreement, both in private Equity and Venture capital is an important element that a lot of the time causes controversy and is very heavily negotiated. For this reason it is very important that both buy-side and sell-side parties understand what various provisions in relation to anti-dilution clauses portend for them.
Anti-dilution clauses are mechanisms in share purchase agreements that provide the buyer with some protection if there is a subsequent round of financing for the startup in which the venture capital firm has invested in or the company in which the private equity firm has invested in. This clause is basically a clause that ensures that the proportion of the company that the investor holds is not eroded because more investors joined the party and investor is forced to share his slice of the cake.
The way that this particular protection works is that it in case of a second round of funding for the startup is carried out and the share price to these subsequent investors is lower than the share price offered to the initial investors then in that case the anti-dilution mechanism will kick in. For example if Investor A initially invested in the startup and the startup founders sold to him a stake in the company for 10 shillings per share and a during a later stage of financing another investor B puts money in the startup and in exchange is offered shares in the company at a value of 5 shillings per share then such a scenario would trigger the anti-dilution mechanism. The reason for this is because investor B will gain a stake in the company for a cheaper price than investor A which will have the effect of diluting the ownership share of investor A.
Specific Anti-Dilution mechanisms
This article discusses two anti-dilution measures that form the basis of negotiating this provision in the term sheet and subsequently it being included in the substantive share purchase agreement. These measures include full ratchet provisions as well as weighted average calculations.
Full Ratchet
The full ratchet provision is one that most favors the investor and causes the most harm to the startup founders. The basic proposition of this mechanism is that where the price of the new shares offered to investor B are lower than the price that was offered to investor A, then the share price of the shares held by investor A will be revised to be equal to the price offered to investor B. So if, for example, investor A was offered a shareholding in the startup for 10 shillings a share and the startup during a later round of funding offered shares to investor B for 5 shillings, then the shares that are held by investor A will also automatically be converted to 5 shilling shares. The effect of this would be that if the investor A had initially held 10,000 shares valued at 10 shillings per share, he would now have a total of 20,000 shares valued at 5 shillings per share.
The effect of the full ratchet is a harsh one as it greatly dilutes the holding of the founders of the startup. A second negative effect of the full ratchet is that it has the effect of deterring other investors from investing in the company. For this reason, the startup founders and their counsel should push back very heavily on this provision. This provision may look like an attractive one for the investor but in my opinion it would greatly hamper the ability of the startup to raise capital in the future which could affect the overall success of the company and by extension that of the investor.
It is acknowledged that sometimes the investor has much of the bargaining power, especially for early stage untested startups. These investors may therefore insist on a full ratchet basis. In such a case, the startup founders should insist on the inclusion of a pay to play provision to mitigate the effects of the full ratchet provision. Pay to play provisions are provision that provide that in the event of any further rounds of funding, the full ratchet provision will only apply if the investor participates in that round of funding. This way, if the full ratchet provision scares off other investors, then the startup founders are still guaranteed financing from the initial investor.
Weighted Average Anti-Dilution
This is the more sensible and equitable anti-dilution mechanism that both offers protection to the investor on the one hand and at the same time isn’t manifestly unfair to the founders of the startup. This particular anti-dilution technique is one that is based on the number of shares that are held by the round one investor compared to the total number of shares that are outstanding.
The formula for calculating the weighted average dilution, which protects the initial incvestor in case of a down investment, is:
CP2 = CP1 (A + B)/ (A + C)
CP2= the new conversion price for the preferred shares after the new investment round
CP1= the conversion price of the preferred shares that was in effect immediately before the subsequent financing
A= Number of common stock shares that are outstanding before the new investment round
B= the total amount invested in the new round divided by the conversion price immediately before the new financing round (CP1)
C= the number of shares of stock that have been issued in the new round of financing
Conclusion
It is imperative that the startup founders and their counsel push back on any mention of a full ratchet provision and instead insist on at worst a weighted average dilution clause. However, due to an imbalance in the negotiating power of most startups in relation to investors, it is important that the startup founders protect themselves in other ways. The most effective protective mechanism available to founders is the proper valuation of their company and the pricing of their shares. If the initial valuation placed on the company is too high, then if the company fails to live up to this billing then it may be forced to get into a down round in subsequent financings. If the valuation is done right however, there will be no occurrence of a down round and therefore no need to invoke the anti-dilution clause.
Risk allocation Between Sponsors and Lenders in Public Private Partnerships
Risk Allocation in Public Private Partnerships
Undertaking a public private partnership is a journey that is fraught with immense risk. This is especially because of the amount of investment that is required for the endeavor. The risk involved increases exponentially in the African context, based on various factors ranging from political volatility to market conditions.
