Governance Bites #62: agreements in angel investments, with Richard Coon

In this interview, Mark Banicevich asks Richard Coon about the agreements and key terms that form part of angel investment arrangements. Richard outlines the term sheet, its purpose, and its contents. He talks about other documents, such as the company constitution, shareholder agreement, and founder agreement. Mark asks about when angel investors might seek a seat on the board, and asks what advice Richard would give to a new director. 
Richard Coon, ONZM, was co-founder of two of New Zealand’s largest life insurers, Sovereign (now part of AIA), and Partners Life (which sold to Dai-Ichi Life in November 2022 for NZ$1 billion). He has an MBA from Harvard University, and he is a Fellow of the Institute of Chartered Accountants of England and Wales. He currently sits on or chairs several startup or early-stage company boards.
#governance, #director, #boardroom, #boardcraft, #angelinvesting, #angelinvestors

Transcript

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Hi everyone. My name is Richard Coon. I'm chairman, well, past chairman, now patron, of a group called Angel Investors Marlborough. We're a group of just over 180 members based in Blenheim, and we are really an angel club. We invest in small companies, so it's a very exciting space, but certainly an interesting area in terms of governance. That's really why I'm here today. Right, we're going to talk about key terms and agreements in angel investment. Hi, I'm Mark Banicevich. Welcome to Governance Bites, and as you just heard, once again, I have the privilege to spend time with Richard Coon. Richard, thank you very much for your time. You're welcome. Richard was recently appointed an Officer of the New Zealand Order of Merit for services to business and philanthropy. He is a co-founder, a former co-founder and director of Sovereign, which is the largest life insurance company in New Zealand, that was bought recently by AIA. And then co-founder and director at Partners Life, which was sold to Dai-Ichi Insurance in November 2022 for a billion dollars. He is a Fellow of The Institute of Chartered Accountants of England and Wales and has an MBA from Harvard [University]. So, a very, very experienced director and business person, and now, as you heard, he's involved in Angel Investors Marlborough and on a number of boards of companies he's invested in as part of that. What we're here to talk about today is the terms and agreements that are involved in angel investment. So, as a director of a company, if you're looking to seek investment for the business, some of these areas will be particularly useful to you. To start off with, Richard, can you talk us through the process of completing an investment? So, if you've decided to invest in a new business, what's the process of investing? Yeah, well, we have screening teams, and they go through, and then the companies come down and pitch to us, and we work out an offer we're going to make to them, including the value. Then we give them what's called a term sheet. The term sheet is perhaps 10 pages, and it lays out exactly what the nature of the relationship should be so that there are no surprises for anyone. That term sheet is not only important for us, but we're often leading an investment where we might involve other angel groups. We can then go around and share that term sheet with other groups around the country if we need them to come and make up the total amount of capital that's required. This term sheet will say we're going to have ordinary shares or preference shares, we're going to value the company at this level, these are the sorts of decisions that have to come back to the board or the shareholders, and it would define something about who's going to be on the board. It might involve something about employment terms and any particular - what are called - vesting rights. Because quite often, when you see a company and they come to you and the owners own 100% of the shares, you don't want to put money in alongside them as ordinary shareholders and then, if it all collapses, they then take all the money. Yes. So you have to have what's called "vesting", which basically says to them,"Look, you keep 50% of your shares, but the other 50% goes into a pool, and you earn those over the next four years." Okay."If you, for whatever reason, decide not to continue in the business, you don't get those shares,"but they're available for whoever we need to bring in to replace you to run the business." So, that's a very key part. The things you cover also in the agreement are what's called preference, which means that if things go wrong, at least we know who gets paid first. Who gets paid first. And then vesting is the other key one. That point you raised about vesting is an interesting one. If they're held and not owned legally by those founders for a period of time, who actually holds the legal interest on those shares before they vest? Well, they're sort of held by the company, but it's a bit like an option scheme really. Right. Okay. Oh, that makes sense. Except it doesn't get taxed like an option scheme. They're treated as they own them, but they don't have any rights to them. What there is, is a buyback clause in place. So basically, they're forced to sell them for a dollar if they leave. Right. Oh, yes, okay. That makes sense. The question I was just going to ask has jumped out of my head, so while I'm thinking of it... Oh, actually, that was the question I was going to ask. When you invest into an entity like this, do you tend to create a nominee company to own those shares, and all the angels go into that? Yeah, within AIM we have an AIM Investment, Angel Investors Marlborough Nominee Company. And that nominee company holds all the shares in all the companies for its members. Okay. We have a deed of commitment between the nominee company and the individual investor - Yes. - basically saying what the rights are, and if there's any votes or whatever. We still have to seek their instruction as to how they want to vote. But it is purely a nominee. It just makes it a lot easier. Obviously, a lot of companies, if there are going to be 20 of us investing, you get caught by the takeover rules in New Zealand if you have 50 investors. Right, okay. So most of