There is a saying in the trade that investing in a start-up is essentially investing in the people who start the project. How to build and maintain a long-term and sustainable relationship with the founding team, and how to hedge against the risk of the failure of an early-stage start-up with the expected return on a new project are subjects of art for both investors and lawyers. In this light, a special term of pre-emptive right to the new project is born.
It is well known that the failure rate of early-stage start-ups is quite high, as founders may lack sufficient experience, connection and human resources. But failures can crystalize as a foundation for the next start-up project, significantly increasing the success rate of later projects.
Thus, a pre-emptive right to the new project becomes the last defence for the investor to guarantee its investment return. Its role is particularly important in projects in seed-round and angel-round financing.
A pre-emption right clause shall comprise two core elements, i.e., the conditions for the exercise of the right, and the agreement specifying that the investor has the right, to invest in the new project before other investors. However, these two core elements are not enough to construct a clause sufficient to maximize the rights and interests of the investors. This article will analyse how to construct a pre-emption right clause.
Key points of the clause
Conditions for exercise of the right. This pre-emptive right is aimed to safeguard the investor’s right to invest in the new project. Therefore, a priority of the clause is to define the new project.
In practice, the situations prompting the founders to start a new project include: (1) the existing company is no longer feasible and liquidation takes place; (2) the founder or the founding team leave the existing company; and (3) the founder or the founding team establish a new company to carry out a new project with the consent of the investors.
With these situations, there must still be the acts of the founder of establishing a new company, or investing in the equity of another company and the actual operation. The reasons impelling the founder to have a new undertaking may be many and varied, and it may be difficult to include all these reasons, so the focus should be on the acts of the founder to set up or invest in a new company, and these acts shall be specified in the clause.
If the investor is in an advantageous position in the negotiation, the clause can be generalized as “the conditions for the exercise of the right would be satisfied as long as the founder starts a new company or makes an equity investment in another company, irrespective of the reasons”.
Founder’s notice. Practically, the investors cannot have the full details of the movements of the founders, so a key consideration when constructing the clause is to ensure that the founder timely informs the investor of his/her acts. In this regard, a first consideration should be the notifying time, and there are two points to consider.
First, in the author’s view, there is no need for the investor to stay informed about the movement of the founder. As long as the founder gives notice to the investor before the first financing of the new project, or the latest round of financing of the new project after the founder makes investment in it, the founder is deemed to have performed its obligations.
Second, there are some issues that may mean the founder refuses to perform relative obligations, and render the investor unable to exercise the pre-emption right in time as a result.
These issues include, for example, that the investor is not in a good relationship with the founder, or the founder has better financing plans or options. To guarantee the exercise of the right, when the investor is in an advantageous position, it is recommended to specify a punishment when constructing the notice obligation to bind the founder.
The scope of the pre-emption right. The pre-emption clause grants to the investor the right to buy the equity at the same conditions before other investors. There are two common situations: the first is that the investor enjoys the right to first buy the equity before other investors of the new project, and the second is before the other investors of the old project with pre-emption right.
The tricky part is to deal with other investors with the pre-emption right. First and foremost, the investor shall conduct a thorough review of all the agreements signed by the founder, and then try to exclude other investors from enjoying the same or similar rights in the term sheet of the intended project. If the investor finds it difficult to negotiate the terms, it is recommended to add an exercise sequence in the agreement, or to partition the rights among the preferred investors of the first order on a pro rata basis, which is similar to the redemption right and liquidation preference clauses that are common in term sheets.
How to exercise the right. The ultimate goal of the right is to secure certain equity shares in the new entity owning the new project for the investor. If that new entity is a corporation, the equity in the new project company may be obtained through new issues or stocks transfer. In this case, the investor shall comply with the provisions on new shareholders in the Company Law, and there are two situations.
First, the founder has absolute control over the shareholders meeting of the new project company, which means that the founder holds more than 50% of the shares of the company, or the founder otherwise has actual control of more than 50% of the equity of the company. In this situation, the pre-emption right can be guaranteed as long as the founder is willing to perform the relative obligation.
Second, when the founder does not enjoy the absolute control over the shareholders meeting, the investor’s investment might be rejected by other shareholders of the new project company. Due to the principle of relativity of contract, other shareholders are not bound by the pre-emption right clause. Thus, the investment opportunity can only be earned through negotiation.
Pan Jieda is an associate at Grandway Law Firm