AANZ November Expert Session with Murray Whyte Director avid.legal

This podcast link and below summary is of Murray Whyte’s Expert Session held online November 2024. 

Podcast: Navigating the Evolving Landscape of Angel Investing: A Deep Dive into the Updated ANZ Term Sheet 

The Angel Association of New Zealand (AANZ) recently updated its standard term sheet for priced equity investment rounds, a pivotal document in the early-stage ecosystem. This session, led by Murray from Evan Legal, provided a comprehensive overview of these changes, their rationale, and their implications for investors and founders. This rewritten summary aims to capture the key insights, jargon, and real-world context shared during the discussion, offering a detailed yet engaging perspective on the current state of angel investing in New Zealand. 

The Foundational Role of Term Sheets: 

The session began by establishing the fundamental purpose of a term sheet. A term sheet serves as a faster and more efficient starting point for investment negotiations compared to immediately drafting lengthy legal documents like subscription agreements, shareholders agreements, and constitutions. Consolidating key investment terms onto a few pages, typically written in plain English, allows for quicker alignment on crucial aspects before significant legal costs are incurred. 

Murray highlighted two primary contexts for utilizing term sheets: 

• With a Lead Investor: In this common scenario, particularly in New Zealand, where the ANZ term sheet is frequently used as a starting point by 80-85% of investors, the lead investor often provides the initial draft. The company then reviews and responds, initiating the negotiation process. 

• Without a Lead Investor (Party Rounds): Increasingly prevalent is the situation where multiple investors participate without a designated lead. In these “party rounds“, a term sheet can be instrumental in getting various parties on the same page, outlining the proposed terms to garner commitments and facilitate the investment round. 

Key Updates and Their Underlying Drivers: 

The core of the session focused on the updates to the ANZ term sheet, driven by evolving market norms, efficiency gains learned over time, and recent changes in the law. 

1. Addressing the Rise of Syndication and Co-investment:

A significant shift in the angel and venture capital landscape since the 2019 version of the term sheet is the significant rise in syndication and co-investment. Single-investor transactions, once relatively common, are now rare. This trend necessitates re-evaluating control rights traditionally granted to a singular “the investor”. 

• Introduction of “Investor Majority”: The updated term sheet introduces the concept of an “investor majority” for certain control rights, moving away from the need for approval from just one investor. 

• Default Definition of Majority: The default for this majority is based on the number of shares held in the current investment round, excluding shares from previous rounds. 

• Optionality for Broader Majority Definitions: The term sheet offers flexibility to define “investor majority” more broadly, potentially including shares from previous or future rounds, depending on the specific context and negotiation. This is particularly useful for longevity term sheets across multiple funding rounds. 

• Accounting for Lead Investors in Syndicated Rounds: The updated term sheet acknowledges the continued importance of lead investors who may not hold most shares but still play a crucial role in due diligence and setting terms. It allows for requiring the named lead investor’s approval as part of the investor majority threshold. Murray cited Motion Capital as a prime example of a lead investor who often doesn’t hold a majority stake. 

• Context for Different Majority Definitions: Murray clarified that using a majority based solely on the new investment round is often relevant for distinct new rounds, such as a Series A following a seed round led by an angel club. This facilitates a natural “handing of the baton” regarding investor director appointments and control as new, more prominent investors come on board.

2. Accommodating the Influx of Fund Managers:

The market has also witnessed an influx of fund managers investing in early-stage companies alongside traditional angel clubs. Even angel clubs themselves are increasingly running their own funds. This shift brings specific requirements standard to fund structures: 

• Assignability of Pre-emptive Rights: Fund managers often seek the ability to assign their pre-emptive rights to related funds within their management structure (e.g., from fund 4 to fund 6). This is now explicitly captured in the updated term sheet. 

• Enhanced Information Rights: Funds typically have more extensive information rights requirements due to their reporting obligations to their Limited Partners (LPs). This can include ESG reporting requirements that they need to flow down to their portfolio companies. The updated term sheet now consists of these more common requests for information, improving efficiency. 

