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Exit Rights – A Founder’s Perspective (Exit of Investors)

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Treelife

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Published on

February 14,
2024

Last updated on

August 21, 2024
00:08

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https://treelife.in/legal/exit-rights-a-founders-perspective-detailed/

Blog Content Overview

1 Introduction
2 Various Exit Mechanisms
3 Founders’ Perspective on Exit
4 Conclusion

Introduction

Exit provisions determine how, when and at what price investors can sell their stake in a company and procure an exit from the Company, thereby, being the most crucial exit rights that an investor seeks in an investment transaction.

Important aspects of an Exit provision –

Exit period: This determines the maximum period within which the Company and the Founders are required to provide returns to the Investors on their investment. Typically Investors agree upon an exit period of about 5-7 years.
Exit Price: Investors usually do not incorporate an exit price in the documentation at an early stage as it is difficult to determine the growth trajectory of a company so early on, hence, exit is to be procured at the fair market value at the time of such exit
Exit Mechanisms: The investment documentation sets out the manner in which an exit can be provided such as IPO, third party sale, etc.

Various Exit Mechanisms

IPO: An investor can procure an exit by ensuring their shares are sold in an initial public offer, in case the Company decides to be listed on a stock exchange.
Strategic Sale and Third Party Sale: In case the Company has an offer from a strategic buyer to buy substantial amount of shares/assets of the Company, the Investor can procure an exit by selling their shares in such a strategic out, whereas, a third party sale is a simple secondary transfer between the investor and a proposed buyer.
Buyback: In the event the Company/Founders are unable to provide an exit to the Investors within the exit period, the Investors may require the Company to repurchase the shares held by them.
Put Option: Considering the legal barriers in executing a buyback, investors seldom insist on having a Put Option on the Founders, i.e., at the option of the Investors, the Founders are required to purchase the shares held by the Investors.
Sale in a new fundraise: In case the Company raises a new round of funding, they could offer the investors exit by way of facilitating a secondary transfer of their shares to the new Investors.
Liquidation Preference: The Company may provide an exit to the investors at the time of a liquidity event ,i.e., an event including but not limited to merger, acquisition, corporate restructure, change of control of a company, liquidation, etc. by providing them at least 1x of their investment amount or such amount from the proceeds of a liquidation event, proportionate to their shareholding in the Company.
Tag Along Right: This is right enables the investors to tag alongside the Founders in case the Founders find a third party buyer for their shares.
Drag Along Right: In the event the Company is unable to provide an exit to the Investors, the investors have a right to invoke a right to drag all the shareholders of the Company in a drag sale (sale of substantially all shares of the Company) facilitated by such investors.

Founders’ Perspective on Exit

Let us look at certain exit provisions from a Founders’ perspective and what kind of safeguards do founders need to build in the exit rights:

Exit Right	Founder specific provisions
Exit Period	Founders can be about providing an exit period of not less than 5 years.
Exit Price	Founders of especially early stage companies should not agree on a delta on the investment amount, and instead provide the exit price equivalent to the fair market value at the time of such exit.
IPO	It is important to ensure that while Investors would be able to sell their shares in an IPO, the Founders should also have the right to do so in order to realise the value of their shares.
Put Option	A Put Option ensures a direct obligation on the Founders to purchase the shares held by the Investors from their own funds and hence, it is not recommended to sign up to such provisions.
Sale in a new fundraise	While this right is not a major redflag for the founders, it may act as an impediment to raise funds in the Company. In case such rights are exercised, a substantial portion of the investment will be provided to such existing investor leading to shortage of funds to the Company.
Liquidation Preference	Founders should be wary of the mechanism of liquidation preference clause. Some investors require more than 1x of their investment amount along with a participating liquidation preference, meaning, once they are provided with their investment amount, they will have a right to participate in distribution of funds to the other investors as well on a pro-rata basis. This is to the detriment of the other investors and especially founders, as, they are at the lower end of the liquidation preference recipients and leaves very little funds for distribution amongst the Founders.
Tag Along Right	Founders to ensure that in case they provide a tag along right to the Investors, they must provide only a proportionate tag along right, i.e., in the event the Founders transfer 10% of their shareholding in the Company, they facilitate only a 10% exit of such investor’s shareholding. Having a complete tag on Founder’s shares leaves very little opportunity for the Founders to procure liquidity on their shares.
Drag Along Right	Founders should ensure that while Investors have a right to drag all the shareholders (including the Founders), the Founders should get an exit on terms which are pari passu with the terms provided to such dragging investors for their shares.

Conclusion

In conclusion, ensuring safeguards for the Founders/Company in the exit clauses of shareholders’ agreements is not merely a legal formality, but crucial for the interests and vision of the Company. These provisions ensure that founders retain a degree of benefit from the company’s growth, even as they navigate the complex waters of investment and potential corporate events such as mergers/acquisition. This careful consideration of exit strategies reflects a mature approach to entrepreneurship, recognizing the importance of legal foresight in the unpredictable journey of business growth.