Venture Capital (VC) funds have invested billions of dollars in Indian start-ups in the last two years, often at seemingly outlandish valuations. But as valuations have risen, investors have ensured their capital is protected by adding tough clauses to their fund-raising agreements. In the process, start-up founders and employees may be left with very little after a sale.
VC investors have chosen to protect their capital through downside protection clauses such as so-called liquidation preference (LP), which comes into play when a firm gets sold. To put it simply, at the time of the sale of a start-up, LP allows an investor to take back its entire capital or the amount due to it in proportion of its shareholding in the firm, whichever is higher.
LP has become a standard practice and a non-negotiable clause for VC investors. This provision can, in certain cases, lead to investors walking away with all the money from the sale of the firm.
From January to October this year, VC funds invested $4.41 billion (across 368 deals) in Indian Internet start-ups, while VC investments in 2014 and 2013 stood at $2.39 billion (308 deals) and $1.53 billion (251 deals), respectively, according to data from VCCEdge, the financial research platform of VCCircle.com.
“The last two years, the way fund-raising has happened, very few founders negotiated strong agreements. For them, the bigger concern is raising funds and building the business,” said Vishal Pereira, managing director at financial advisory firm CreedCap Asia Advisors.
According to Pereira, if the industry sees a slowdown, the first signs of which are becoming visible, and if fund-raising becomes difficult, these conditions might hurt founders.
So how does LP work?
The most common form of the clause is a non-participating LP of 1X (1 time), which guarantees the investor the return of its capital.
Assume that a VC firm—call it ABC Ventures—invests $50 million in an Internet start-up at a valuation of $100 million, giving ABC a 50% stake in the company. The rest is owned by the founders and employees of the firm. At the time of fund-raising, ABC included LP of 1X in the agreement.
In good times, if the company finds a buyer willing to pay $200 million for the firm, ABC takes home $100 million for its 50% stake and the rest goes to the founders and employees. Everyone is happy.
But if market conditions are hostile and the business has been hit, the company may only manage to find a buyer willing to pay $75 million to acquire the firm.
At this valuation, ABC should only take home $37.5 million for its 50% stake. But if the investor has a 1X LP clause, it will actually take home its entire $50 million investment, leaving a far lesser amount to be divided among founders and employees.
In the firm is sold only for $50 million, the investor bags all the proceeds. “LP is less likely to be enforced in large exit deals, where VCs would make their target IRR (internal rate of return); for instance, it wasn’t necessary in Myntra-Flipkart deal,” said a VC investor seeking anonymity.
Flipkart India Pvt. Ltd, India’s largest e-commerce firm, bought online fashion retailer Myntra.com last year in a cash-and-stock deal last year. The deal likely valued Myntra at more than $330 million, Mint reported in May last year.
The VC investor cited above added that LP is normally triggered in early-stage firms.
While the 1X liquidation clause is standard practice in Series A and later-stage deals, such clauses get more onerous at the angel investment and seed investment stages where investors usually demand a 2X LP, meaning the investor is guaranteed to take home twice the invested capital.
“In the angel/seed stage of investments, liquidation preference of 1.5x and 2x are commonly seen,” said Sharanya Ranga, partner at Advaya Legal, a law firm which advises startups in fund-raising.
“Also, liquidation preferences at these stages tend to be of ‘participating’ kind, wherein in the case of a liquidation event, the investor will first pull out his invested capital (depending on the preference of 1.5 times or 2 times), and then whatever surplus capital is left will be divided between shareholders (including investors) in the proportion of their shareholding,” Ranga said. “Thus the investor possibly takes home a significant sum of money from the sale proceeds.”
“While the 1X liquidation preference is a fair one and a standard industry practice, the participating 2X LP, also known as ‘double dipping’, is very unfair on entrepreneurs,” said a start-up founder, who declined to be named, adding that when entrepreneurs don’t have a choice, they agree to these conditions.
Seed-stage investors justify such clauses by pointing to the higher risk associated with putting money in a fledgling firm where the business model is yet to be proven and revenue is minimal or absent.
Such unfavourable conditions can also be the result of an entrepreneur chasing higher valuation, investment bankers say.
“It’s a function of what valuation you ask for. If an investor is willing to pay a certain valuation but the entrepreneur wants a higher valuation and if the investor is still keen to participate in the company then he will demand a higher LP,” said Sumir Verma, managing director at investment bank Merisis Advisors, adding that, by nature, entrepreneurs tend to be optimistic and believe that things will never go down.
However, as the ecosystem evolves, even entrepreneurs with early-stage firms are becoming more aware and cautious while signing off on such conditions.
“In recent times, we have seen that entrepreneurs have become much more aware about onerous clauses and have no qualms in negotiating harder to strike a fair deal from angel/seed stage investors, such as 1X non-participating liquidation preference,” said Ranga.
Legal experts also believe that while, on paper, VC firms may build in downside protection through LP, enforcing such conditions is not easy.
“For foreign investors, enforcing such conditions can be very difficult. When foreign investors are involved in the sale transaction, the Foreign Exchange Management Act comes into the picture and under the FDI rules enforcement of liquidation preference becomes limited,” said Vaibhav Parikh, partner at law firm Nishith Desai Associates.