You’re sometimes intimidated by the law aspects of a deal? When I think about law I need a lot of clarity from a competent person to feel safe, otherwise I feel intimidated about the possible negative outcomes.
Sometimes there are changes in the legal system and if we don’t keep up with these changes we will make costly mistakes that can easily be avoided if we are properly informed.
Fortunately, I found some secrets about venture deals at a great workshop at Techsylvania 2019 named “Venture Deals. Tricks and tips”. It was hosted by Achim Sorin Răzoare, lawyer and partner in Laurentiu, Laurentiu & Associates.
In this workshop, we covered critical subjects that are increasing the chances for you to have a successful deal that will benefit all the parties involved and that keeps you away from costly mistakes. Bellow are the main aspects when you conclude investment deals.
1. The IP (Intellectual property) rights should be owned by the company and by the brand identifiers registered
IP rights are often a startup’s most valuable asset. All the IP rights should be owned by the startup company, not personally by the founders. All the IP rights for the content developed by external collaborators and/or employees should also be owned by the company.
All contracts concluded with collaborators and/or employees should contain IP assignment clauses that effectively transfer ownership of the IP rights developed by these providers for the company.
The IP rights of a creator of a computer program for example are protected by Romanian law, but it does not protect the idea or the concept. However other mechanisms can be used in order to protect them, such as NDA’s (non-disclosure agreements).
The company’s logo and any other brand identifiers ensure the recognition of the company and/or its product in the minds of its clients and they should be registered as a trademark (nationally and internationally) as soon as possible.
2. The company should be ready for the investors’ due diligence process
Usually, the investor conducts more or less detailed research into the financial, corporate and contractual status of the company.
The investor will probably request documents or information regarding IP rights, trademark, budgets, forecasts, key supplier/customer contracts in place, employees and employment contracts.
Besides this, you may need a list of equipment owned by the company, details of other investors, shareholders, bank loans, any existing or future litigation and data protection policies.
The number of documents you will actually have will depend on how long you have been in the business. It is recommended to organize all of these documents for the quick delivery to a potential investor, so you don’t slow down the process when it asks for them.
It is also recommended to see if there are any items to clean from the past. Any snag list could represent a weak point in negotiations, sometimes with implications in the price of investment.
3. The term sheet
When one or more investors are interested in investing in a startup, the next step should be concluding a term sheet that should contain the agreed-upon points of the deal and will serve as a basis for drafting actual investing documents.
It is recommended not to present your term sheet to an investor. You get no benefit by playing your hand first since you don’t know yet what the investor will offer you. Why run the risk of aiming too low? Also, investors usually have their own term sheets to begin with.
It is also recommended not to address deal points necessary in order of the legal paper but in the order of their importance. If you allow a person to address each point and try to get closure before moving on to the next point, you might lose sight of the deal as a whole.
Try not to accept arguments like “That’s the way it is because of the market.” Instead, try to discuss why the market condition applies to you. If the other party is not able to justify it, you’ll immediately have the higher ground.
Usually, investors are concerned with two main aspects: Economics (Price, Liquidation Preference and Anti-dilution) and Control (Board of Directors, Protective Provisions and Drag-Along).
4. Liquidation Preference
This is probably one the most important economic terms of the deal, after the price, or sometimes maybe even equally important.
Liquidation preference determines the payout order in case of a corporate liquidation and it is used in order to specify which investors get paid first and how much gets paid in the case of a liquidation event, such as bankruptcy or the sale of the company.
Liquidation preference is especially relevant in cases in which a company is sold for less than the amount of the capital invested and it can be non-participating or participating.
Liquidation preference non-participating means that a certain minimum amount is returned to the investor before the founders receive any consideration. The number is generally equal to the investment, although sometimes the investor wants to have priority also on some margin.
This means that the investor either gets the liquidation preference (when the investor’s share in the distribution of the assets is higher than the liquidation preference) or chooses to participate in the liquidation with the founders on a common equivalent basis (when the investor’s share in the distribution of the assets is higher than the liquidation preference).
Liquidation preference participating means that besides the amount returned to the investor with the priority, the investor will receive also his share in the distribution of the remaining assets.
You could try to get a limited time frame for the liquidation preference but normally the investor will ask for a reasonable explanation for such limitation.
Special attention should be paid to the liquidation preference clause in order to avoid the so-called “leonine clauses”, known as the clauses under which a shareholder reserves for himself all the benefit or is exempted from participating in the loses.
