Investing in Asia’s Unicorns – Mitigating Governance Risk – Part II

Part II: Founder and Company Covenants, and Exit Rights and Other Investor Rights

In Part I of this article, we discussed a range of governance and monitoring rights, which a private equity investor should consider incorporating into its next investment from a risk-management perspective. In this Part II, we will discuss a number of important founder and company covenants designed to safeguard the value of your investment in the company, as well as a range of provisions that give the investor tools to have at its disposal if the company or the founders breach their obligations, including those we have discussed in both parts of this article.

Founder and Company Covenants

In each investment, the founders and the company will often be required to give various highly deal-specific covenants that should reflect particular areas of risk identified during due diligence, as well as the investor’s individual requirements, for example, with respect to compliance and tax. In this section, we will discuss a few common covenants that you may want to include in your investment documents from a risk-management perspective.

Non-Competition/Key Man

When making an investment decision, it is important for the investor to know that the founders are committed to the company. It is typical for founders to be required to give undertakings that they will devote all their business time to running the company and also agree that they will not compete with the company’s business while they are with the company and for a period post-termination. As with other provisions, depending on the specific drafting, these provisions greatly vary in effectiveness.

While on the face of it, the wider the non-compete is, the more investor-favorable it is, you should take care not to draft the non-compete too widely. An overly broad non-compete provision could be at risk of being unenforceable, which would, in some jurisdictions, leave you entirely without the benefit of a non-compete. This is more likely to be an issue for post-termination non-competition clauses and those that are given as part of the founders’ employment (as opposed to in their capacity as shareholders), and employment arrangements are more likely to be complicated by local law provisions. A well-drafted non-compete provision should instead be suitably tailored with limitations as to time, geography and business scope.

In order for these provisions to be effective, it is important for breach to result in some tangible consequences. We will discuss this in section “If things go wrong…” below.

Founder Transfer Restrictions

As further comfort for investors that the founders will stay committed to the company, there should be a full lock-up of founders’ shares in the company, including a prohibition of any indirect transfers. The concept is not generally controversial, though founders will likely try to negotiate for certain exceptions to the lock-up, for example, tax and estate planning purposes. We would advise against accepting these carve-outs as there is often limited visibility on these arrangements, and they could be used to get around the lock-up restrictions. As a bottom line, we would recommend always having a cap (for example, 5% of the total shares held by the founder as of closing of the investment) that would apply to all carve-outs to the lock-up on an aggregate basis. Further, any other transfers (for example, transfers the investors decide to approve at a future time notwithstanding the lock-up) could be subject to a right of first refusal/offer and/or tag-along rights in favor of the investors.

Compliance and Internal Policies

While unicorns tend to be more established companies, they may not always have good corporate governance and well-developed internal policies and procedures. There are also likely irregularities or deficiencies in compliance practices, particularly in certain Asian jurisdictions and/or in certain industries, where rules may be underdeveloped or change frequently. It is, therefore, important that the investor conducts robust compliance due diligence and requires that the company remedy any deficiencies and implements proper internal policies as a condition precedent to closing or a post-closing covenant. In addition to reducing the risk of your investment, taking these steps will also help the company ensure that it gets the highest possible valuation in an eventual listing or trade sale. The U.S. Department of Justice has made clear that an investor may face liability if its inability to extricate itself from a company leads to it taking acts in furtherance of violations of the U.S. Foreign Corrupt Practices Act by the company or its representatives. In light of this and the potential reputational damage that could result particularly for high-profile unicorns in Asia, it is important that the investor should be able to extricate itself from the company if the policies have not been implemented or if despite their implementation a compliance issue arises. We will discuss these rights in more detail in section “If things go wrong…” below. 

Some examples of common policies include:

• Conflicts of interest and related-party transactions policies
• Founder succession plans
• Anti-corruption, sanctions, export control and anti-money laundering policies
• Business continuity and crisis management. The COVID-19 outbreak has made clear that investors should be focusing more closely than ever on business continuity and how company decisions should be made in a crisis. Consider requiring that a crisis management committee be established that would be able to make decisions quickly and effectively in the event of a crisis. Ideally, there would be at least one investor representative on that committee and a CEO designate who would be prepared to step in and take over if the crisis results in the CEO not being available to make decisions
• Data privacy and cyber security policies
• HR policies, such as employee handbook, anti-harassment and anti-discrimination policies

This concludes our discussion (together with Part I of this article) of the ongoing governance and monitoring rights you should consider negotiating for in your next investment for better risk-management. In the next part of this article, we will discuss the range of provisions that give you recourse if the company or the founders breach any of the covenants that have been covered in Part I of this article. As we have noted, it is important that you have rights that you can exercise effectively, since bringing legal action for damages against the company is often not effective or realistic, particularly in the case of breach concerning the types of covenants we have been discussing, such as governance and compliance-related covenants.

