Our Open Approach to Long Form Legals
TL;DR Signing a term sheet is the start of a legal process that can feel like wading through treacle. For founders, understanding why investors include certain terms makes for vastly more efficient negotiations. It also enables founders to proactively manage their lawyers, saving time and money.
Let’s start by looking at what happens after you sign a term sheet with your lead investor. Here’s a rough outline of the typical process you can expect:
- A due diligence process will start (this will be the subject of another blog post)
- Lead investor’s lawyer produces initial drafts of the Investment Agreement and Articles of Association
- Company’s lawyer reviews the initial drafts of the Investment Agreement and Articles of Association
- Several turns of the drafts go between the law firms as the lead investor and the company negotiate the finer details of the investment — if there are co-investors, their lawyers will likely have input too
- Company’s lawyer produces ancillary documents to implement the investment — board minutes, shareholders’ resolutions, consents, etc.
- All documents are agreed and signing (every party signs) / closing (everybody wires funds) takes place
It all sounds relatively simple, but generally takes longer than you expect to get to point 6. Real challenges tend to arise when founders — or investors — dig in on terms that are important to the other party. This is where emotion can cloud the conversation and lead to significant delays or worse.
We’ve closed every single deal where we have started long form legals, but there were times when things got rocky. And we’ve certainly heard about deals falling apart during the legal process so it happens from time to time.
At Playfair, we recognise that founders having a clear understanding of why we are asking for certain terms is key to a smooth legal process and continuing to develop a strong founder investor relationship.
In this post, I’m going to look at the main terms that get negotiated in the Investment Agreement and Articles of Association, why we take the position we do, and considerations for founders on where to accept and push back.
It’s worth noting that the negotiations at this stage should be fairly limited given that the majority of key terms are agreed upfront in the term sheet.
Warranties are a strange concept if you haven’t come across them before. In short, they are statements of fact about the company. To give one example:
Each warranty is intended to give comfort to the investor that they have a full understanding of the company. In this case, it provides assurance that there are no other entities or shareholdings that the investor doesn’t know about.
With warranties, you also need to understand the concept of disclosure. This is where founders can qualify the warranties with additional information.
In this case, a disclosure might be:
The Company has a wholly-owned Subsidiary, [Name] Ltd, incorporated in Ireland with reg number XXXXXXXX.
The negotiation here typically centres around the scope of the warranties and the standard of disclosure required to be undertaken by the founders.
Investors will want a complete set of warranties including a ‘catch-all’, while founders may try to push back on the ‘catch-all’ and argue that warranties should be precisely worded. This negotiation can go either way — founders who successfully negotiate out a ‘catch-all’ may find an unintended consequence is that the investor then needs to add additional specific warranties causing delay.
In terms of the standard of disclosure, founders will sometimes try to disclose the entire contents of a data room against the warranties, while investors will resist. From an investor point of view, it makes me nervous when founders are insistent on disclosing the entire data room since (a) it raises the concern that there is something they are hiding or that they don’t fully know all the details about their own company and (b) it feels like they are avoiding doing a thorough and diligent job of the disclosure process, which is not a quality you want in a founder.
Limitation on warranty claims
Breaching the warranties — in other words, omitting some relevant information or actively providing misleading information — needs to have consequences for the founder and the company since investors are relying on them being true and complete when they make an investment.
There appears to be a market standard here for the limit of liability being (a) for the company, the investment amount and (b) for the founders, 1x annual salary.
Talk of breaching warranties, law suits and limitations is an emotional topic for founders, particularly as there is the possibility of personal liability.
I always say the same thing to founders: we need the amounts to be meaningful so that it provides adequate incentive for the disclosure process to be completed to the highest possible standards. Arguing to reduce the amount sends the message that either (a) the process will not be done properly or (b) there is something the founders are worried that we might find out about after closing. If I was a founder, this isn’t the unintended message I want to be sending.
Investors require information from the companies they invest in to make sure they understand what’s going on, have enough details to be able to identify challenges and make suggestions to help, and can report to their LPs.
Founders are often concerned that providing this information can be burdensome and a distraction from building so try to negotiate the scope.
As an investor, I don’t want to be creating unnecessary work for founders that distracts from building the company. That said, I do want the company to have sufficient rigour in place around accounting and reporting that sets solid foundations for the future.