These forms of partnerships however, with their risk and all provide an immense opportunity for Private Equity firms on the continent. This is because even though Africa is seen as the new frontier for Private Equity and Venture Capital investment, there just aren’t enough Private Equity investment ready companies and even those that are attractive investment targets are unwilling to give up stakes to private equity firms. Further, exit options for Private Equity firms are limited, especially since most African capital markets are not yet mature enough to provide IPO exits.
PPPs are therefore a perfect investment option for Private Equity firms investing in Africa. Kenya for example, with its Vision 2030 strategic plan, seeks to step up infrastructure, from energy to roads, to set it towards being a middle income country by 2030. Concessions in the energy sector, specifically in renewable sources such as geothermal power production are a current high interest focus area in the country. Their specific regulation in Kenya will be discussed in the next article.
This article will focus on three parties in a PPP transaction, the grantor of the concession (the government and its agencies), the sponsors (in this case the private equity firms) and the lenders.
The analysis of risk and its efficient allocation in a PPP contract depends principally on the concept of Value for money (VFM). The optimum value for money in a PPP transaction can only be achieved by allocating each identified risk to the person best suited to handle that risk. The importance of optimum risk allocation arises from the fact that bearing risk comes at a price. Hence, the more risk that is borne by the sponsor, the higher premium the sponsor will charge. On the other hand if too much risk is borne by the government, then this would exert pressure on government resources to mitigate the risk if it materializes.
Lender Risk Mitigation
As already indicated above, PPPs are capital intensive undertakings. For this reason therefore, if the sponsor was to infuse all the capital from its resources, this would not only tie up the available resources the private equity firm would have at its disposal for other projects, it would also exponentially raise the cost of equity for the project. For this reason therefore, PPP transactions are highly leveraged transactions. The debt Equity ratio typically stands at 80:20 and rarely goes as low as 60:40.
Considering therefore that most of the financing for the project comes from the lenders and also that the loan is legally speaking given to a special purpose vehicle (SPV)created for the purpose of the project, the lender runs great risk which it would be important to mitigate against. Funneling the lending directly to the special Purpose vehicle therefore means that in case of default, recourse can only be to the project property and income of the SPV and not those of the sponsor generally.
Lender Risk Allocation and Mitigation Instruments
1. Taking Security
The most obvious and widely used method that lenders have available for risk mitigation is the taking of security for the amount lent. In this regard, creating fixed and floating charges on the property of the SPV is a viable method of ensuring this.
Still on security, counsel for the lender would also most likely explore other methods of taking security. These alternatives arise from the fact that most concession agreements would have a provision prohibiting the sale of the project equipment and structures. One of the alternatives that may be set forth by counsel for the lenders is taking security over the shares of the SPV in case of default.
However, counsel for the Private Equity firm (Sponsor) should in my view push back on the requirement for general security on shares which would dilute the stake of the sponsor in the SPV. The counter to this should be the creation of a special class of preference shares setting out specific (and expressly no general rights, including voting rights) in case of default.
2. Step-in Rights
The lender would most likely provide in the lending instrument that they shall have step-in rights which confer upon them the power to step in the place of the SPV to fulfill a contractual requirement on the part of the SPV which it has failed to perform as required under the concession agreement or under any other project agreements. For these agreements to be binding upon all the parties, counsel for both the lender and sponsor will have to enter direct agreements with the other parties to the project providing for such rights. Such direct agreements would therefore provide that in case of default on the part of the SPV to meet contractual obligations, the contract shall not be terminated until the lender is given a specified time period to remedy that breach on behalf of the SPV. Under the basic step-in rights, even though the lender is stepping in, the SPV is still bound by the obligations under the contract.
With regard to the basic step-in rights, counsel for the sponsors should ideally insist on the step in applying only to payment defaults on the part of the SPV. This is because this is the area of expertise of the lender. If the lender purports to step in an area of the project not being an area of its expertise, it would potentially lead to injury to the SPV which still holds the risks attendant to the obligations.
Counsel for the sponsor should therefore insist that any other form of step-in, other than to pay any money due, should constitute novation rights. With regard to novation rights, the lender completely replaces the SPV, not only with regard to satisfying the obligations of the SPV under any project agreement, but also takes up all the rights and risks attendant to that contractual obligation.
3. Reserve Discretions
SPVs have rights and discretions under the project agreements to undertake certain actions. In the lending agreements, the lender may reserve the right to compel the SPV to either act on these rights and discretions or refrain from acting on them depending on what the lenders interest is with regard to ensuring the protection of its interests.
