Rockstart Law School: The EPOS for early stage investments as an easy alternative for convertibles
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Rockstart Law School is a combination of blog posts by outside contributors and vlog posts by Rockstart’s very own legal counsels Els Metten and Lisette Schuilwerve. They will show the roadmap to the legal side of starting and running a startup company. Rockstart Law School focuses on the Dutch law system and is meant as a resource and gives you lessons learned and suggestions, but is not meant to be used in the place of legal advice. Always consult your lawyer, but we hope these series of posts will give you a greater understanding of the legal needs and points of attention that you may encounter during your startup journey.
Most early stage investment rounds in the Netherlands are currently done by way of convertible loans instead of equity. Convertibles are often preferred for early stage deals because they tend to be faster and consequently cheaper than equity rounds. Moreover, discussions on valuations can be postponed, which is generally favorable to the founders since discussions on incomplete teams, less than impressive traction and an incomplete product having a negative effect on the valuation are less a subject of discussion. Investing via a convertible loan will initially be structured as a regular loan, which will only convert into shares at a future qualified investment (or take-over of the company, depending on the convertible terms), against the then applicable valuation (with a discount for the converting investor and usually a conversion cap to protect the converting investor).
Given the popularity of convertibles, several alternative investment instruments have been introduced in the US as alternatives to convertibles, like Y Combinator’s SAFE (Simple Agreement for Future Equity) and 500 Startups KISS (Keep It Simple Security). These documents are certainly worth looking at, but they are written for US deals not for Dutch deals and are governed by US law (and no you cannot simply replace the “governed by US law” clause by Dutch law), which is why mid 2016 I introduced the EPOS (the Easy Prepayment On Shares), an investment agreement on little over 2 pages of legal wording for our open source legal documentation platform Capital Waters which has to date inter alia successfully been used in effectuating Uber’s investment in Rockstart Web & Mobile alumni Otly.
The EPOS is an agreement pursuant to which the investor provides funding in return for the right to be issued shares at a qualified investment in the future, against the then applicable price per share (minus a discount and with a cap). This is very similar to the convertible, but unlike the convertible, the EPOS is not a debt instrument (although the tax authorities could try to challenge this) and consecutively has no maturity date, nor accruing interest.
The intention of the EPOS is that the investor will be issued shares at a later investment round. Until that happens, the investor has hardly any control over the company, but is provided some protection by way of an obligation of the company to pay the investor back a multiple (standard two times) of the prepayment amount in the event of occurrence of an Event of Default (a material breach of contract, payment of dividends, transfer of a material part of the assets of the company). This effectively gives the investor a 2x liquidation preference and the EPOS will terminate after such payment is received. In the event of a Liquidity Event (transfer of the majority of the shares or other events which lead to a change of control), the repayment obligation is also triggered. In that case, it could also be considered to include an automatic conversion into shares. This would typically happen at a later investment round, provided that the issue of shares to the EPOS investor is done prior to the closing of the Liquidity Event. This element is crucial because if the then applicable shareholders agreement (to which the EPOS investor must adhere) contains tag and drag along rights. These rights may be exercised (tag for the investor or drag by the other shareholders) immediately in the context of the Equity Event (leading to a return for the investor of at least the discount rate and potentially the higher difference between the cap and the actual price per share paid in the context of the Liquidity Event). Should you wish to amend the standard language in the EPOS to this feel free to contact me and I will provide you with the applicable wording.
In the event that the envisaged qualified financing occurs, the EPOS prescribes that the investor will then receive the most senior class of shares outstanding or issued and that the Investor must adhere to the then applicable shareholders agreement setting out the and obligations relating to the Shares that are to be acquired and providing at least a minimum level of protection for minority shareholders.
The EPOS provides for an easy way of investing, with nearly the same characteristics as a convertible but with the added advantage for the company that it does not include the risk that the company is faced with insolvency or liquidity problems as a result of a repayment obligation to the investor at maturity. The investor will consequently have to be willing to take a slightly more founder friendly approach than with a typical convertible, given the lack of control on the moment of being issued shares due to the absence of the maturity date. The investor should hence have confidence in the company being able to secure subsequent financing, bearing in mind that more often than not if a convertible is used and the conversion or repayment is triggered due to the maturity date being reached (and hence no qualified investment or exit has taken place), the company is probably not doing so well which means repayment will be difficult and conversion will likely result in the investor being issued relatively worthless shares.
Maurits Bos – Partner Corporate at Benvalor Attorneys
e:firstname.lastname@example.org | t:088-3030047
I would highly appreciate to hear your feedback on and experiences with using the EPOS.
Maurits is a corporate lawyer who assists many start-ups and (impact) investors in the tech- and sustainable (energy)sector. He mainly advises on investments, m&a, employee participation plans, business structuring and commercial contracting. Maurits leads the Benvalor team as legal partner of Rockstart’s Web&Mobile Program and is an active contributor to open source investment documentation platform Capital Waters.
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