FOUNDER’S PLAYBOOK FOR FUND RAISING
Fund raising is a big milestone for a company. The influx of funds opens up numerous avenues and possibilities. As a founder, it is imperative that one is aware of atleast the broad structure of the fund raising exercise to ensure that the founder group’s interests are protected. In this article, we aim to set out a broad structure of the fund-raising process and also the key-points that founders should look out for.
Stage 1 – Getting the Term Sheet right
Once the investor has gone through the pitch deck and conversations with the founders are in an advanced stage, a term sheet is shared by the investors. Simply put, the term sheet broadly sets out the agreed terms between the parties and it is an important document as it forms the basis of preparation of the final definitive documents. If important principles are agreed upon at the term sheet stage itself, it greatly speeds up the definitive documentation and negotiation process as parties have a clear picture on the fundamental aspects from the beginning.
Points to consider in a Term Sheet
- Binding and Non-Binding provisions: There are certain clauses in a term sheet which are ‘binding’, meaning, they are legally enforceable in the court of law. Usually, such clauses pertain with confidentiality obligations, dispute resolution mechanism and an exclusivity obligation on the founders. Non-binding provisions pertain to the commercial terms agreed between the parties such as valuation and the rights of the parties in the company post investment. Such provisions are non-binding at the term sheet stage as the investment is subject to completion of the due diligence exercise. Investors do not commit to such obligations unless the findings of the due diligence exercise are addressed to their satisfaction by corrective action or adjustment in the valuation.
- Exclusivity period: There would an obligation in the term sheet which would require the founders to provide exclusivity to an investor for a certain period, during this period the founders are not permitted to solicit investment or enter into any form of discussions in relation to an investment with other investors.
- Indemnity package: Indemnity is an obligation on a party to make good the losses suffered by the other party due to a breach of any representation, warranty or obligation of the indemnifying party. Usually, the founders are required to provide representations and warranties with respect to the company and its operations. Naturally, the investor would require the founders to indemnify the investor in case of any breach of such representations and warranties. Indemnity is a heavily negotiated point in the definitive documents, it is recommended that the parties are clear on the nature of the indemnity package being offered at the beginning to avoid disagreements at the advanced stage.
- Reserved Matters / Veto Matters: Reserved matters are a bunch of actions that the founders and the company are prohibited from undertaking without the express consent of the investor. Example of such actions would be, raising loans, selling any substantial asset of the company, incurring major expenses and issuing shares to any other person. Founders are vary about having any kind of fetters with respect to operations of the company while investors want to ensure that their investment is protected. It is beneficial to agree on the set of reserved matters at the term sheet stage as it provides the founders clarity on the amount of involvement that the investors would have in the operations of the company and also provides comfort to the investors that their interests are safeguarded.
Stage 2 – Due Diligence
Due diligence is conducted by the investors to gain a deep insight into the company. The DD exercise brings to the investor’s attention the issues in a company. Such issues range from the company being exposed to financial risks of paying penalties due to non-compliance with applicable laws, inadequate protection of the company’s intellectual property, absence of agreements with key employees, vendors or customers, risk exposure due to ongoing litigation and restrictions imposed on the company by financial lenders.
Impact of DD findings
Basis the findings of the DD, the investor will require the company to address issues which are capable of being addressed such as making pending filings, obtaining approvals or licenses. In the event wherein larger issues have been discovered during the DD process, the investor may seek an adjustment in the valuation of the company to cover his risks or even worse, call off the deal. Usually, the actions required by the company or founders pursuant to the findings of the DD are divided into conditions precedent and conditions subsequent. Conditions precedent are actions that need to be completed before the investor makes the investment, while conditions subsequent are actions that are required to be completed in a defined period post the investment has been made.
Ensuring a smooth Due Diligence
As an exercise to speed up the fund-raising process, founders can undertake an internal due diligence exercise to address the issues that would generally come up in a DD exercise. Founders can ensure that their corporate filings are updated and in compliance with corporate laws, the company is compliant with applicable labor laws, intellectual property of the company is protected by obtaining relevant intellectual property right protection, agreements with key employees, vendors and customers are in place.