5. Anti-Dilution Clauses
Dilution of an equity position occurs when an owner’s percentage stake in a company decreases because of an increase in the total number of shares.
Anti-dilution provisions are used in order to protect investors from equity dilution resulting from later issuing of stock and are often materialized in the right of first refusals for the existing investors.
These types of provisions are almost always part of the financing and it is often better not to try to eliminate them, but rather to focus on minimizing their impact.
6. Drag-along clause
There are investors who prefer the drag-along clause also to make sure that, even if they are a minority, should a company sale occur. The founders can be forced to sell their stake to the same proposed buyer, on the same terms and conditions.
If you accept such a clause, it is recommended to try to agree upon a formula for calculating the minimum price offered by the proposed buyer, which can trigger the Drag-along clause.
7. Protective Provisions clause
Investors will often want to gain as much control as possible over the business. Protective provisions are effectively veto rights that investors have on certain actions done by the company, especially when it impacts the investors’ economic provisions.
8. Typical hot topics the investors want to have an influence on:
- Increasing or decreasing the company’s share capital.
- Any merger, other corporate reorganization, sale of control or any transaction in which all or substantially all of the assets of the company are sold.
- Any by-laws amendments (set of rules made by a company to regulate itself and to control the actions of its members).
- Increasing or decreasing the seats in the board of directors.
- The election of the board of directors and establishing their remuneration.
- Any deal amounting more than a certain limit.
Instead of focusing on how to eliminate clauses which give the investors control over the company, it is better to concentrate on how to structure such provisions in order to give investors some control, but ensure that the decisions regarding operational matters and the main directions of the business remain with the founders.
It is recommended to try to keep the number of investors’ necessary votes as low as possible, to avoid having to convince all the investors or most of them to agree upon your proposal.
As far as the protective provision clause is concerned, most of them are fair and are common for almost any investment deal.
Regarding the one related to deals amounting to more than a certain limit, you should try to get a limit as high as possible or specific exclusions, such as equipment financing.
9. Board of Directors
It is also recommended to try to avoid reaching more than 5 members of the board. A board of seven, nine or more people usually slows down a well-functioning board.
Some investors like to propose that an agreed even number of members should be named by the founders and an equal number by the investors.
Under Romanian law, the administrators can be appointed only by the shareholders in the general assembling, so naming some of the members directly by one of the shareholders or mandating the existing administrators to appoint a member on the last seat is not possible.
However, a possible solution might be to set this kind of arrangement through shareholders' agreements, while paying special attention in order to avoid any kind of agreement on the vote prohibited by the Romanian law.
10. Disposal of shares restriction
The investor will want you to stay in the company as a shareholder for as long as possible. That’s why you might find in the term sheet a clause that restricts your right to the disposal of shares for the period since the signing of the financing and lasting for as long as the investor is a direct or indirect shareholder of the company.
It is recommended not to accept such an absolute restriction of the right of disposal of shares. Moreover, under Romanian law, its validity is questionable.
While a certain restriction in what concerns the disposal of shares is common and fair, try to stipulate a more specific time limit for such a restriction or to get an exclusion for predefined clauses such as an offer coming from a Proposed Buyer which can trigger a Drag-along clause (assuming there is such a clause in the term sheet) or a sale of part of the shares held by the founders for a specific purpose.
If the Startup is an SRL (Limited Liability Company) the Romanian law provides that the disposal of shares to a purchaser outside the company must be first approved by the shareholders representing 75% of the capital.
Therefore, in such a startup, if you have got financing in exchange of more than 25% equity, any subsequent disposal of shares can be blocked by the investors since you no longer hold at least 75% of the capital.
11. The Long Form Documents
The shareholders’ agreement is the contract that will be concluded between the shareholders of the company, including the investor/investors which details all the points of the deal included in the term sheet, that was agreed upon.
It usually contains anti-dilution clauses, tag-along and drag-along rights, any agreed upon liquidation preferences and protective provisions which give the investors the right to have a saying regarding certain actions by the company.
The Bylaws establish the rules for the operation of the company and, unlike the shareholders’ agreement, the Bylaws are public.
Among other things, they define the responsibilities and the power of the administrators and the means by which the shareholders can exercise their control over the administrators through the general assembly.
The Bylaws can often include some of the causes which are also included in the shareholders’ agreement (such as tag-along and drag along).
I am very grateful for this workshop because it was filled with valuable information and it gave me a lot of clarity regarding the legal aspects of a deal. You can contact Achim Sorin Răzoare here. Also,check out about Techsylvania here.
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