Following the Leader: Tips for "Passive" Seed Stage Investors

Rob Go, co-founder and partner at NextView Ventures , wrote an interesting article towards the end of 2018, which, among other things, highlighted the fact that of the universe of active investors in the seed space, only a small percentage of those investors take a lead position in their portfolio company investment rounds. I wasn’t surprised by the data, particularly based on my experience representing seed stage investors in early rounds of financings. Often times, those fund clients approach me to “look over their shoulder” as they invest a “modest” check into a round of financing being led by an alternative investor or syndicate of investors. In that capacity, there are 3 key items which become part of a shortlist of paramount points to highlight to ensure a passive investor is receiving the benefits and protections of the bargain they might be expecting:

Major Investor Threshold. Often times, in order to qualify as a “Major Investor” and therefore receive the benefit of participation rights in future rounds, information rights, and, in some cases, RoFR rights set forth in the financing documents, a threshold ownership level is set to correspond to a particular check size in the round. The threshold to qualify obviously varies deal-to-deal but given the importance of these rights, particularly the right to participate in future rounds of financings (a right at the core of a seed investor’s business), this becomes an important hurdle to identify and comprehend. In some cases, even as a minority investor, you may be able to persuade the company (and the lead investor) in setting the hurdle to ensure your check qualifies.

Voting Percentages.  Beyond confirming the amount of $s being allotted to a passive investor in the round, it is important to understand the preferred voting % thresholds on key decisions throughout the documents and what constituency is required to carry those votes, whether particular investor or group of investor holds on a block on such votes, etc. Even in a non-lead position, voting your shares a certain way might have the effect of influencing those decisions. Understanding whether that power would come with your check size is an important point to understand.

Side Letters. The business of entering into “side letters” is a common practice in the investment arena. Often times, lead investors request rights which a company prefer not to incorporate into the primary suite of financing documents distributed to the broader investor group and instead offer to incorporate into a short side letter which would not otherwise be broadcast widely, perhaps in some cases to avoid having all the “other” investors asking for similar rights. It may cover topics around press release control, observer seats, MFNs, special blocking rights, perpetual pro rata rights, etc. The universe of things I see in these letters is endless. As a non-lead investor in the round, however, you have an interest in understanding the landscape into which you are investing. Without knowledge of whether a side letter exists would fall short of delivering a full picture. Therefore, it is always important to confirm whether side letters are being delivered in connection with the round. And in some cases, you might ask for the same rights :)

Seed Investors: read this if you care about your pro rata!

Pro Rata Right to Participate. Preemptive Right. Participation Right. Call it what you may but this is one of the most important economic rights that attach to the preferred security received by a seed investor when making an investment into a portfolio company. For early stage investors, particularly those funds with limitations on their ability to cut larger checks to put them in the running to lead future rounds, preserving the right to participate in a portfolio company’s follow-on financing is paramount to future returns. Here is a word of caution for you seed stage investors (and your lawyers): Don’t risk being shut out of your participation right by missing a simple, yet key, technical drafting feature in your deal documents. The following anecdote sheds light on how that could happen:

Recently I was representing a VC in a subsequent round of financing for one of their portfolio companies. The round was being led by a strategic investor that had not previously invested in the company. My client and certain other existing investors planned to exercise their right to participate in the deal pro rata through a subsequent closing but, as is standard in financings, at the initial closing, existing stockholders, including my client, agreed to waive their contractual right to participate pro rata in the round, with the understanding that they would participate nonetheless. Note to the reader: This waiver is almost always solicited by the company, regardless of whether the company and new investor intend to honor the right of existing stockholders to participate, as it removes the need for the company to comply with the hoops and notice periods set out under the existing preemptive rights provision and, by doing so, a company avoids further delay on closing the current financing. Existing investors end up getting comfortable consenting to the waiver so long as the handshake business deal allows them to participate for an amount at least as large as what they were contractually entitled to had they not waived. 

So back to the deal I was working on….when the deal documents were distributed for final sign off, the lead investor had included language which would have subject participation in subsequent closings to that lead investor’s approval. Cue the lawyer’s alarm! With the participation waiver in hand at the initial closing and the lead investor’s ability to block who the company could accept as investors in subsequent closings, that set up a situation where existing investors could have technically been shut out of investing in the deal all together, in spite of the company’s desire to let them participate. Lesson for seed investors: ensure that your deal documents expressly carve out existing investors from lead investor’s block on who participates in subsequent closings, otherwise risk losing your ability to invest pro rata……and getting burned!