Some of the rights that the lender would have an interest in reserving discretion include amending any contract agreements, transferring or assigning any such contracts as well as ….
4. Trigger events
As already mentioned, for purposes of carrying out a financed project, the deal structuring usually involves the creation of a special purpose vehicle for the specific project. This therefore means that the sponsors liability for the amount lent would only be to the extent of the property held by the SPV. Servicing of the loan therefore depends largely on the cash flows of the SPV during the lifetime of the project.
Lenders are therefore extremely guarded about the performance of the project and its ability to continually bring in cash that can be used to service the loan. The lender would therefore insist on incorporating terms within the contract that set out tests for the health of the project with reference to its ability to service the loan. Where the project operations fall below the required minimum under the test, this would be termed as a trigger event and would mandate the lender to take specified actions outlined under the lending instrument.
• Debt-Equity ratio
The first test for determining trigger events is the debt-equity ratio. Once this ratio is set, any drop or variation would be considered a trigger event and would therefore mandate the lenders to exercise their rights under the agreement.
• Loan Life Cover Ratios
During the continuation of the project, the lender would require constant assurances that the SPV would be able to service the loan over the life of the loan. With the uncertainty and volatility that comes with PPP projects, no guarantees can be given. For this reason therefore, the lender would utilize the above ratio to determine the likelihood and ability of the SPV to service the loan over the life of the loan. The ratio is calculated by dividing the amount of money at hand and available for debt repayment by the outstanding amount of the loan repayment for the
My Take On Heshan De Silva
My take on Heshan De Silva
Heshan De Silva has over the last few days taken a lot of flak for information alleged to be inaccurate. This is information regarding his Venture Capital firm, how much the fund is worth as well as what companies he has invested in.
In my view, Heshan is a leading light in the area of venture capital in Kenya and East Africa at large. Vilification for not making public information regarding his private company is at best a low blow. Granted legitimate questions have been raise. These questions are not however an indication of the gentleman being a fraud.
I would like, in this forum, to look at the questions raised from a fairly objective perspective. I will analyze three different issues raised in turn.
The Billion Dollar Question
Heshan has since the Business Daily profile clarified that the fund value is one billion dollars, $ 500 million from each of the two hedge funds. While this may seem like a stretch, it may not be entirely untrue. A lot of American return on VC is flat lining and Africa is the new frontier and so therefore it is very much conceivable that two hedge funds can commit $ 1 billion dollars to VC in Africa.
However, considering that some large VC and Private Equity funds in Kenya and Africa, such as Fanisi and Catalyst Investment do not have a comparable funding raises an eyebrow. These two funds are run by MIT trained as well as other very highly trained professionals so the question would be how they got by-passed by this investment which went to Heshan De Silva.
On the flip side however, a lot of people are looking at the figure as one that is sitting in his bank account. That is not really how it works. Investments in VC funds are usually a pledge by an investor to invest a particular amount over a certain period. So for example one hedge fund has pledged $500 Million. Say the life of the fund is ten years, which would be average investments spend of $ 50 million every year. For a fund covering the whole of East Africa that would not be entirely implausible now would it?
The way that the money is handed over to the VC firm (in this case Heshan’s firm is by way of a call right. This right gives the VC fund the right to demand from the investor a portion of the money pledged as and when viable investments avail themselves. So while he has been pledged a billion dollars, if not enough viable investments are not found within the life of the fund then he may end up only calling say $20 million dollars out of the a billion pledged. That is probably the reason why Heshan De Silva has clarified that the amount is available if there are potential IPO exit investments.
So clearly, a one billion Dollar VC fund run by Heshan De Silva is not an entirely improbable proposition.
Investment in 24,000 businesses
On the face of it this may seem like a highly improbable figure. It’s too high. I have seen calculations that indicate it would take 65 years to invest in this number of enterprises. Two things, first, Heshan’s business model is not that of a traditional VC fund that invests in an early stage business enterprise. His firm instead invests in ideas. For this reason, fifteen people may walk in to his office every day and pitch ideas, say in the area of robotics. Different ideas, original ideas, but ideas that can be merged to form one enterprise. So his business model is counting ideas and not actual businesses.
He is investing in 15 different sectors all across East Africa. Breaking that down into Kenya, Uganda and Tanzania, that is 8000 ideas across each country every year. Break that down across fifteen sectors and what you have is about 530 ideas per country per sector each year. Over a 12 month period that is 44 ideas per month. If on a good day two good ideas come in then it would fit the bill. A little tight but it would fit the bill.