Founders should feel comfortable challenging anything that looks burdensome and have the investors justify the requirement. As a founder, I’d push back on any requirement to fill in reporting templates provided by the investor solely for their internal LP reporting purposes.
Matters requiring consent
There are two levels of consent matters in a typical Investment Agreement.
The first level concerns more business/operational matters which can be approved by the Investor Director. The second level concerns fundamental matters, such as a decision to acquire another company, which requires Investor Majority Consent (a shareholder level approval).
These consent matters are generally standardised nowadays so founders will need to have good reasons to deviate from them.
One practical concern is that seeking consent will slow the founders down so understanding how approvals will be obtained in practice is important and the founders should ask about this (for example, I will give Investor Director consent via WhatsApp provided I am not sleeping!).
Investor Majority Consent
Investor Majority Consent is usually straightforward at the seed stage with a simple majority of the investors being sufficient. It gets significantly more complicated as you get into later rounds of funding with multiple investors.
Restrictive covenants are intended to protect the company as well as the investors and provide, amongst other things, that the founders will spend all their working time dedicated to the success of the company and will not compete with the company if they leave for a set period of time afterwards.
Investors are generally happy to carve out charitable commitments, mentoring, etc. provided the time spent on them is sensible.
Any negotiation around the provisions that protect the company in the event they leave will naturally raise concerns about the long term commitment of the founders.
Articles of Association
Good leaver vs Bad leaver
Whilst the vesting period will be agreed in the term sheet, the exact situations in which a founder is a ‘Bad leaver’ (i.e. what constitutes ‘Cause’) often comes up in the long form negotiations.
This is an emotive topic for founders since being a ‘Bad leaver’ means that all of their shares will be converted to deferred and they will get nothing.
This sounds draconian, but let’s just understand the thinking behind it. At the earliest stages of a company, we are investing in the founders since their commitment to work on the business is essential to its success and, frankly, not much else has been built yet. There needs to be a clear economic incentive for founders to stay to ensure long-term alignment of interests.
If a founder ultimately does leave in circumstances that are within their control (e.g. resigning) or they have done something bad (e.g. get a criminal conviction) their equity needs to be made available to help fix the problem they have created.
Leaver provisions are not included solely to protect investors. They are also there to effectively deal with founder break-ups, both amicable and where things have gone badly wrong. Fundamentally, their aim is to ensure that equity is held by those who are creating value for the company and not with those who do not.
Founders generally negotiate the definition of ‘Cause’ which determines whether a founder is a ‘Bad Leaver’ or not. Investors will get concerned if it appears the founders do not trust them. Arguments along the lines of ‘but you could make it look like [something a founder did] amounted to Cause’ do not go down well.
Be sensitive to the founder investor relationship in these negotiations. If you have concerns about your investor’s bona fides, that should be pause for thought.
A drag right enables a majority of shareholders to force the remaining shareholders to sell their shares so that 100% of the company can be delivered to a purchaser. It is helpful when either (a) a shareholder is not contactable to sign the sale agreements (happens often) or (b) a shareholder is being difficult for a variety of reasons (happens rarely, but can be a pain).
Drag rights make founders nervous because they think they might lose control of the decision to sell their company. This is not the case and we would never include a provision that allows a drag to be activated without the founders agreeing to it.
A Note About Co-Investors
Rounds usually have more than one investor. In general the lead investor will take the lead on long forms (hence them being called lead investor), but sometimes co-investors will want to have input into the negotiations.
Founders should try and structure the workflow so that all feedback from co-investors goes via the lead investor’s lawyers. This makes for a more efficient process and ensures that unnecessary fees are not incurred company side.
Two Notes About Lawyers
In the smoothest deals I’ve been involved with, the company has been represented by a lawyer and law firm experienced in early stage venture capital investments. In the most difficult deals, the company has not. Founders should carefully research and reference their lawyer and law firm and not rely on a firm who does not have expertise in this area.
Lawyers are paid to be pedantic. That’s a bit unfair actually, but they generally feel a need to prove their value by making lots of little points on documents which are generally a massive waste of time. Founders should brief their lawyers at the outset of the transaction that the expectation is for them to be commercial / not send needless mark-ups / focus on the big points.
A Final Comment
Whilst it’s impossible to cover ever nuance of legal negotiations on a early stage venture capital transaction, I hope the above gives at least some insights into many of the key terms that get negotiated and how we think about them.
Ultimately, legals are a necessary evil and just part of the much broader relationship that we build with founders over many years working together.