After the pitch deck has been prepared, submitted, chosen from a variety of competitors, translated into a business plan and the term sheet is signed and diligence concluded, the last hurdle blooms into vision i.e. deal documentation. For the first time fund-raiser, the mere exercise of flitting through 300 pages of deal documents is mind-boggling to say the least and oft on looking back, also quite educating. This article seeks to accelerate that education.
Broadly, any deal documentation would comprise of (a) the term sheet (b) subscription agreement; (c) shareholders’ agreement; and (d) founder employment agreements.
The Non-Binding Term Sheet: Prior to the commencement of the diligence, the investor provides a term sheet to the promoters of the company setting out the broad rights and obligations of the two sets of shareholders i.e. the promoters and the investors. The term sheet is only an expression of interest and not a binding document as diligence is still underway and the investor will decide on his final asks after the results of the diligence. Term sheets, therefore, are never exhaustive as it only provides the broad contours of the transaction. There are two clauses however which are binding on parties –
- Obligation of exclusivity: Exclusivity precludes the founders from soliciting interests from other investors during the process of the ongoing fund raise
- Sharing of costs: The cost of the transaction (including cost of investor counsel) is usually deducted from the investment amount and is therefore borne by the company post the transaction. However, if the transaction does not go through, then the investor is responsible for their costs. Further companies are also within their rights to ask that the investor cost expensed from the investment amount be capped to a reasonable amount.
Once the diligence provides the green signal, parties move to the remainder of the definitive documents: (a) subscription agreement; (b) shareholders’ agreement; and (c) founder employment agreements.
I like to say that the share subscription agreement is backward looking while the shareholders agreement and the founders employment agreement is forward looking.
The share subscription agreement lays out the conditions which should be pre-existing for the investment to occur. This is fleshed out in two forms:
- active concrete steps required to be taken by the founders in order to proceed with the diligence such as a government approval or a third party consent or rectification of issues identified in the diligence; and
- schedule of warranties and associated indemnities. Warranties are akin to representations of existing facts than a covenant to perform. Here, the founders provide assurances to the state of affairs of the company and against any undisclosed liabilities, potential or pre-existing.
In order to provide a sense of equitable treatment, it is customary to allow promoters to formally disclose to the investor in a “disclosure schedule” known liabilities in the Company. This will be the only recognised disclosure of liabilities to the investor the knowledge of which can operate to vitiate any subsequent indemnity claim on the matter. The idea being that the investor has been informed of the issues and has decided to proceed with the investment with no change of terms and has therefore by implication agreed to take such disclosures as a buyer’s risk. Disclosure schedules are carefully drafted and heavily negotiated submissions. Investors will insist that the disclosures be specific against the relevant warranty sought by the investor. It is also customary to provide for limitations on the quantum of indemnity claimed and sunset periods for the right to claim indemnity, etc.
A Shareholders Agreement defines the relationship of the shareholders post the investment. A shareholders agreement can broadly be arranged into the following four heads:-
- Management and governance dealing with investor representation on the board, mandatory presence of investor in the quorum in board and general meetings, notice requirements for board and general meetings, the right of the investor to appoint observers to meetings of the board, etc. These provisions ensure that the company is vigilant about conducting board and general meetings in an organized manner by serving notices with adequate notice period. They also provide the investor with the right to actively participate and contribute in meetings without unduly obstructing the decision making process.
- Affirmative Vote Matters or veto matters that require the consent of the investor even if the vote of the investor is not required under law as they are minority shareholders. The guiding principle being that the investor is entitled to protect his financial interest in the company by ensuring that material decisions are not taken by the founders without the buy-in of the investor. The much debated topic of control and promoters versus controlling shareholders have arisen from this right of veto. While founders argue that veto rights cripple the freedom of the promoters, the counter-argument is that investors who are funding the growth of the company are well deserved to veto an action plan that depletes the investment they have made in the company. Examples of such veto matters include aggressive growth plans whether organic or inorganic, significant capital expenditures, borrowings, loans and advances, management of key employees, business plan, any change in share capital, winding up and insolvency, etc. The veto list is reflective of what the investor deems critical in its commercial wisdom as well as any negative business practices observed during diligence that the investors seek to discourage.
- Dilution Protection and Promoter Lock-in
- Investors will want promoters to be locked-in until the investors have exited. While in more mature fund raises it is customary to permit promoters to transfer their shares to spouses or children for estate planning, in a pre-series A the company is not yet on growth phase and therefore the argument for estate planning of an undeveloped asset is premature. If the company has a team of founders and the investor is convinced of the contribution by each team member, he will most likely require each of them to be individually invested and not permit any shares transfers between the promoters.
