It should come as no surprise to anyone active in the Australian technology industry that we are behind the curve in terms of investment norms. Just one example of this the expectation of “pre-emptive rights” as an standard right for all investors.
In short, a pre-emptive right is the right for an investor in this round of investment to participate in all future rounds of investment.
Australian investors, (or perhaps just their lawyers) are absolutely obsessed with pre-emptive rights, and we see them come up again and again in negotiations, often as the first thing to be discussed.
Now, that doesn’t sound so bad, right? What company wouldn’t want their existing investors to double down on their investment later at a higher value, saving them from the trouble of going to market for the same funds?
Well, unfortunately, these pre-emptive rights often look something like this:
- The startup must determine the terms of the proposed investment round;
- The startup must offer each Investor its respective proportion of shares on the terms of the proposed investment round;
- The Investor has 30 days from receipt to confirm its interest.
How does this play out in practice?
Let’s work through a couple of quick scenarios with respect to how this might play out in practice with a hypothetical startup.
SCENARIO 1 - APPROACHING EXISTING INVESTORS IN ADVANCE
This scenario lays out the process as envisioned by the pre-emptive rights clause as drafted.
The startup decides for itself the terms of its proposed investment round in advance of approaching any outside investors, a contract is drafted, and offered to all of its existing investors as required by the pre-emptive rights clause. (14-21 days)
The startup waits for each investor to confirm its interest or refuse. (30 days)
At the end of the waiting period, a portion of the proposed investment round is taken up by existing investors, and the balance needs to be sought from the venture capital market.
VCs are willing to invest, but after a period of negotiation, require changes to the proposed terms on some axis (price, valuation, share type, etc). (20-30 days)
The startup is now required to make a new offer to all of its existing investors, as the terms of the investment have changed.
The startup waits another 30 days for each investor to confirm its interest or refuse the new deal, during which time, the deal may go cold.
Total wasted time: 60 days.
SCENARIO 2 - APPROACHING EXISTING INVESTORS AFTER TERMS ARE DECIDED
This scenario lays out the ideal outcome for a startup.
The startup directly approaches the market without first consulting its existing Investors, pitching to VCs (20-30 days).
VCs are willing to invest, and a contract is drafted and terms of the investment are decided after a period of negotiation (20-30 days).
The startup takes the VC’s offer to all of its existing investors as required by the pre-emptive rights clause.
The startup waits for each investor to confirm its interest or refuse, during which time the deal may go cold. (30 days)
If the terms of the external investment do not perfectly match the expected uptake of the pre-emptive rights from then either:
- the round is over subscribed; or
- the incoming VC’s investment is reduced, which may cause the deal to go cold;
Total wasted time: 30 days.
HOW DO WE SOLVE THIS PROBLEM NOW?
There is one “easy” solution to this problem, and that is for founders to pester their existing investors to waive or take up their pre-emptive rights as soon as possible after a deal is settled.
This is an “all or nothing” proposal however, and if a single shareholder refuses or can’t be contacted, the whole 30 day period must be waited out.
If a startup has a handful of existing investors, this works. Given that the number of shareholders is likely to increase over time however, this is only a viable solution for so long.
HOW DO WE FIX THIS FOR GOOD?
Ideally, we would like to see a future more like the United States, where pre-emptive rights are not the norm, but rather a reward for high value investors.
In the mean time, we think the answer to this problem is a standardisation of “pay to play” provisions in venture deals in Australia.
Pay to play provisions are also more common in the US, and will usually look something like this
- Only “Continuing Investors” will have pre-emptive rights;
- If a “Continuing Investor” fails or refuses to participate for at least its pro-rata proportion of shares in any future fundraise, they will cease to be a Continuing Investor;
We believe that pay-to-play provisions are good for both investors and startups.
- For the startup, it reduces, over time, the administrative headache of each subsequent round;
- For the investor, it gives them an incentive them to continue to support and participate in a successful business.