3. The Growing Prevalence of Sunset Clauses on Investor Rights:

A notable trend, particularly in New Zealand, is the increasing negotiation of “sunset clauses” on certain investor rights. These clauses stipulate that specific rights are not evergreen but expire under certain conditions. While less common internationally, sunsets can be a valuable tool for compromise during negotiations. Common areas for sunset clauses include: 

• Anti-dilution Rights: These rights protect investors from a “down round” (a subsequent funding round at a lower valuation) by providing them with extra shares to adjust as if they had invested at a lower price. Sunsets on anti-dilution rights can be time-based (e.g., expiring after two years) or triggered by the size or valuation of a future funding round (e.g., a subsequent round at a higher valuation and of a significant size). The rationale behind valuation-based sunsets is that a successful up-round de-risks the earlier investment, making the continued need for anti-dilution less critical. 

• Investor Director Appointment Rights and Approval Rights: Sunsets can also be applied to the right to appoint an investor director or the approval rights held by such a director. A common trigger for sunsetting director rights is the investor’s ownership percentage falling below a certain threshold, often around 10% of the cap table. This ensures that investors remain sufficiently relevant to the company to justify board representation. 

• Elevated Thresholds and Special Resolutions: Sunsets can also be negotiated on requirements for elevated shareholder approval for specific actions. 

Murray noted a growing maturity in the New Zealand market regarding the understanding that businesses need to raise capital in rounds. Some rights should naturally transition or expire if investors don’t continue to participate and maintain their relevance. 

4. Clarifying Liquidation Preference Rights:

The updated term sheet provides more detailed guidance on “liquidation preference rights” to address increasing misunderstandings, particularly from investors outside traditional US/UK venture capital ecosystems. 

• Non-Participating vs. Participating Preference: The footnote guidance now clearly explains the difference between non-participating liquidation preference, where investors receive either their initial investment back or their pro-rata share as ordinary shareholders (whichever is greater), and participating liquidation preference, where investors receive their initial investment back plus their pro-rata share of the remaining proceeds. An example illustrates that in a sale for less than the post-money valuation, non-participating preference holders get their initial capital back first, while participating preference holders also share in the remaining proceeds, potentially leaving less for ordinary shareholders. 

• Normalization Towards Preference Shares: There’s a strong trend in New Zealand towards using liquidation preference rights (i.e., issuing preference shares) in seed rounds, now closer to 90% of deals, aligning with US practice. Previously, ordinary shares were more commonly used. 

• The Prevalence of “One Time” Preference: The most common liquidation preference is “one time non-participating“. Multiples like “two times” or “1.5 times” are less frequent and typically seen in later-stage, more mature companies where investors have a higher return expectation or in distressed company investment scenarios where investors take on significant risk. 

5. Enhancing Transparency Around ESOP Pools:

The updated term sheet encourages more upfront disclosure and better quality conversations regarding Employee Share Option Plans (ESOPs). 

• Beyond Total Size: The term sheet now prompts for information not just on the total size of the ESOP pool but also on the number of shares already granted and the number remaining unallocated at completion. 

• Understanding “Dry Powder”: This increased transparency helps investors understand the “dry powder” available in the ESOP for future hiring needs to reach the next funding milestone. It prevents mismatches in expectations where investors might assume a 10% ESOP pool is entirely unallocated while the company has already granted a significant portion. 

• Impact on Valuation (Fully Diluted Basis): Murray explained investing on a “fully diluted basis,” where valuation calculations consider all shares outstanding plus those reserved under the ESOP and other convertible securities. This means the issue price per share is slightly lower when an ESOP pool is factored in. While existing shareholders may hold a higher percentage of actual shares initially, their stake will dilute as the ESOP pool is allocated. Understanding the allocated vs. unallocated portion is crucial for assessing the true impact of the ESOP on the cap table and future dilution. 

• Size of ESOP Pool (Art, Not Science): Determining the appropriate size of an ESOP pool is more of an art than a science. While 10% is a common starting point for early-stage rounds, a more informed approach considers the company’s hiring plan, the roles needed, and the amount of equity required to attract the right talent. It’s generally more efficient to create an ESOP pool sized for the immediate round’s needs, with the expectation of expanding it in future rounds. Overly large early-stage ESOPs can unfairly transfer wealth to investors who won’t face further dilution. 

• Pre-Money vs. Post-Money ESOP: ESOP pool size is most commonly expressed post-money (i.e., the percentage after the investment). However, expressing it on a pre-investment basis can simplify cap table calculations, though it requires careful understanding to ensure the post-investment available pool meets expectations. 

