Essential clauses for investors
An investors’ obvious commercial intent would be to ensure that he gains from his investment. He wants to maximize his returns and minimize the obstacles. For that, he will ensure to insert certain mechanisms that will work in favor of him so that he can get his investment back (at least minimum guaranteed return) in case the company doesn’t perform as estimated. Certain boilerplate and specific clauses are included in the Shareholders agreement (SHA) which provides rights to the investors and puts obligations on the promoters or the founders. However, these clauses can be negotiated by the founders and can hence work in favor of both the parties. Some of the essential clauses that are included are:
Liquidation preference clause- In situations not just winding up of a company but in other events like bankruptcy, merger, change of control etc. the investor may ask for liquidation pref (as it is colloquially called) which will give an advantage to the investors over other shareholders in the repayment of the investment money at the time of such liquidation.
Investors may also seek for the specific interest rate at the time of liquidation of the company and not just a repayment of the investment amount. They usually seek a specific internal rate of return or IRR (which is similar to compound interest).
An entrepreneur should carefully go through the investment agreement to see which events qualify as ‘liquidation events’ –, ideally only winding up and bankruptcy events should be included. A profitable exit should be excluded from the list of liquidation events. Merger, consolidation or change of control or sale of assets or a profitable exit opportunity should not be included in the clause as it will oblige the promoters to take consent of the investors first.
Protective rights and anti-dilution provisions: To ensure that the investment is not misused in the hands of the founders and there is no prejudicial dilution of the shares.
To ensure that their control in the company remains and their stakes are not diluted investors may ask for veto rights against an issue of fresh shares.
In cases where there is a fresh issue of shares the stake of the existing shareholders may get diluted. To maintain their shareholding percentage the existing shareholders get a right to proportionately subscribe to a fresh issue of shares so that it is not diluted.
Tag along rights
This right allows the investor to sell his shares the moment founders sell a portion of their shares. Lock-in provisions are inserted by the investors (which do not allow the founders to sell their portion of the shares for a significant period of time generally, 4-5 years) after the expiry of which if a founder dilutes his shareholdings then the investor gets to preserve his freedom to exit the company due to tag along rights.
A more founders’ friendly term would be a proportionate tag-along. It enables the investors to dilute shares proportionately in accordance with the founders' dilution. (for example, if founders have a 90% shareholding in their company and they sell 20% of their shares then the investors can only sell 20% of their total 10% shareholding and not the whole of 10%).
It may be possible that in a subsequent round of fundraising fresh shares are issued at a lower valuation to the third parties than they were issued to the investors. The old investor would want in such situations that the fresh shares are issued to him to adjust the amount the investment amount at a lower valuation. The earlier investment is treated as if it was done at the new (lower) valuation. Ideally, a weighted average anti-dilution protection is executed – the adjustment of the price is dependent upon the ratio of shares that new investor has subscribed to.
To ensure that founders are committed and dedicated to the growth of the company
Founders’ lock-in provisions
To ensure that the founders are dedicated, interested and invested in the business, investors include a certain lock in provisions which restrict the founders from selling, transferring, pledging or any other way encumbering their shares till the time of investment.
The duration of such lock-in period and the extent of the shareholding which comes under the purview of such provisions can be negotiated. Such restrictions can be rationalized and a minimum extent of shareholding by the founders can be permitted to be diluted after the expiry of the lock-in period.
Before any investment is made the investors may insist the founders enter into as full-time employment agreement with the company. It can be negotiated on the basis that the founders will not take active management control or will not devote much time to the new business.
To protect the commercial interest of the investors a non-compete clause is included in the agreement. It prohibits the founders from competing with the business of the company. The restriction applies till the duration of the investment horizon or for some time period after they have exited from the company (due to termination or transfer of shares). Competing businesses should be clearly defined, a vague definition may widen the scope and include related business as well which will be against the interest of the founders if they want to start any other business.
To ensure that investment is protected
The investors would want to be aware of the day to day activities in the business though they may not ask for active participation. To ensure that they are updated and informed about the latest developments investors nominate their representative to the board of directors. As long as the majority rights are with the founders it is not a problem for them. Since the investors are minority shareholders and a representative is nominated through a majority vote a clause is included in the agreement which requires the founders (majority shareholders) to exercise their voting rights in such a manner that the investors’ representative can be appointed to the board.
Affirmative voting rights
SHA will contain a list of “reserved matters" – matters in which an affirmation from the investors needs to be obtained. These are not pertaining to ordinary course of business for example- issuing further shares, taking a loan, incurring financial burden, modifications of rights of existing shareholders, declaration of dividends, initiation of winding-up proceedings, transfer of assets in a manner which is inconsistent with the business plan submitted to the investor, change in directors of the company, initiation of legal proceedings against any other entity.
A careful examination needs to be done by the founder of these reserved matters. If such matters extend to daily affairs of the business then it might lead to interference and operational inflexibility.
Investors may ask for periodic reports from the promoters – like cash flow statements, balance sheets, projected budgets, business and marketing plans etc. As producing such periodic information for a start-up might be difficult for the want of resources negotiations should be made regarding the frequency and the number of statements that are required to be furnished.
Right to inspect
SHA may provide for the inspection of books of accounts and other statutory documents by the investors. An advance notice of such inspection must be furnished. An investor may also ask for the right to conduct an audit of the company.
Right to first refusal (ROFR)
When a founder exits the company, the investor has two options- to exercise tag along right and exit the company itself or to purchase the stake of the exiting shareholder. The latter option can be exercised through a right of first refusal- which ensures that the investor has the first right to purchase the shares of the exiting shareholder. He can sell out to third parties only when the investors refuse to buy his shares.
To ensure that exit can be made in cases when certain events occur
Material Adverse Change (MAC Clause)
If after the signing of the SHA there is a fundamental change in the business or if the business faces major liabilities or claim -for example, there is a material impairment of the assets or the operations of the company -there will be no obligation on the investor or he will be able to exit the company under MAC clause. Founders need to be careful when such clause is drafted as sometimes vague reasons can be assigned as a material change. Founders should negotiate to keep some minimum thresholds which would indicate such change or occurrence of major claims upon the company.
Representations and warranties
These are the statement of facts on the affairs of the company which is expressed to be true (at a particular point in time). A warranty from the company could state that the liabilities against the company is not more than INR 5,00,000. Such warranties are stated on the date of signing and are expressed to be true on the date of closing. In a case of breach of warranties the company (or promoters) may be required to ‘indemnify' the investors of any losses suffered by them. Founders have to be careful if the indemnity clause puts a personal obligation on them to indemnify for any loss since the investment is for the company there shouldn’t be any personal liability. Founders may include ‘knowledge qualifiers’ instead of absolute warranties- by stating that there is no liability against the company to the best knowledge of the promoters.
SHA includes clauses in cases where any dispute arises between the parties. It specifies a negotiation period to resolve in cases of conflicts. The parties may have the option to arbitrate if the dispute is not resolved amicably. It should be ensured that the seat of arbitration is a place which is convenient for the founders.
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