What Should Startup Entrepreneurs Know to Negotiate with Outside Investors and Handle Equity issues?

(By You Yunting) The other day I had a conversation with a lawyer of a foreign law firm. That lawyer, who specializes in handling legal affairs of VIE financing on behalf of the investment side, told me that many startups would sign investment agreements proposed by investors directly without any argument. To be honest, I can hardly understand nor agree with this kind of practice. I think investors may actually feel ambivalence in face of such situation, too. On one hand, they can get more control over the invested business as well as other extra benefits. With probably unfair terms being included in an investment agreement, investors may be happy to have a favorable position in the relationships with startups. On the other hand, the investors are expecting to gain lucrative profits, so they may doubt whether the startups will be able to win fierce competitions of the market as they behaved so obediently when making investment agreements. This article talks about common points of financing negotiation between startups and investors as well as startups’ internal equity allocation issues.

Keys for startups to know about how to deal with investors

Investments for startups can be classified into foreign and domestic ones. Startups had better appoint lawyers to review legal documents for them wherever possible. A VIE agreement in English covers at least a hundred pages so that even a person with a good knowledge of English has to spare a lot of time and efforts to review it from beginning to end. The agreement written in Chinese seems easier to read, but people other than legal professionals will still find it difficult to understand them clearly because of various terminologies contained therein. More importantly, as professionals are more skilled and experienced in what they specialize in, it is advisable to ask legal professionals to deal with legal matters for you. Although lawyers’ fees incurred by one round of financing activities may be as high as a hundred thousand RMB or even above, any right lawyers can help to secure will worth much more after the business expands.

Take term sheets seriously. Term Sheets, also known as letters of intent on investment, are first written records of what a startup entrepreneur and investor(s) have agreed upon through mutual consultation. A term sheet is not a formal contract and has little binding effect, but usually contains important clauses that may be included in a formal contract. Consequently, be sure to take term sheets seriously. For a number of times, as a lawyer for entrepreneur, when I told my client that the clause in the Equity Purchase Agreement and the Shareholder Agreement is not acceptable for it damaged our interest too much, he just replied that the investor refused because it was already a deal in the Term Sheet.

Despite some exceptions, what has already been agreed in the Term Sheet can hardly be changed in most occasions. Therefore, after being given a term sheet, a startup should carefully review at first or ask a lawyer to review it before proceeding to the next step.

Focus on the issues of business control. The business control is very important and the bottom line for a startup entrepreneur is that all terms and conditions regarding it should be reasonable. Accepting an unreasonable term could incur risks that the entrepreneur may lose control of the startup company. Take two examples for illustration. The first example is about an article specifying that all resolutions of the board shall be void without the presence of the investor’s director. If this is written in Chinese, no startup will accept, but if written in English, this clause will be likely to become effective without being reviewed by a competent lawyer. Another example is about a clause regarding tag-along rights, to the effect that if the investor agrees to sell the business at a price of more than USD 100,000,000, then other shareholders shall all agree to sell the same. Investors are money-oriented, while most business founders are reluctant to sell their businesses. If a startup accepts the aforesaid clause regarding tag-along rights, it will incur the risk that the startup may be sold out for some baffling reason. In case that a tag-along right related clause have to be included in an agreement, the startup should at least strive for the preemptive right.

Reasonable terms are acceptable in some cases. For example, clauses regarding the investor’s right to decide on option schedules. These are actually used to prevent startups from abusing their right to grant options, in order to protect other shareholders’ interests. Furthermore, clauses regarding the investor’s veto power of important contracts are acceptable if prices agreed therein are reasonable, as such contracts having no adverse effect on the startup’s normal operation.

Disclose business information to the fullest extent. Startups should fully disclose business information and risks to the potential investor(s), and these disclosure documents are usually attached to investment agreements. My recommendation is that startups should disclose potential risks to the possible fullest extent. If a startup discloses information insufficiently, investors may claim that they have been deceived in the future. If information is fully disclosed, risks will be transferred to investors. While preparing disclosure forms for investors of internet businesses, I am particularly concerned with risks in business models and possession of licenses. All risks in business models and absence of any necessary license must be disclosed to investors. A subversive innovation project absolutely has risks in its business model, most of which, however, are acceptable to investors except for criminal risks. Furthermore, most startups do not hold necessary special licenses in early phases, but I have never encountered an investor that declines to offer investment for any of the aforesaid reason.

Things startups should know about distributing equity inside

As mentioned above, as a result of immediate and complete acceptance of an agreement drafted by an investor, startups may lose some important rights and interests in their business and incur additional risks. Also, failure to create and maintain secure internal decision making and profit distribution systems may result in division, vulnerability and even dissolution of a startup team. For this reason, major venture capital (VC) providers usually require that startups seeking investment from them should have good option policies. Such requirement is necessary because startups need to correlate achievements of employees with those of their companies by using options.

Avoid too many registered shareholders. Startups are advised to register no more than three shareholders with the Administration for Industry and Commerce (“AIC”). If a conflict arises among shareholders, some of them might refuse to compromise or even refuse to sign any shareholder agreement that they believe unacceptable. As a result, application for shareholder agreement registration with AIC has to be suspended. In that case, shareholders involved would have no choice but to file a lawsuit to the court, and this can be time consuming and costly. In addition, later financing activities may be affected on that account. Therefore, registered shareholders should be carefully selected.

To make a concerted action agreement. Founders of a startup team may become shareholders themselves, establish a shareholding company or limited partnership, or grant employees of the right to hold shares on behalf of real shareholders in the form of equity or options. Whatever the case, it is necessary to make a concerted action agreement with each of the direct and indirect shareholders. Provisions contained in a concerted action agreement should include internal voting rules of startup team members. By signing a concerted action agreement, a startup team will be easy to reach agreement on issues concerning management and business negotiation.

Option award and equity withdrawal can be paid by installment. There are various things that should be taken into account for formulation of an option plan. It is not suggested that option award be granted all by one time. The common practice is that only employees who have worked for particular period of time may be eligible to be granted an option. Such award shall better to be paid by installment, and take achievements and working performance into account. When a shareholder leaves his company, other shareholders may repurchase his equity, provided that such a repurchase does not affect the company’s cash flow. And such payments for repurchasing equity may also be made by installments.

Lawyer Contacts

You Yunting86-21-52134918  youyunting@debund.com/yytbest@gmail.com

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