Lessons from Redbus and what to watch out for in a termsheet

Should you negotiate termsheets and investment documentation? What can the consequences be like if you fail to negotiate? Let’s see what happened in the case study of Redbus (if you have known about the issue before, we suggest you read this to understand precisely how business logic and legal terms apply to a funding transaction).

At the time of exit to the Indian arm of the Ibibo group, Redbus had an enterprise valuation of around Rs. 600 crores (USD 125 million). Do you know what was the shareholding of its two founders Phanindra Sama and Charan Padmaraju? Less than 15 percent. The amount of shares controlled by the founders of Redbus, and consequently the valuation individual shareholders received for their ownership of the company was extremely low in comparison to the amount of funding Redbus had raised.

Do you know why?

A startup’s valuation in subsequent rounds does not always increase – often it may decrease. This is exactly what happened in the case of Redbus. What happens when the valuation decreases and the startup raises new investment? In the case of Redbus, the investors who funded the company in its first round had inserted a special clause to prevent their shareholding from being diluted, in the event the company’s valuation was lower in subsequent rounds. This clause is known as a ‘ratchet’. Essentially, if the company’s valuation in a subsequent funding round reduces, the old investor is given additional shares to bring his percentage levels on par.

Ratchets are of two kinds – full ratchet and weighted average ratchet. A full-ratchet protection entitles the previous investor to get additional shares to maintain his previous percentage of shareholding, in case the valuation in a subsequent round is lower. Every investor wants a full-ratchet, as far as possible. A weighted average ratchet on the other hand limits the number of additional shares issued to the proportion of his investment amount in comparison to the fresh investment. So, if a subsequent investor is investing six times the amount invested by the initial investor, the amount of anti-dilution shares issued to the previous investor will be reduced by a sixth – that is, the previous investor will not be restored to his original shareholding levels. This method can substantially reduce the additional number of shares issued to a new investor – and prevent dilution of founder stake.

Entrepreneurs who are aware of the consequences may not be able to negotiate and eliminate the ratchet, but are able to significantly water it down to a weighted average ratchet. 

The full-ratchet clause can be extremely disadvantageous for any startup (The Redbus founders had raised about 8 million in three rounds of funding, without ever hiring a lawyer for negotiating those investments.) Knowing about the implications of key clauses in term sheets and shareholder agreements can significantly   impact the way you negotiate and raise investment.

Do you understand the impact of negotiate liquidation preference, founder lock-ins, non-competes, tag-along, exit rights, conversion, affirmative voting rights, ratchets and anti-dilution clauses in termsheets and shareholders agreements? Can you negotiate these clauses?

It’s not just about raising investment, there can be many other commercial risks in the business which you can address by understanding business law related issues and contracts better.

You may be smart and there may be many advisors, fellow-entrepreneurs and self-proclaimed ‘experts’ who will be willing to help you – but nothing is comparable to yours having a hang of things.

Would you like to learn how to negotiate investment agreements? Did you know that there is a systematic way in which you can learn how to negotiate investment agreements? The subject is elaborate and is comprehensively dealt with in this diploma course on Entrepreneurship Administration and Business Laws with the help of explanations, videos, negotiation pointers and case studies from top industry experts. The course also deals with structuring businesses, joint ventures, non-profits, licences and registrations, raising foreign loans, IP contracts and registrations, information technology, money recovery strategies and much more. 

You can see the syllabus here. Drop an email to startup@ipleaders.in or call Pallavi on 09582630056 – don’t forget to ask her to connect you with someone with a similar educational or professional background as you who has earlier taken the course.