If Things Go Wrong…

Investors will need to have recourse beyond suing the company and the founders for damages and relying on liquidation preferences over other classes of junior equity. Legal processes, even if you are willing to pursue them against the company, are expensive, time-consuming, and often pointless if there are limited assets left to enforce against.

You should therefore negotiate for “step-in” or interference rights as well as exit rights, outlined in further detail below, so that you can invoke them or at least be in a much better bargaining position when things “go wrong.” Some possible default/trigger events include:

• breach of material obligations, including those discussed earlier in this article, such as the company taking corporate actions in breach of veto rights and breach by founder of non-compete obligations
• major disagreement over business or future direction of the company
• failure to comply with applicable laws
• regulatory requirements, for example CFIUS or antitrust concerns, or the company being placed on the Entity List published by the Bureau of Industry and Security of the US Department of Commerce, all of which may have a severe negative impact on the company’s business
• risk of management fraud or dissipation of assets
• incapacity, professional or personal misconduct or other controversy relating to founders and key management
• failure to achieve liquidity for investors after a certain period of time or failure to meet other KPIs

In our experience, triggers relating to non-compliance with laws, regulatory reasons, and fraud and incapacity of founders tend to raise fewer objections from the company, whereas performance-related triggers tend to be the most difficult to successfully negotiate for investors.

As a general point, the details in drafting of each of the provisions we discuss below are crucial. Where possible, obligations should be drafted so that the default/trigger can be objectively demonstrated. Detailed procedures, including timelines, should be set out in the documents for parties to follow to make it harder for founders to delay the process. Everything should be automatic to the fullest extent possible, and you should consider negotiating to obtain proxies and power of attorney from the founders and the relevant board members to effect these procedures so that cooperation from founders is not required to complete the procedures.

Taking Control

If your shareholding is substantial (for example, more than around 20% in a widely disbursed cap table), or if investors who are not aligned with management together hold a very large portion of the company (for example, more than 40%), you may want to be able to take control of the company away from the existing management, either by yourself or together with other investors. This would allow operations to continue, new management to be appointed, and changes implemented if needed, and eventually an exit through a sale of the company.

The key is to have control of the company’s board — as discussed above, the vast majority of operational decisions can be taken on behalf of the company with a simple majority of the board, including to replace the existing management (subject to any shareholder veto rights discussed above). Having independent directors and directors appointed by other financial investors with which your interests are aligned will be crucial. However, if normally the board is controlled by the founders, the constitutional documents of the company should provide that upon the occurrence of any of the trigger events, the founders lose some of their board votes, or the investor directors automatically are granted additional votes that together constitute the majority of the board voting rights. Needless to say, this will be difficult to negotiate, so the trigger events will need to be limited to the most egregious. If this is not possible, the investors could also negotiate for the ability to approve and enforce emergency business plans and other rectification actions, which could be less objectionable to the company as these are more interim measures designed to keep the company operating.

Certain major transactions the investors may wish to pursue will require majority or super-majority shareholder approval: for example, mergers, economic distributions or transactions affecting share capital such as repurchases and share swaps. In unicorns, founders normally hold a fairly small portion of the company’s shares after a few rounds of financing, so are less likely to be able to block these transactions if pursued by investors. However, in the last few years we have seen a trend of founders in Asia and elsewhere seeking to change this by giving founder shares super voting rights that will give them at least a majority of the total voting rights, or asking investors to sign voting proxies or voting agreements effectively giving up all or a portion of their rights to vote. We recommend that you strongly resist this, as otherwise you would be giving up voting rights on shareholder-level matters that are normally fundamental transactions affecting share capital and corporate status of the company. At the very least, any such proxy or voting agreement should carve outs for matters over which the investor has a veto right and should terminate upon the occurrence of certain events.

Investors may also negotiate for a call option over the founders’ shares upon certain events occurring, potentially at a discount to the then current valuation if misconduct is involved. This would require additional capital, but is nevertheless useful to have as a means to achieve control of the company and to give investors additional leverage in negotiations with the founders.

Exit Rights

These rights allow the investor to achieve an exit from the company after the occurrence of a trigger event, and most of them tend to be strongly resisted by the company. As with almost all provisions discussed in this update, the details of how each provision is drafted have a big impact on how they are received by the company and how effective they are if invoked (or attempted to be invoked).

