Planning for funding or strategic tie ups? Don't ignore this

There are some key legal terms that gets thrown at startups looking to raise funds or engage in strategic tie ups. Many of such legal jargon could as well be Greek and would stump an entrepreneur.

YourStory brings you another post by our CFO, Rohan Arinaya, which will decipher some of the most frequently used jargon found in a Share Purchase Agreement and Shareholders Agreement -- two vital legal documents for entrepreneurs scaling up their startups.

Right of first refusal (ROFR)

This refers to the right of an entity to be given the opportunity to enter into a transaction with an owner before the owner is entitled to enter into a similar transaction with a third party. This can be better understood with the help of an example. Let us assume companies A and B enter into a Joint Venture called AB where both A and B hold 50% each. In the event that company A decides to exit the Joint Venture, ROFR held by company B empowers them to be offered the shares of company A in the Joint Venture before Company A can look to sell the shares to a third party.

Right of first offer (ROFO)

This is very similar to a ROFR with the only difference being that this is a right of the owner of the asset and not of the rights holder. An example would help understand this better. Supposing you own a house that is leased out to a friend. If you decide to sell the house, generally you will first check with your friend if she/ he would like to buy it. When you’re friend is not able to or is not interested in buying the house only then would you approach third parties. The act of offering the house first to your friend is nothing but ROFO. A ROFO is considered to favour the seller (Company A in ourprevious example) whereas a ROFR is considered to favour the rights holder (Company B)

Conditions Precedent (CP)

After agreeing to acquire a company or invest in a company and before infusing the promised amount, investors/ acquirers require certain conditions to be completed by the target. Such conditions are known as Conditions Precedent or CPs (as known in the investment banking circles). The investment in or the acquisition of the Company is contingent upon the target completing these CPs within a specified period of time. Examples of some conditions are completing registration formalities with regulatory agencies, obtaining approval from regulatory agencies etc. Failure to complete CPs typically give the investor/ acquirer the right to reconsider whether they want to proceed with the investment/ acquisition.

Covenants

After signing the Share Purchase Agreement and prior to the target completing the CPs as mentioned above, the investor/ acquirer typically chooses to restrict certain operations of the Company until closing (ie. Payment of purchase price in exchange for shares). Such restrictions are known as Covenants. The investor/ acquirer may choose to prohibit certain actions that the company may propose to take (eg. Repayment of all creditors which is not in the normal course of business) or may require the company to obtain the investors/ acquires approval prior to executing certain decisions (like purchase of a new equipment). The intention of having covenants in the Share Purchase Agreement is to enable the investor/ acquirer to be in the know of the Company’s actions even after signing the agreement.

Representations & Warranties

An investee company/ target/ promoter is required to represent and warrant the accuracy or validity of certain aspects of the business/ company/ assets and liabilities to the investor/ acquirer.

Examples of representations and warranties are:

a) all assets and liabilities are recorded in the books;

(b) there are no claims due by the promoters on the company;

(c) shares of the company are free from encumbrances;

(d) there are no hidden liabilities. If a particular representation/warranty after being made is found to be untrue by the investor, the investee company/ promoter could be required to refund a part of the purchase price.

About the guest author:

Rohan Arinaya, Chief Finance Officer of YourStory, is a chartered accountant. He also heads Merican Consultants, a team of professionals specialising in the field of financial, tax and payroll advisory services.