Now while the above figure may be a little on the high side, it is based on popular Venture Capital strategy. The performance of Venture Capital investments are pegged on the concept of power law. This concept is basically based on the premise that the best performing portfolio business of a VC fund performs better than all the other investments of that fund COMBINED.
So basically if in the 1990s a VC fund invested in Google as a startup and also invested in ten other startups that we have never heard of because they didn’t perform as well as Google in this scenario Google becomes the best performing Portfolio Company. Even if the other startups were later sold for $ 10 million each, the performance of Google still outdoes them combined. So basically venture Capital funds apply this strategy in their investment with the belief that there will be an outlier or two, their Google and Facebook.
Of course the math behind calculating power law for an investment is a little more complicated than what I have outlined but that is the very basic premise. I got lost in the scientific calculations (because… lawyers and math). In looking to invest in 24000 ideas, Heshan’s company is seeking to apply power law in ensuring the success of the fund.
We have not heard of a Single Business he has invested in
First of all his is a private fund with private investors, there is no duty to disclose. But the reason for not disclosing goes beyond merely the law. VC funds invest in startups which posses a very high potential. They have ways and systems of spotting such potential (Algorithms and what not).
For this reason, if they released all the information on what they were investing in their competitive position would be highly compromised. VCs are like market leaders. If Warren Buffet came and invested in the Mama mboga business today, everyone’s interest would be piqued about that business as they would be sure there is a huge margin to be pushed. The same goes for VC funds. Of course there are companies and ideas that are ahead of the curve and even disclosure won’t give competitors enough time to catch up.
However, for proprietary ideas such as the ones Heshan seeks to invest in, it is imperative that trade secrets be kept, at least until they can develop say a prototype and get a patent (which could take up to 18 months to obtain). So the need for secrecy is imperative in the initial stages of a startup.
Case in point, a court ruling in the USA requiring that any VC fund in which a public institution, such as a university, invests in would have to disclose information to the public as they are utilizing public funds. The effect? VC funds are now turning away public institutional investors as they would rather look for funds elsewhere than disclose (They would rather die!). University of California which was involved in the case was turned away by Sequoia VC fund (who are the VC fund that invested in Google and made UC a tone of money).
Forming a Startup Part 1:Founders Collaboration Agreements
Founders Collaboration Agreement
Start-ups that go through the various stages of funding, become widely successful and then go public, and in the process earn the founders a whole lot of money, is every entrepreneur’s dream. This is the very foundation on which the Silicon Valley was built on, the same foundation upon which our very own silicon savannah has been conceptualized and the template influencing our Konza techno city.
However, aside from having the brilliant idea coupled with the technical know-how to create a scalable start-up, start-up founders may sometimes be clueless as to how to initiate the company and brand down the road to success. This article is the first in a series of articles looking to shed some light on how to start on the process, avoid pitfalls and increase attractiveness to investors.
There is an adage among lawyers that says “contracts are not for the happy days, they are for the rainy days.” Some may argue this is a ploy by lawyers to make money. However when disagreements arise, and often they will when the success and big money finally rolls in, see the Facebook story for example, then the contracts signed during the early days will come in handy.
The first step in the start-up process should always therefore be to clearly outline, in writing, the rights and responsibilities of the start-up founders, who is entitled to what. The first step should therefore be to draw up a founder collaboration agreement. This document would govern the interaction of the founders with regard to the start-up. This charts a clear path for the start-ups and avoids any blurred lines.
Importance of Founder Collaboration agreements
This agreement is important first for purposes of settling any disputes that may arise in the future regarding the start-up. Avoiding he said she said allegations is paramount for long term success. Such disagreements may be the barrier between the founders and that coveted IPO (which I must add is a highly regulated process).
A second reason is for purposes of raising funding from angel investors as well as venture capital firms. Venture capital firms in particular are very stringent in their requirements. Part of the legal due diligence that is carried out by venture capital firms is with regard to such agreements. It gives them an insight into the start-up, who is responsible for what, whose consent they have to acquire before they can be allowed to invest etc.
A third and very important function of the founder collaboration agreement is the fact that most of the time, the registration of the start-up as a legal entity i.e a company usually comes after the process of product development has begun. The problem with this scenario is therefore the question of intellectual property. Who owns the rights to the product developed and in what proportion? Since Venture capitalists will insist on any and all intellectual property to be vested in the company, it is important to outline in the collaboration agreement that once the company is set up then all the intellectual property rights automatically are transferred to the company.
Important clauses
1. Intellectual Property Rights
This clause should expressly indicate that once the incorporation of the company has been completed and a certificate of incorporation issued, that all intellectual property rights with regard to any product developed shall be the property of the company and not any individual founder. This is very important as VCs will generally not agree to invest if the property is vested in an individual.
