Exit rights are sought by investors to give them a route to sell their shares in a startup if the company hasn’t got to a liquidity event (e.g. a trade sale or IPO) within a set period of time. In this ‘Tricky Clauses’ guide we look at how these rights work and how to negotiate the provisions in shareholders’ agreements.
what are exit rights?
When you receive a series A term sheet, you might see something like the following paragraph:
“The Company will provide customary exit rights acceptable to the Investors within a period of [X] years from the date of closing of the investment.”
Exit rights come in all shapes and sizes. Best case scenario (as a founder): the exit right might just be a reasonable endeavours obligation. Worst case: the exit right could be an absolute requirement on the company to secure an exit within the agreed period – with investor remedies if the company fails to do so.
how common are exit rights?
A couple of years ago we didn’t see these in series A financing documents. They wouldn’t appear until at least series B when valuations are higher and the business further on in its lifecycle. Mapping out the journey to exit at that point at least made sense.
Now we see some kind of exit provision in most term sheets. The Singapore VIMA model shareholders’ agreement, which is intended to be used on series A financings, includes such a provision. However, this is a fairly soft obligation to try and work towards an exit within the period of time. And if the exit doesn’t happen, the board’s only obligation is to engage a corporate adviser to review exit strategy.
what is a typical exit period?
Typically we see periods of 5-7 years. Five years from closing your series A is not a long time. Which is one of the reasons why we think it is not fair to introduce exit rights at series A. In any case, anything shorter than 5 years is not market standard and 7 years is preferable.
what happens if the exit is not achieved within the period?
This is the key question. A reasonable endeavours obligation to try and secure an exit is one thing. An absolute obligation, with investor remedies if the company fails to do so, is quite another.
Investors taking an aggressive approach often seek one of the following remedies (and sometimes a combination of more than one of these):
- a right to require the company to buy-back investors’ shares at a specified price (for example, based on fair market value)
- investors having the option to reconstitute the board giving them full voting control
- an obligation on the board to engage an investment banker to find a buyer, coupled with a drag-along right so that all shareholders (including founders) can be forced to sell
how to approach and negotiate exit rights
say no if it’s too early
We think that at series A, exit rights are unfair on startups and founders. It is too early to set the clock running towards an exit date and to give investors additional remedies when they are still in effect just taking a punt on a very early stage company.
extend your timeframe
If your investors insist on having some form of exit clause, we think the period from closing of a series A should be at least 7 years.
soften the remedies
A buy-back or similar redemption right removes much of the investors’ risk and effectively turns equity into quasi-debt. Avoid at all costs, if possible.
The approach taken in the VIMA model shareholders’ agreement is more reasonable in our view – if the company has not exited, the board just needs to appoint an investment banker to consider exit opportunities and strategy.
Finally, we sometimes see exit provisions that put personal obligations on founders as well as the company – even a buy-out obligation! Asking founders to buy out investors at any point is essentially a personal guarantee and completely unreasonable. If you see this in a draft shareholders’ agreement, say no.
If you are currently discussing a series A term sheet get in touch with us or book a time to chat with one of our VC lawyers.