them, we want to keep away from that problem, and we do that through using a nominee. Right, okay. So, is it one nominee company that then invests in a number of different companies? Yes, it's the same nominee company. Okay. But the investors invest in different businesses, so the nominee company would say this particular individual has got money invested in this company, in this company. Yes, it keeps all those records. Right, okay. Then the nominee company would have its own board of directors- Yes, it has. Yeah. - that then talks to the investors of a particular company around decision-making. It doesn't make any decisions. The investing company is purely a nominee structure. Right. But yes, it does have a board. It gets a bit problematic when you sell a company because of the money laundering side of it. Because often they want the money to go directly to the individual beneficial shareholders; they don't want it going through the nominee. Right. So, that does create a problem sometimes. Right. But we can solve it usually through a solicitor's bank account. Yes, and then you just, if you're in anti-money laundering and counter financing of terrorism reporting entity, you simply have to do your risk matrix and get a review every couple of years. And so forth. It's three years now, isn't it. Well, we use a product called Catalyst, which is basically New Zealand's small, well, it's a regulated stock exchange for small to medium-sized enterprises. That's right. We use that structure so that all our members are AML [anti-money laundering] checked, - Yes. - and they are on there, and then all the investments are done through there. Right. It's a great system. That maintains the registry. Maintains the registry. Okay. And then I believe Catalyst then has trade windows, doesn't it? Yes. So it has a secondary market. It raises money for companies, and all our individuals go in as do other investors. I think they've got about 5,500 investors on the system now. And the secondary trading is done on there through auctions. Okay. One of the important things as an angel investor is you're not necessarily wanting to hold a share for 20 years. That's right. So you need some liquidity, and certainly platforms such as Catalyst enable you to get that liquidity in your shares. Yes, absolutely. Coming back to the agreements that are involved in this process, what are the key legal agreements that you need when you're investing? You've got to have a constitution, which defines the types of shares, the rights of the different classes of shares, transfers, and things called tag-along and drag-along. Which [tag-along] basically says if someone wants to sell a large amount of shares, sometimes other shareholders will have rights to go with them. Drag-along means if someone comes in and wants to buy the company and some of them want to sell, there's a minimum percentage that have to agree to sell before they can drag the others with them. But it does mean that if 75% of the shareholders want to sell, they can force the other 25% to go along with it. Yes. So, you won't have people holding out, and holding hostage, sort of thing. That's your first main document, is the constitution. Then you have the shareholder agreement, which is where everybody agrees on what the objectives are, what sort of board it's going to have, the management, what budgets, how it's going to report, how it's going to raise capital. There are things called anti-dilutes. So that is something that says, if I come and invest and pay a dollar for my shares, and in a year's time you bring shareholders in at 50 cents, I can have all mine repriced to 50 cents. Okay. That is quite common in young startups because it is an art rather than a science to value a company, and you might have got it wrong. Yes. And things can change quite rapidly, and it would be somewhat unfair if people went in at one price and then suddenly a load of others came in at a much lower price. So, you have that protection. It's not forever; it's often one or two years of anti-dilution just to give you that protection. Usually, we will look for that to be in there. Vesting - that's also important, I think I mentioned that. So that, just make sure that there are shares available, if a founder wants to walk away, that there are then shares available for his replacement. And non-compete is usually important, because so much of the value of the business is in the people you're putting your money into. Yes. And if you don't want to put your money in, and then the next day they walk away and do the same thing somewhere else. Yes. So, you usually have a two-year non-compete clause. That's the shareholder agreement. You have a subscription agreement where that's really to do just with the issue of the shares, confirming what information has been provided to you and what warranties the company is offering. So, if you've been misled in any way, or something like that, then there is an opportunity for you to get something back. But, you know, - Two cents in the dollar. - you're hoping that never happens. There's usually a founders agreement because most of our companies have one or two founders. That will be that the intellectual property is in the company; it's not in their names. Right. The vesting thing I've mentioned. Usually, you put transfer restrictions on founders' shares. So you say, "Look, we want to make sure you guys are locked in." So maybe you can only sell 10% of your shares a year, or no share sales for three years, - Yes. - or just something that's reasonable. And any non-competes. Usually, the board and what the voting rights will be. And often founders do have some special voting rights. They might have both of the founders being on the board. So you have to look at that balance of board and voting. Yes. Because you don't want something pushed through that the majority of the people who put the money in don't like. Yes. And then the final document, most companies will have an employee share option program (an ESOP). In New Zealand, that's typically 10 to 20% of the total equity in an ESOP. And it will cover, you know, not necessarily all employees, but certainly their most senior employees. It is a good incentive. It's not very favorably taxed in New Zealand, unfortunately. Hopefully, that'll change. Yes.

