How startups can attract investors by offering more liquidity options

Liquidity, or the ease with which an asset can be converted into cash, has always been the province of traditional investment instruments like stocks or bonds.

It has rarely been a focus of venture capitalists (VCs) – until now. The long-lasting effects of the recession caused by Covid-19 have brought into sharp focus the need for funds, investors, and startups alike to refocus or pivot altogether for survival.

On one hand, Preqin figures put global VC deals value at US$84 billion in the third quarter of 2020, a 39% jump from the same period in 2019. On the other, there remains a longer-term downward trend in transaction value, which has been observed since mid-2018.

Dry powder has remained at more than a third of total assets under management of US$4.4 trillion globally. Suffice it to say, investors continue to have an appetite for investing, but funds are wary of misfiring too much and too soon amid a once-in-a-century crisis.

One way for startup founders to distinguish themselves from the pack is by looking to mitigate investor risk from the get-go, outlining key ways to improve liquidity within investment agreements or term sheets.

Not only does this allay VC fund worries, it also means founders are going into deals with eyes wide open, well aware that there are other exit options available to them beyond the typical M&A or IPO routes.

There are three main clauses that may prove handy to bridge this liquidity gap: trade sales, qualified IPOs, and buybacks.

Trade sales

Trade sales account for around 80% of exits because the process is more straightforward than launching an IPO. There are two types of trade sales: assets and shares.

For asset sales, the startup’s assets that are sold are then transferred to buyers – but not its shares. One notable example was the 2018 asset transfer from Uber’s operations in eight Southeast Asian countries to fellow super app Grab. In this case, Uber retained IT and intellectual property rights while its assets including equipment, contracts, and employees were sold to Grab.

A share sale is more common and is a blanket term for transactions where a buyer purchases shares from existing shareholders. This can include M&As but also the secondary market, where later-stage investors buy existing shares from earlier-stage backers.

Here, key clauses that startups can introduce in term sheets or investment agreements include right of first refusal (ROFR), co-sale rights, and tag-along rights.

These clauses protect existing investors in the case of a secondary offering where existing shares are sold. For instance, if an existing shareholder tries to sell their shares, ROFR gives investors the right to buy the stock before it goes to a third party.

Co-sale rights and tag-along rights give minority investors the right to join any secondary transaction, on the same terms that the selling shareholder is offering to third parties.

Qualified IPOs

Buybacks