Ofo's fall shows why startups need to retain control

Early-stage companies are learning from Ofo’s failure and adding more terms and conditions to their fundraising contracts in order to prevent losing management control.

The rise and fall of bike-sharing businesses make a dramatic show, but start-up founders view it as a warning for their own business and are starting to change some of their fundraising terms.

Bike-sharing company Ofo gave us a perfect example of how things can go wrong when investors do not agree with the management team.

The Chinese start-up, best-known for its dockless yellow bikes, ran into serious cash flow problems and is on the verge of bankruptcy, founder Dai Wei said late last year.

In light of Ofo's problems, many start-ups are redefining the rights that investors enjoy for preferred stock and veto powers as a way to keep control of the company.

Adding new terms and conditions on fundraising is not a move that investors would like to see, since it would add more restrictions during corporate decision-making.

Ofo’s dramatic fall – from a multi-billion dollar unicorn to a cash-strapped business in less than a year – was triggered by a dispute between investors and the company's founder. 

Launched in 2014, Ofo quickly drew attention from the capital market when people saw potential in its big user data and deposits. Since then, money kept pouring in from multiple investors.

Didi Chuxing participated in Ofo’s $130 million Series C investment in 2016, and finally held about 30% of Ofo shares after investing in the start-up’s $450 million D round. The craze for bike-sharing businesses allowed Ofo to attract about $2.1 billion in investments between October 2016 and March 2018.

“There are too many shareholders in Ofo’s equity structure,” a corporate lawyer who does mergers and acquisitions said. “And too many of them have the veto right.”

BATTLE FOR CONTROL

Ofo’s dispute broke out during the two last rounds of fundraising after Alibaba came on board. Didi, as the biggest shareholder – and backed by Tencent – was using its veto right to prevent Ofo from taking Alibaba’s investment and pushing Ofo to merge with its rival, Mobike. In response, Ofo fired three Didi’s executives who were sent to the company to manage the daily operation.

As a consequence of this dispute, Ofo cannot find any more investors to solve its liquidity problem, and big investors such as Tencent and Alibaba have lost interest in the firm and turned to other bike-sharing companies.

“Before Ofo’s case, no one seriously used the veto right in start-ups’ decision making,” the lawyer said. “Now start-ups don’t easily give the veto right to investors.”

Start-ups are now restructuring the decision-making process in the board and shareholder meetings to gain more control of the company. And companies are restraining the time and buyer of their issued preferred stock, which limits an investor’s exit.

Investors and their subsidiaries are also restricted from investing in a rival company. Such moves were quite common in China’s private equity investment field as some investors continuously invested in the same industry for years. To fight back, investors are now asking start-ups to list the competitors before negotiations start.

Fighting for control of the company will always be in contention between start-up founders and investors, especially in 2019 as everyone is holding tight to their money now. The disappointing behaviour of the secondary market in 2018 also took the heat off the primary market.

As many predicted, we will see more mergers and acquisitions in 2019 when the surviving companies try to grow bigger and seizing control of the newly merged company is the only way to stay in the business.

Investors are getting reluctant to sign fundraising contracts – and 2019 may be a tough year for start-ups too. 

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