And it's usually based, well it goes one of two ways: 13:09

it's either a time-serve type of thing, which says,"Look, if you're still here in four years' time, you can exercise these options." Or there might be a performance-based, which says, "If we get to this position of turnover or this value as a company, your shares can vest, your options can vest." So it's much more determined as to how well the company does, as opposed to just a time thing. But those are really the five key documents, and they're pretty well will be standard for every company to have one. Generally, there are in New Zealand, some reasonable standards. Some of the law companies have them on their sites. The Angel Association in New Zealand has a set of documents on its site, so often most of us will use the standard. The standard templates. Yeah. And then you'd probably... It saves a lot of time. Everybody's familiar with them. Yeah. And then you'll be able to just change the terms and things slightly to use. And they're designed to be fair. They're designed to be quite well-balanced between the founders and the investors. They'd have to be, right. Yeah. Because if you're the founder of an entity, you don't want to hand over control to these investors; otherwise, your baby can be taken. If you think about it, they're investing in you as a person. Yes. You know, they don't want to come and control your company unless you go totally rogue. Absolutely. You have to allow for that, that a founder might go rogue or decide it's not for them and they want to do something else. You've got to allow for that in whatever agreements you've got. But you try to be fair, and it is very much a partnership. Absolutely, yes. You mentioned in our earlier conversation around, when, on some occasions, you'd seek a seat on the board, and in other cases, you wouldn't. You mentioned in particular that in some cases, you might have founders without any board support around them, without an existing board structure. In other cases, there may be a little bit more structure involved. When would you seek a board seat, and what would the circumstances look like? Well, I guess you've got to be conscious of the fact that there are liabilities as a director. And these are early-stage companies where people will tell you that 70% of new businesses go bust. So you don't go in lightly to become a director, you know. But if you get heavily involved in the business, it probably doesn't make much difference whether you're a director, because you'll be deemed to be a de facto director. And I have to say, we do like to be involved in the businesses, but not to the level where you would be like an executive or something like that. But you could get involved in major decision-making. And you do, when you're a director of these companies, need to make sure that you are solvent at all times. Of course. We do make sure. And I know, a number of companies I'm involved with make sure they record that in their minutes at every meeting, that they have reviewed the situation and agree they are solvent. Right, okay. Because otherwise you are taking risks as an individual director. Within AIM, we appoint, basically, an investor rep [representative] to every investment. That investor rep may or may not become a director. We may have a situation where we find someone else to be an independent director who has much more skills than we offer in that particular area, and we would encourage them. We like to see independence on every board, - Right. - but it's not necessarily us; it's the person with the right skills that is most important thing. Yes. I did mention before, we do want to make sure we're getting regular reporting. We want to know if there's a problem, and certainly having that independent person on the board helps us get a better understanding without any bias - Yes. - as to how well things are going. You also mentioned, I think in our earlier conversation, that one of the things you do as an angel investment team is create a governance structure if there isn't one already. Yes. Yeah. So making sure that there is some sort of board in place. As you say, your investor rep may or may not sit on the board. You might get an independent person in, if they've got a different skill set, but certainly setting up that regular reporting cycle and the governance is a big part of what you do. Oh yeah. If you think about it, you just set the board timetable for the year. You know you want to have a good strategy session; it might be a couple of days off-site. You want to do that. You know you're going to have to produce some accounts and have an AGM [Annual General Meeting]. You know you want to do a risk management matrix at some stage. You know there's going to be a need for a pay review because usually the board will be involved in the managing director's pay review. Right. Usually within small companies, you don't set up a remuneration committee and you don't set up an audit committee. It just becomes part of the board's. It tends to be just all part of what the board does. Right. Yeah. So you just do those key things and make sure they're covered in the year. Another question for you,

