Acquiring funds is pivotal for any startup to truly get going and thus, once a startup is formed and begins its operations, it starts searching for investors. However, it is very essential for the founders to have the requisite knowledge and understanding of the hurdles that may arise with respect to the terms and conditions subject to which the investors agree to put their money in any startup. It is always fruitful to be prepared before entering into negotiations with investors. This is why founders should have a basic idea of the rights they should be entitled to and the responsibilities they must undertake in their association with the investors.
There are various issues which come up while discussing and negotiating investment terms with the investors and founders should be ready with their homework on the same. Some of these issues, which require the special attention of the founders, are detailed here:
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Generally, the investors 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 startup. Such a representative would have the same powers as any other board member. Nevertheless, in the terms of their agreement, a startup must avoid any unnecessary interference by such a representative in the functioning of the company. Their prerogatives should not supersede that of other board members. In this context, some key aspects include a quorum for board meetings, matters that require compulsory approval of such investors’ representative and reserved matters.
It is vital to ensure that the voting rights granted to the investors do not have any unfavorable consequence on the interests of the startup and its founders. Preferably, voting rights provided to the investors (in their capacity as shareholders) should be in proportion to their shareholding in the startup and should not usurp the rights of the founders or the startup.
Since investors have shareholding, they also have all the rights attached to it, including the right to further sell and transfer their shares. Terms pertaining to the transfer of shares are of principal importance for the future of a startup. Ideally, these specifications should restrict the investors from transferring shares to people who are, directly or indirectly, in competition with the startup concerned.
Normally, investors 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. An 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 offered to the investors. An ROFO also gives the investors the opportunity to purchase the founders’ shares first, but here, the investors have to state the price they are willing to pay; if this price is unsatisfactory, the founders can offer the shares to a third party at a higher price. The key difference between the two arrangements is that in the latter, the investors do not know what price the third party is willing to pay for the shares.
Normally, the investors would insist on a lock-in period for a certain number of years (normally 3 years) on the shareholding of the founders. During this period, the founders would not be allowed to transfer or sell their shares to any third party… While negotiating with the investors, the founders should refrain from accepting a complete restriction on the transfer and sale of their shares during the lock-in period. Founders should negotiate for a monthly periodic unlocking of shares during the lock-in period and for at least 20 percent shares to be unlocked at the time of signing agreement with the investors.
To illustrate the working of the monthly unlocking of shares, let’s have an example. Say the founders have 3,600 shares and the lock-in period is 3 years, without a periodic unlocking of shares, the founders will not be able to sell their shares under the lock-in period i.e., before the completion of three years. But if the shares are unlocked on a monthly basis over a period of 3 years (36 months), then 100 shares out of the total 3,600 shares held by the founders will be unlocked every month over 36 months. This is better for the founders as compared to absolute restriction.
Further, founders should also try to negotiate that they be allowed to sell and transfer at least 15 percent of their shareholding so that they have some liquidity.
Liquidation Preference (LP) is the order in which the proceeds of the assets of a company are divided amongst its shareholders, and it is contingent on the happening of a pre-determined liquidation event. Investors may ask for participatory LP with a certain multiple to their investment (for ex: 2X participatory LP). Founders should settle and negotiate for 1X non-participatory LP. It is very critical that founders also deeply analyse the definition of liquidation events. For illustrative purposes, let’s have an example:
2x Participatory Liquidation Preference
In the event of liquidation, the investors will get preference over the other shareholders and will get an amount that is equivalent to twice of their investment. In addition to this, the investors shall also be entitled to participate in the distribution of any remaining proceeds in proportion to their shareholding along with other shareholders.
1x Non Participatory Liquidation Preference
In the event of liquidation, the investors will get the preference over the other shareholders and will get an amount equal to their investment… The investors shall not be entitled to participate in the remaining proceeds after the preference of the investors is satisfied.
The founders or promoters of the startup should agree on terms related to liability only when the personal liability of founders for any loss or damage incurred by the investors is minimised. The parties can opt for a suitable insurance scheme, like the Directors and Officers (D&O) Liability Insurance.
The investors may ask the founders to provide for certain specific situations in which an investor may be able to exit from the company. This exit option may be exercised in form of an Initial Public Offering (IPO), strategic sale or transfer of shares to a third party. The founders or promoters 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 liability.
As an exit mechanism, investors may be given Tag Along and Drag Along rights in the event that they are not provided a satisfactory exit by the founders and the startup. , It is essential for the founders to negotiate such terms so as not to grant the investors unfettered powers of transferring their shares with other shareholders or compelling other shareholders to sell their shares when the investor is selling his own shares. These rights should be restricted to limited situations and may accrue only when the company has failed to provide reasonable opportunity of exit to the investors.
While negotiating the terms of the investment, the startups should protect their information rights, trade secrets and IPR against undue interference by the investors. The founders should ensure that the agreements entered into by the startup with the investors do not transfer ownership of such rights to the investors or provide rights to access or to use the information generated by the company without the company’s authorisation.
The founders must make certain that investors do not disclose to third parties any sensitive information pertaining to the startup or its founders, solicit the clients or entice the business of the startup away from it, or make offers of employment to any existing or former employee of the startup or its associates.
These are the important grounds which must be settled before entering into any final agreement with investors. Failing to do so may land any startup in an undesirable situation. It is, therefore, advisable to hire the services of a professional for framing such terms and conditions.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)