Founders’ guide to VC investment terms — Part 3
Raya Yunakova, Investor at LAUNCHub Ventures explains the main investment terms that every founder needs to know.
The final list of important venture deals terms is here. We will take a look at Drag along and Tag along clauses, Representations and warranties, Legal fees and Non-competes. Check out Part 1 and Part 2 if you haven’t already and since this is the last part of the series — let me know if I’ve missed something major.
Reminding you all to refer to the Venture Deals book for a more detailed look into things.
Drag along and tag along (co-sale) rights
These are pretty standard clauses whose ultimate goal is to treat the company and its assets as a whole entity as much as possible, as well as protect minority shareholders. It is extremely rare to actually have to enforce them as people usually reach an agreement before the decision to sell is formally taken, but if worse comes to worst you should have them. For your own benefit, as much as that of your investors.
The drag-along clause comes into effect in the event that the majority of shareholders want to sell the company, but a small percentage do not. The threshold for a majority in this case is usually quite high, in the range of 75%+, so that it would indeed mean that there is a strong conviction in the decision to sell. You would also only discuss this when there is an offer on the table. The drag along can be used to force smaller shareholders to sell and thus complete the deal, as the buyer is not likely to be interested in acquiring fractional ownership of the company. Important to note that a drag-along is an obligation.
The tag-along (or often referred to as co-sale) rights on the other hand mean that if a sufficient majority of the owners decide to sell their shares others can also sell their holding, either a proportion of it or in full. Essentially tagging along to the deal. The threshold here is usually set at the controlling stake of the company, or 51%, and its purpose is to allow smaller shareholders to achieve full liquidity. For example, if you’re holding 10% of the company and a buyer wishes to acquire 70% of the holding, the tag along would give you the opportunity to sell your full 10%, while the other 60% would be acquired from other shareholders. You can of course, also choose to sell 7% and continue holding the remaining 3%. Investors are not normally interested in holding small percentages of ownership so this clause gives us the opportunity to sell in full. Important to note that the tag-along is a right and not an obligation.
Restrictive covenants (non-compete)
These clauses state what you cannot do during or for a certain period of time after you work for the company (often 6 months for employees and 12 for founders). Essentially, their goal is to discourage key people from leaving and working for a competitor; poaching team members or clients, creating a competitive product or service, etc. All of these situations will be severely damaging to your business so it is good practice to try and prevent them. However good your current relationship with your team is, things can change and it’s best to be protected.
“Such clauses are not enforceable in Europe”. Maybe. However breaking them would make the person a bad leaver (see Part 1 for details) and at the very least you won’t be sharing shareholders with a competitor. Additionally, they do tend to make people think twice about making such steps, so they do work. Even if your company doesn’t raise venture funding, I would strongly advise you to include this in your employment contracts.
Representations and warranties
This is a straightforward one — reps and warranties are there to ensure that everything that needs to be disclosed about the company’s state of affairs prior to the investment has indeed been disclosed. Things like debt, ongoing lawsuits, or other liabilities, need to be brought to the investors’ attention so they have full information coming in. These are unlikely to break the deal (unless you have intentionally committed fraud for example, in which case you aren’t likely to be reading this anyway), but holding back information can.
The important aspect of this is the liability attached to breaching warranties, and that founders, and not the company, are personally and severably liable. There is usually a threshold to the liability, so that insignificant mistakes don’t result in severe actions (e.g. your investors won’t come after you for not paying an office supplies delivery). The amount up to which you are liable can vary, but it is typically connected to either your gross annual remuneration or to the amount of the investment. Each founder is responsible up to their respective shareholding. There is also a period during which you are liable, normally ranging from 12–24 months. What this means in practical terms is that if you didn’t disclose a tax liability for example and that became evident during your quarterly reporting, you might be asked to return the invested amount.
This isn’t really something that should bother you unless you’re trying to be sneaky, so it’s really not worth spending much time on it.
Legal fees
This is rarely discussed and often not understood by founders, but generally investors will expect the startup to cover their legal fees during a funding round. The investor will hire a law firm to do the legal due diligence of the company and prepare the investment documents, and upon successful completion, the company will pay that bill out of the investment. On the flip side, if the deal doesn’t go through the investors generally cover these costs. There is a cap on the amount which the company is expected to cover which is rarely reached, but this is worth having in mind.
I am not entirely sure why this is the case, except of course that we would prefer not to pay 6 legal fees, however it is the standard practice and VCs will expect this, so it’s something you’d most likely have to live with.
In conclusion
I hope this series provides a useful insight into some of the key terms you are likely to discuss when getting funding for your startup as well as your VC’s perspective on them. Ultimately, the best way to get comfortable with signing a deal is to work with your investors and have an open discussion about the nature of your relationship. If things work well, most of these will remain solely on paper and you will probably not have to look at the documents again.
Acknowledgements
If you’re feeling confused, don’t worry. It took me a while to get familiar with this quite complex matter, especially coming from a non-legal background. I was lucky enough to be able to participate in multiple venture deals and running into things in real life taught me a great deal. However, the credit for helping me properly understand legal terms in detail goes to a large extent to my former boss and friend Dom Wilson. Having both legal and venture capital experience he is able to bring theory to practice and is great at explaining things in a way anyone can understand. In other words, if you need help navigating venture deals, he’s a great source of knowledge. Thanks, Dom!
Originally published at https://www.linkedin.com.