in terms of the fundraise itself: 18:41

generally, as you said before, some of the companies that come to you don't have a revenue stream yet. Or they'll be in the very early stages of revenue, and generally, a startup will be in a loss-making scenario for a period of time. So when they're coming to you asking for money, I expect they're wanting 6 to 12 months' worth of money to create a runway, but they don't need all that money on day one. Does the angel investment team tend to drip-feed the money in, or is it provided in a lump sum? How is that expected to go? No, we tend to know they're going to come back for money. A typical company may have like five raises. Right. We'll probably make sure they've got enough for 6 to 12 months, but we know they're going to come back. Right. You don't tend to try to define all the terms now and let them draw it over a three-year period, because the valuations and the situation is going to change quite dramatically. Yes. If they do really well, they could be coming back in 12 months' time at two to three times the valuation they had originally. And that's fine. Often, as an investor, if we've got new investors coming in at twice the money we went in at, you feel good about that. Absolutely, yeah. You know. Normally, you'd be supportive as well, so you'll normally put a bit more money in. You usually don't put quite so much money in on the second and third rounds as you did in the first round. It just seems to be the nature of things. It might be half the money they ever want to raise in the first round, but then the balance will be over a few rounds after that. Okay. But you know it's going to be a long journey of capital raising. Very few raise and are profitable in a year. No. Of course, yes. Have you learned any hard lessons that you could have avoided with some of these agreements that you talked about earlier? Yeah. I would say vesting has probably been our biggest area. You do find that you can meet a great team, and they're working well together, but under the stresses of building a new business, that team may not stay together. Right. We've had quite a few situations where an initial founder has gone. And that may be their choice, or it may be someone else's choice. The partnerships don't necessarily stay together. And you've got to make sure that vesting is covered, that you've thought about that situation occurring. There have been quite a few situations where that hasn't been covered properly. Right. And it can be very, very difficult to say to somebody, "Well look, we want you out, and we want to take your shares off you for a small sum." And they turn around and say, "Well no, I want X." Yes. And quite rightly, because you didn't allow for it.