Stage 3 – The Definitive Documents
Definitive documents which usually consist of a shareholders’ agreement (SHA) and a share subscription agreement (SSA) are sacrosanct documents which capture in detail, the final understanding between the parties. They set out the rights and obligations of the investors and the founders. It is very important that such documents are carefully negotiated and drafted to ensure that the final commercial understanding of the parties is clearly captured.
Important aspects of the Definitive Documents
Shareholders’ Agreement: As the name provides, this agreement is between the shareholders of a company and sets out the rights and obligations of such shareholders. Following aspects should be carefully considered by the founders:
- Board composition – It is common for investors to have a right to appoint a director on the board of the company. The founders should be clear on matters such as quorum rights. For instance, if quorum rights are granted to the investor director, the board will not be able to have a quorate meeting without the presence of the investor director. Founders will have to consider what would happen in situations wherein the investor director refuses to attend board meetings. Founders can propose a mechanism wherein the board of directors would be able to pass resolutions on certain pre-agreed matters without the presence of the investor director, or wherein the quorum rights of the investor director will fall away after a pre-agreed number of adjournments due to his absence.
- Transfer restrictions – The founders being the face and brain of the company, it is natural that the investor would seek to restrict the transferability of their shares to a third party. The investor would want the founders to continue having their skin in the game. The founders should carefully assess the restrictions put on their shares and understand the process through which they would be able to sell their shares and see the colour of money. If the founders seek to have some liquidity by selling their shares, it is recommended that such flexibility be clearly captured in the agreement. Restrictions on shares are in the form of a right of first refusal, right of first offer, lock-in, tag-along right.
- Exit rights – One of the most aspect for the investor would be the exit rights. Exit rights contemplate the manner in which the investors will be able to sell their shares and obtain a return on their investment. This being the essence of the deal, the founder must make sure that the commercial agreement is appropriately captured as a failure to provide exit to the investors in the pre-agreed manner will trigger onerous clauses of the agreement.
- Non-compete – It is common for investors to cast an obligation on the founders requiring them to devote all their time to the company. In the event, the founders are part of any other company or have any pre-engagements, it is necessary that such carve-out be clearly captured in the non-compete provision.
Share Subscription Agreement: The Share Subscription Agreement provides for the manner in which the investment will be made into the company. Following aspects should be carefully considered by the founders:
- Representations and Warranties – The Share Subscription Agreement will usually contain a list of representations and warranties sought by the investor from the founders. Breach of these representations and warranties would trigger the indemnity provision of the agreement. It is critical that the founders assess each representation and warranty and include necessary carve-outs to ensure that each representation and warranty is accurate.
- Conditions Precedent – Basis the DD findings, the investor will require the founders and the company to complete certain set of actions before making the investment. The founders should assess these actions from a time and logistical perspective. For example, it may take several months for a company to obtain a license from a statutory body, in such cases the founders can consider negotiating the condition to be making application for such license. As the investment is contingent on completion of the conditions precedent, it is necessary that each condition precedent is property evaluated by the founders. It is important that a clear time bound obligation is cast on the investor to make the investment after the conditions precedent have been completed.
- Conditions Subsequent – Basis the DD findings, the investor will require the founders to complete certain actions post the investment is made into the company. There are usually pre-agreed timelines within which these actions need to be completed. Failure to complete these actions triggers a breach of the agreements and onerous clauses of the agreement come into play. Founders should ensure that timelines of each condition subsequent are in line with the expected time of completing such actions.
- Indemnity Package – The indemnity provision is usually triggered due to a breach in the representations or warranties or by breach of the definitive agreements. The founders should ensure that the indemnity obligation is capped, which means that in the event the indemnity obligation is triggered they would not have to pay in excess of a pre-agreed amount. It is common to have different indemnity thresholds for breach of separate representations and warranties. Founders should take special care that the indemnity mechanism is clearly understood by them and their understanding is clearly captured in the definitive documents.
The fund raising process is complex wherein several actions occur simultaneously. It is important for founders to have the basic principles of the deal in mind at all times while structuring, negotiating and finalising the deal. While we have captured the process in brief, the entire process also consists of various other minute aspects which need to be considered.
– Karan Narvekar | Partner
You can reach out to Karan at karan@bridgeheadlaw.com.