6. Formalizing the Option to Recycle Founder Shares into the ESOP Pool:

The updated term sheet includes an optional clause allowing founder shares clawed back under founder vesting agreements to be added to the ESOP pool. 

• Founder Vesting as a Fairness and Incentive Mechanism: Founder vesting ensures fairness among co-founders. It protects investors by allowing the company to repurchase shares from departing founders, mainly if they leave early. It also creates a pool of shares that can be used to incentivize new hires without further diluting existing shareholders. A typical vesting schedule includes a one-year cliff followed by gradual vesting over four years. While sometimes perceived negatively by founders initially, it’s crucial for the long-term health and attractiveness of the company. Founder vesting should ideally be in place even before the first investment round, especially with co-founders. While less common, founder vesting can sometimes be reset in later, critical investment rounds, particularly for deep tech companies. 

• Legal Enforceability of Founder Vesting: Founder vesting is typically documented in the shareholder’s agreement, to which all shareholders agree. Legally, it’s a buyback of shares, and the agreement often allows the company to sign on behalf of a refusing departing founder. However, the buyback is subject to the company passing a solvency test under New Zealand company law, even if the buyback price is nominal. This might necessitate waiting for a subsequent capital raise to ensure solvency. 

• Efficiency of Recycling Shares: Directly adding clawed-back founder shares to the ESOP pool streamlines the process of incentivizing replacement talent, as the ESOP pool is already pre-approved by shareholders. This avoids the need for separate shareholder approvals to reissue these shares. 

7. Raising Awareness of National Security and Public Order Notifications:

The term sheet now includes a condition to raise awareness about the National Security and Public Order notification regime under New Zealand’s overseas investment rules. 

• Post-COVID Protectionism: Introduced during the COVID-19 pandemic, this regime aims to safeguard strategically important New Zealand businesses from potentially opportunistic foreign takeovers. 

• Broader Definition of “Strategically Important”: The definition of strategically essential businesses is broader than commonly perceived. It includes companies using technology with dual military or civilian use capabilities and businesses holding the personal data of more than 30,000 individuals. Examples include nuclear fusion companies with powerful magnet technology and B2C businesses with a large customer base. 

• Notification Requirement: Overseas investors investing in strategically essential businesses must notify the Overseas Investment Office. This clause in the term sheet reminds companies and investors to consider whether this regime applies to their transactions. 

Removals from the Term Sheet: 

The updated term sheet also saw the removal of certain elements to reduce noise and potential misunderstandings: 

• Fixed Rounds: The option for purely fixed-size funding rounds has been removed, reflecting the increasing prevalence of rounds with minimum and maximum targets and rolling closes, particularly in syndicated deals. 

• Tranching: While still relevant in specific scenarios like deep tech with milestone-based funding, the explicit inclusion of tranching (releasing investment in stages upon achieving certain conditions) has been removed from the standard term sheet to avoid complexity in more typical deals. It can be added back in when necessary. 

• Founder Warranties: Including founder warranties (where founders are personally liable for certain statements about the company) has been removed. While common in jurisdictions with potentially lower trust environments like Australia and Singapore, they are very unusual in the New Zealand context. Their removal reflects the higher-trust nature of the New Zealand ecosystem. It shifts the onus onto investors to specifically negotiate these if desired, rather than it being a starting point. 

Key Takeaways and Future Outlook: 

The updated ANZ term sheet reflects the dynamic nature of the angel investment landscape in New Zealand. The changes prioritize flexibility to accommodate syndicated rounds, address the specific needs of fund investors, formalize evolving market practices like sunset clauses, enhance clarity around key terms like liquidation preferences and ESOPs, and raise awareness of relevant legal developments. 

The discussion highlighted the importance of understanding the nuances behind these changes and engaging in thoughtful conversations during term sheet negotiations. While the term sheet provides a valuable framework, context remains everything, and the specific terms should always be tailored to the unique circumstances of each investment. The upcoming update to the binding legal documents will further align the ecosystem with these evolved standards, promising a more efficient and transparent investment process for the future. As Bridget from the Angel Association aptly concluded, ongoing education and open dialogue remain crucial for navigating the intricacies of early-stage investing in New Zealand.