I have attempted to list out below, the key rights and obligations which are contained in a standard term sheet/ investment doc, involving primary fundraise by a company. A company which is in its early stage and raising funds from venture capital players will mostly witness tight obligations and limited rights, with the promoters/founders being liable for most acts, as the Investor decides to invest relying solely on the representations given by the founders. There are many issues which come up while discussing and negotiating investment terms with the Investors. Some of these issues, which require special attention of the founders, are detailed herein below:
A. BOARD COMPOSITION:
Investors generally have the right to appoint a representative on the board of the company for keeping an eye on the day-to-day work as well as the management of the company. The founders should negotiate the agreement in such a manner so as to avoid any unnecessary interference by such an Investor representative in the functioning of the company in the ordinary course of business.
B. RESTRICTION ON TRANSFER OF SHARES:
The Investors generally ask for the Right of First Refusal “ROFR” over the shares of the founders; if possible, founders should try for the Right of First Offer “ROFO” instead. A ROFR entails the founders offering any shares for sale to the Investors first, and if the Investors refuse to purchase the shares at the stated price, only then can the founders offer the shares to a third party, and not at a price below that was offered to the Investors. A ROFO helps the founders in the price identification process. Further, the Investors would want the shares of the founders to be under lock-in for certain period. The founders should negotiate with the Investors on, (i) period of lock-in; (ii) fall-off of the lock-in in case the founders cease to be in the employment of the company within a specified period. The founders may also want the flexibility to transfer shares to affiliates and/or relative and thus the restriction should be exempted on these transfers.
The founders would generally give representation and warranties for the historical business/compliances of the Company and the Investors would want the Company and the founders to jointly and severally indemnify the Investors from and against any and all losses incurred by the Investors, as a result of, arising directly or indirectly from, or in connection with or relating to the representation and warranties of the founder. The founders must properly negotiate this with thorough disclosure schedule. The Investors would push for specific indemnities for due diligence finding for certain critical items. The cap and de-minimis provision should also be negotiated.
D. EXIT OBLIGATION:
Investors generally ask the founders to provide for certain specific situations in which Investors may be able to exit from the company. This exit option may be exercised in the form of an Initial Public Offering (IPO), strategic sale or transfer of shares to a third party. The founders should make sure that the conditions for exit are not of the form that compels them to provide an exit opportunity to the investors at the risk of personal contractually liability. The Investors would ask for a drag right which has to be given. The waterfall application of liquidation preference on drag may harm the founders in case of distress sale. Anyhow, Investor would generally not agree on not having the waterfall of liquidation preference in the drag situation.
E. LIABILITY ON PERSONAL ASSETS:
The founders should always negotiate with the Investors that the liability of the founders at any time under the Investment documents cannot cross the fair market value of their holding in the company. The Investors would generally insist for a "no cap" for “fraud”, “willful misconduct” and “gross negligence”. This carve-out would give the founder immunity for attachment of his personal assets in case of any direct or indirect claim from the Investors. The founders should also make sure that fraud, willful misconduct and gross negligence should only be invoked in case it is proven in “competent court of law”. This theory may not fly with the Investor but the end of the day it is the founders who have to push for this. The founders can opt for a suitable insurance scheme for obligation under the investment docs.
F. NON-COMPETE / NON-SOLICITATION OBLIGATIONS OF THE FOUNDERS:
Investors would want the founders to take non- compete / non-solicitation obligations during the term of the Investor investment in the Company and for a certain period thereafter. The founders should make sure that the definition of the business for non- compete is properly defined and is not generic or subjective in language/nature. The founders should also negotiate post-employment non-compete and non-solicitation clauses carefully. Further, the coverage of this obligation on affiliates and relative should also be negotiated properly.
G. OTHER CRITICAL POINTS:
- The founders should make sure that the rights and obligations of the other shareholders in the Company are not impeded in any way. Generally, the other shareholders should not have any restriction on their shares other than the ROFO/ROFR or restriction on transfer of shares to a competitor.
- Anti-dilution protection for Investors “without full rachet weighted average” is generally the market standard. Hence, the founder should carefully go through the formulae for this.
- The ability of the Investors to transfer shares to a competitor should be restricted for a certain period. The competitor definition should be carefully drafted and agreed. Common board members on the board of the company and defined competitor should be restricted for confidentiality issues.
- The employment agreement of the founders should be carefully negotiated with proper termination mechanism. The termination for cause, severance mechanism, etc., should also be thought through by the founders before they close and pen down the agreements.
- The founders should also make sure that their ability to raise further money for the company is not in any way impeded due to the obligations which they have taken as part of the current round.
Author: Prashant Jain, Co-Founder & Partner.
Disclaimer: The content of this article is intended to provide a general guide on the subject matter. Specialist advice should be sought about your specific circumstances. For any queries, the author can be reached at firstname.lastname@example.org.
Updated as on July 17, 2018
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