- Added to the lock-in, are common rigours of an investor’s right of first offer on any prospective buyer of the Company’s shares, the ability to tag-along, prevention of dilution of share value through a secondary sale. In a gist, these protections ensure that the company is not being sold at a lower value to a new party, the founder is not exiting the company without giving an exit to the investor and to ensure that capital calls are first raised from the shareholders before inviting a third party offer.
- Anti-dilution protections are also common and are of two types:- (a) pay to play where the company is doing an external fund raise at a valuation higher than the valuation at which the venture capital came in, the venture capital investor also has the right to participate in such fund raise only in order to maintain its shareholding; (b) a broad based weighted average anti-dilution. When a company does a down-round it bumps up the price of the investor’s shares disproportionately to the rest of the equity of the company. In order to neutralize the price of its investment, the venture capital investor is extended the benefit of the effective drop in price of shares by being issued shares free of cost to ensure that the effective price per share of the investor is reduced from the bumper caused by the down round.
- The right of liquidation preference: The term is actually misleading as I would prefer to call it a liquidity event. Any event that puts money in the hands of the shareholders would qualify as a liquidity event eg:- winding up, sale of undertaking, change of control, etc. In such a scenario, the investor would get the right to withdraw his investment amount or his proportionate entitlement of proceeds, whichever is higher, in preference to any other existing shareholder. Liquidation preferences can either be a single-dip preference or a double-dip preference (where the investor gets to participate after getting his initial preference amount).
- Exit: every VC fund has a sunset period on their investments. They are answerable to their partners and investors on the life of each fund raised and mirror these provisions in the exit clause of each of their investment agreements. Essentially, without going into granular detail, the exit clauses prescribe the time by which the founders should have facilitated an exit for the investor, the minimum exit price, and the modes of exit. The exit modes are usually set out in a waterfall method with IPO topping the list followed by any third party sale, followed by an exit through a put option on the founders or a company buyback. If the company and the founders have not been able to provide an exit, the investors have the ability to force a sale or change of control of the company in favour of a strategic buyer by requiring the promoters to join forces. As a part of the obligation to provide an exit, the promoters will be required to act pro-actively in allowing a due diligence to be undertaken by the prospective buyer, sign up for customary warranties and indemnities, execute revised definitive documents with the new buyer, etc.
Investors can also accelerate their exit through a drag along or any other mode if they have been notified of an event of default by the promoters i.e. an act of deliberate misconduct or negligence. Events of default are greatly evolved now with certain investors stating that any continued absence for a long period of time or any conviction of the founders for any offence under law, whether or not it relates to the company, or any act that affects the reputation or brand value of the company, is to be treated as an event of default.
Founder or promoter employment agreements are considered necessary to ensure (a) that the employment is treated on an arms’ length basis; and (b) that the promoters are subject to the obligations to not compete or solicit. Founders will have to closely examine the provisions related to termination to ensure there is no arbitrariness in the decision to terminate a founder. The consequences of the shares held by the founder in the company and the obligations of the promoter post such termination will also have to be analysed. It would not be out of place to state that when a promoter has been required to leave the company, his shares (if significant) would either be bought out by the largest shareholder of the company or if allowed to continue, would stand shorn of all rights and obligations, such as the right to a board seat, presence in a quorum, etc. To this effect the employment agreement would make a distinction between a good-leaver scenario versus a bad-leaver scenario.
Definitive documents can be complex even for the seasoned promoter. The aim is to have a document that has thought through every possible situation and legislate for the behaviour of parties. In that sense one can say that definitive documents serve as a roadmap for orderly conduct and crisis management. With increasing developments in the law, enforceability of investment agreements is relatively common in India. Founders are encouraged to seek the advice of independent counsel to ensure at the least that they have been educated to the implications of the dotted line. In some cases transactions can get complex depending on the risk averseness of the investor resulting in escrow mechanisms, deferred investments, earn-outs, etc.
Definitive documents strive for the balance of interests of investors who are zealous to protect their investment and founders who want the freedom to develop the business and retain control of their business. There is no standard or one-size-fits-all approach to deal documentation. It would depend on a combination of facts as to the business model, the size of investment, business projections, culture of both parties, etc. However, promoters and investors can argue for parity in terms of how their compatriots have dealt with similar situations. One can say, that deal documentation is like a pre-nuptial. It has its fair share of controversies and its fair share of uses and much depends on the assets at stake and who is playing the card.
Bhavana Alexander is an advocate and currently a partner with JSA. JSA is a law firm with over 330 lawyers. Bhavana’s key focus area is General Corporate Commercial, Mergers & Acquisitions (M&A) and Private Equity (PE) & Venture Capital. Her spectrum covers assisting business through their life cycle, from incorporation, day to day legal advice on business operations, seed, and early-stage growth capital financing’s as well as in strategic alliances.