That has been probably one of our biggest learning lessons: 22:03

is where we haven't put the vesting rights in place. We make sure that we don't miss that one now. Right. Certainly, when we started, and we do sometimes just get asked to participate in a deal that another group has put together, and maybe the terms are a bit softer than we would like, but we still see that it's a good opportunity. You can't really change things, so we have to accept that maybe it's not a perfect agreement. That's usually the [case]. I think we've been on enough journeys now over a seven-year period that we know what the things are that can happen, and to allow for those in the agreements. Yes. There is a lot of uncertainty, and through no one's particular fault, things don't necessarily turn out as you hoped. But you've got to allow for that. Yes. Right. So it's about being prepared. Yeah. Planning in advance. Yeah, absolutely. As you said before, interesting point — that point that you raised that the shares would legally sit in the hand, the ownership of that founder, for example, but there's an agreement that they would have to sell a portion of them at a lower price. Yes, that's right. That's how it works, right. Yes. So, that is a very important aspect of putting the deals together. As is liquidation preference. They're probably the two absolute biggies. Because often the founders will have ordinary shares and the new investors will have preference shares. Right. Yes, yes. Something you actually mentioned before we started recording was you alluded to the difference between being on the board of a startup versus being on the board of a more established company. Can you share a little bit about that? Yeah. I mean, when you join an established company, you often don't have any financial shareholding, necessarily. You've asked to join the board of a bank or something, and it's much more to do with pure governance. Are we doing the right things? Are we going through the right processes? Are we making decisions in the right way? And there's no personal interest. But when you are an investor going onto a board of one of these young companies, you know you've put some tens or maybe hundreds of thousands of dollars on the line investing in this company, and then you're also trying to be an independent director. You don't know that you're getting that balance right. There is some conflict there. Clearly, if you've got money on the line with a big upside, you might be more open to risk than someone who hasn't got a shareholding. Yes. And I think it's quite important to see if you can get a mixture. If I went onto a board and had a big shareholding, I would like to see one or two other independents without a big shareholding, just to make sure we've got that balance right. Yes, yes. And you also mentioned before that on a startup board you wouldn't tend to have the subcommittees, like your remuneration, your audit subcommittee. It all tends to get done by the board. Oh yeah, well, you're probably not having an audit at all, as a small company. But yes, the account side and the rem [remuneration] committee will be the independents. Yes. You obviously won't have the management team on there. But the audit would be everybody. Yes. And the risk committee, you wouldn't — normally in a big company, you have a separate risk committee. Yeah. Well, you wouldn't there. That's all part of your normal board. But we do stipulate one particular meeting of the year to be our risk meeting, - Yes. - so people can prepare for that properly. In the established companies, you'd have a lot more support, as well. like, you'd have a risk team internally within the company, that's reporting to the risk committee. Yeah. Whereas, in a startup, there's no risk team, right, it's just"the team". No, no. So you've got to get your hands a bit dirtier. Some of them, I mean, they're small companies, but some of them might have like 50 staff. They're not — I mean, there are tiny ones where it is just the team of two. Yes. But they do grow, you know, over a number of years they can be 50. In fact, I had a meeting earlier today, they've now got 90 staff in a startup. That's actually getting very good. There are — I looked at the stats —there are 605,000 enterprises in New Zealand, and under 3,000 of them have more than 100 employees. Oh yeah, yeah. So it won't be long before they become one of the largest companies in the country. Absolutely, no. One final question then for you, as an experienced director: if you were to sit down with somebody who is fairly new to the governance process, being fairly new as a director, what advice would you give them? I think you've got to work out why you're there, and how can you specifically add value to this company. Most of these young companies have got loads of gaps, and with your experience as a new director, you probably can fill some of those gaps. But it's important to clarify that with them and make sure that they know that that's your input. And the other part is, with these companies, actually being a founder of a company can be quite a lonely experience, and when you go into the company, you are becoming a mentor. And I think that's important also to recognise. You may not necessarily be the only mentor, and part of what I do when I go into a company, is find out what other mentors I can introduce them to, because I think you can never have too many mentors, as someone who's running a business. Just someone who's got some experience and can just help you make some of the hard decisions you're going to have to. That's important. So yeah, those are probably the key points. You do become a member of the team. It is very different to being on the audit of a big company. Yes. Where you're just turning up, and, yes, you are involved in the decisions. You're not that closely involved, as you are in a small company. Yes. But you've got to also try to maintain that bit of distance because, you are an independent, as independent as you can be. Your job is to apply fresh eyes, right. Yeah. And you are trying to help them not make a mistake. But sometimes you have to make some hard decisions. I have had decisions where I've been on a board and needed to decide that one of the founders was wrong, in that position, and we needed to push for change. Because you are looking after the shareholder interests. Yes. You have quite a few roles you're playing, and quite a few allegiances that you're having to balance. Right. Well, Richard, again, thank you very much for your time. It's been great to catch up and have a conversation. I appreciate you spending some time with me while you've been up in Auckland. You're very welcome. I'll look forward to seeing you again soon. Okay. And we'll see you next episode. Thank you.