• Put Rights and Redemption Rights. Often considered a “nuclear” scenario for the company, these rights allow the investor to dispose of its shares by effectively selling them back to the company or the founder. Note that redemption is only possible if the company has sufficient funds legally available for this purpose. Both methods should be supported by language requiring the company to dispose of its assets in order to fulfil its put and redemption obligation, though this tends to be strongly resisted by the company for obvious reasons. The put right may also be granted by founders themselves or by other entities of substance that they control, in addition to the company. A put right to a founder or entity other than the company does not raise the same issues as a redemption right. If the put is duly exercised and the founder or the relevant entity does not pay the put price, the investor can seek to put the founder or relevant entity into involuntary bankruptcy or insolvency.
  
  For completeness, we note that if you have strong bargaining power, it is possible to take share security over the founders’ shares in the company to secure performance of the put rights, though we rarely see this in the case of unicorns (outside of special situations).

• Drag Sale Rights. These are somewhat less controversial as they provide the founders also with an opportunity to exit and don’t require the company or the founders to fund the investor’s exit. Note that this drag right is only triggered by the specified trigger events outlined above and differs from a normal drag sale provision (where the right to drag is usually held by the majority shareholder). An effective drag right in this context must not be subject to majority board or ordinary shareholder consent, and should not be subject to valuation floor requirements (or should have a low valuation floor). It should also provide flexibility for the drag sale to be structured as an asset sale or sale at a subsidiary level.
• Facilitated Sale Rights. Under a facilitated sale right, the company agrees to engage an investment bank to procure the sale of the investor’s shares and agrees to provide assistance, including participating in due diligence and management presentations. This is a gentler right than the drag sale right, since only willing shareholders participate — although the potential inability to sell 100% of the company will result in a lower price being obtained for the investor’s shares. In addition, it is relatively easy for the company to provide the required assistance halfheartedly while not committing an outright breach of the facilitated sale provisions.

As a separate point, if the investor’s shares are subject to any transfer restrictions (for example, a right of first refusal or restrictions against transfers to competitors), consider requiring that these cease to apply upon the occurrence of the specified default / triggering events.

Valuation Adjustment

An automatic valuation adjustment mechanism may be useful in situations that don’t justify ousting of the founder or a complete exit from the company by the investor but nevertheless impact the value of the company. Failure to meet pre-agreed financial or operational KPIs or to meet pre-agreed timetable to achieve a qualified exit, or unauthorized disposal of significant assets are some examples. Once triggered, the conversion price of the investor’s preferred shares should automatically be adjusted, effectively lowering the investment valuation and giving you a larger stake in the company. However, this type of term is very difficult to negotiate successfully against unicorns, except in convertible bond financings and in special situations.

Access, Information, and Procedure

All of the rights and protections we have outlined in both Part I and Part II of this article are only effective if the investor is able to access sufficient information. You need to know when your rights may have been triggered, when there may have been a breach, and should you need to exercise your rights, you will need access to corporate and financial information, forecasts, and projections of the company, for example, to enable valuation of your stake in the company.

In addition to the usual information rights covering regular financial information, you should have a general right to request relevant information from the company and to have access to the company’s premises, books and personnel — it is difficult to foresee when negotiating the investment what information you might require down the track. Depending on the company in question, you may want to have ongoing audit rights where you can conduct a renewed “due diligence” exercise, covering both issues previously identified or any new areas of concern and, if necessary, make suggestions for improvement and rectification.

The above is subject to a general caveat that, if you hold material non-public information about a company that is listed, your ability to trade in its shares will be subject to the relevant securities rules, so, if you are negotiating terms of an investment in a company that is very close to listing, consider whether you would want to limit your information rights or have the ability to waive them post-listing.

Final Thoughts

You should assess the need for the various risk-management measures we have discussed as part of your next investment. For your existing investments, now may be a good opportunity to review your rights in your portfolio companies and their compliance with existing obligations. You may want to revisit some of the investment terms, particularly if the company needs additional capital in order to keep it afloat through these trying times.

We have kept our discussion high-level and have had to omit a lot of details due to length, including regional variations due to differences in regulatory framework and market practice. Asian unicorns tend to be strong negotiators on commercial terms and are often unwilling to compromise. However, there are many variations in drafting for each of the provisions we have outlined and also how they interact with each other. It is therefore important to have counsel focus on the nuances of legal drafting so you get the most favorable overall outcome within the confines of what the company is able to accept. We have often seen a small tweak in wording result in drastically different commercial outcomes for parties. We would be happy to take a deeper dive on any specific topics.