If any of the founders are employees in any other organization, the founders with the help of a lawyer should ensure that any invention or product developed by that founder is not attributed to his employer. This is because most employment contracts provide that any invention by an employee in the course of their employment shall be owned by the employer. Ways of ensuring this with regard to the start-up product development should therefore be incorporated in the agreement.
2. Ownership structure of the company
The ownership of the company to be formed should be agreed upon beforehand. This includes how many shares each of the founders shall hold as well as the rights that will be attached to such shares such as voting rights.
A second important issue, one aimed at protecting the continued success of the company is the issue of vesting of the shares. This concept will be discussed in detail in a subsequent post. However the general concept is that once a founder is allocated shares he can only legally be considered to own them after a certain time period has lapsed. So if he leaves the company before this time period lapses he shall not be entitled to those shares. This ensures loyalty of the founders to the company. Most VCs and other investors insist on this provision since they are not only investing on the product they are also investing in the founders and their know-how.
3. Confidentiality
Confidentiality is an important factor for start-ups. You do not want any outsiders getting hold of any proprietary information. A binding obligation on the part of the founders ensuring confidentiality should therefore be in place. In this regard therefore, it should be incorporated in the agreement that any pitch to any potential investor must be by the consent (in writing) of all the founders.
4. Dispute Resolution
The court process in any part of the world, no less in Kenya, is an arduous process that could take years to resolve. By this time opportunities would have passed up the start-up and even its shelf life (especially in the fast paced world of technology) would be passed. It is therefore important to incorporate Alternative dispute resolution mechanisms.
With regard to a collaboration agreement, mediation should be the first option. However since the outcome of mediation is not per ser binding on the parties, Arbitration should be included as the award given by the arbitrator would be binding upon the parties.
While the above provisions are in no way exhaustive, they are some of the most basic and important factors to consider in the Founder collaboration agreement.
Disclaimer
The information provided above is meant for general information purposes and should not be construed as constituting legal advice or solicitation. The writer shall not be liable for any reliance on the above information. Kindly seek the advice of your legal counsel before entering any agreement.
PRIVATE EQUITY IN KENYA
Private equity is a concept for investment where private equity firms ( in industry lingo referred to as General Partners) pool the finances of institutions such as insurance companies, pension funds and those of high net worth individuals (known as Limited partners) and invest these funds in high growth potential companies.
The aim and key strategy of Private Equity firms is to rapidly (over a period of three to seven years) and exponentially increase the value of the investee company and then exit, either by sale to strategic investors or by way of an IPO, in the process making a profit from the sale. The General partners (GP) who are charged with the mandate of investing the funds thereafter take their cut of the profits, typically about 20% (known as carried interest) while the Limited partners take the rest of the profit as return on their investment.
The private Equity landscape in Kenya is shaping up to be an industry to reckon with. According to the Delloitte 2012 Private Equity survey, 45% of all private equity deals in Africa were snuffed up by three countries; Kenya, Nigeria and South Africa. This is a clear indication of a rising industry in the country, one that deserves more focus.
The survey goes on to note that of the 13 Private Equity Deals closed in East Africa in 2012, 6 were in Kenya, a total deal value of $ 36.1 million. This figure, in my view, is set to rise even further in the future based on various factors. One important factor is that in 2012 alone, there were 4 new funds launched and dedicated solely to the East African region. Notable among this is Catalyst Principal Partners who launched a $125 million fund.
A second important factor informing my prediction of increased deal incidence and value is the problem of reduced returns in the more developed countries as compared to Africa whose potential for higher returns is more promising according to Bloomberg (as high as 30%).
Thirdly, and very prominently, the reputation of Kenya as an ideal destination in the region sets it apart as particularly ripe for Private Equity. According to a research conducted by the economic intelligence unit, Nairobi is ranked above Lagos in ranking of top investment hotspots. This fact is evidence by various multinationals setting up regional offices in Nairobi including Google, IBM, JP Morgan, BP group, General electric, Pepsi and Nestle.
Lastly, according to the survey, sector categorization of Private Equity most targeted investment are all in areas that Kenya performs particularly well at. Manufacturing and industrials in the region raked in total Private equity investment of $102 million, Agribusiness (which Kenya is known for) attracted P.E investments of $284 Million in the region, Financial services ( $57 million), tourism and Hospitality ($31 million) and Healthcare (2 Million).
There should therefore be a justified increased interest and appetite, not only by P.E investors in the country but also by P.E professionals and practitioners, to ensure the realization of the full potential of the industry in the country. This blog hopefully will be influential in this endeavor.
Private Equity Kenya 