In an interview by Financial Chronicle. J.Sagar Associate’s partners Sidharrth Shankar and Aarthi Sivanandh explain crucial aspects to a venture capital funding.
Do entrepreneurs conduct the necessary due diligence before signing on the dotted line? What all should they look for in a VC?
There is no standard commercial behaviour with entrepreneurs. However, extensive diligence at the VC stage are not heard of. Sanity checks are commonplace with some level of comfort the founder enjoys with the VC that propels their conversations forward. If such VCs are popular investors in the sector the founder operates in, diligence becomes an ongoing process. There are more detailed reviews if it’s an unfamiliar bet that the VC is placing. These rigours of diligence also disappear if the founder is hard pressed to raise an immediate round of capital. Diligence at this level is a function of time, necessity and familiarity.
However, it would be prudent before dealing with a VC, for an entrepreneur to undertake checks on the jurisdiction from where the investment is coming; the experience of the VC; the relationship enjoyed by the VC with banks, other VC funds and financial institutions for the company to leverage the relationships in the small ecosystem post the funding round. The relationship becomes a formal marriage requiring chemistry, and vetting the partner is equally important from both sides.
What are the standard clauses in a contract between a startup and a VC?
Generally, the standard clauses in any investment agreement between a start-up and a VC involves conversion terms (in the case of convertible securities being issued to the fund), corporate governance matters (board seats, reserved matters) and exit terms.
Although at times these clauses may seem over engineered for a start-up round, it often sets the platform for negotiation of all rounds of future funding and it would pay the founder well to pay keen attention to what is being negotiated and agreed to.
How do contracts between start-ups and angel investors/ VCs/ PEs differ? What are the key clauses that entrepreneurs should focus on?
The key difference as regards contracts executed amongst start-ups with angel investors or venture capital investors or private equity investors, as the case may be, is with respect to the stage of investment and the quantum of investment. Typically, investments from angel investors/ venture capital investors are sought at the stage of inception of a start-up/ early stage of the start-up and, therefore, the quantum of funding is also relatively modest. On the other hand, private equity investments are larger in size and are targeted at growth stage and mature companies.
While both VCs and PEs are in the business of investing as cheaply as possible with a view to seek the maximum possible returns, they approach this challenge very differently. Venture capital truly ventures into pre-product, pre-revenue and sometimes even pre-company; private equity is the diametric opposite of all of those. Thus while the clauses may appear the same, the way they are negotiated and agreed upon are very different.
That is in fact the key differentiator in the ways these contracts differ, to oversimplify it is to simply say the headlines of the term sheet are exactly the same. The nature of the rights and obligations associated with such investments are different and the way the same clauses are written up are different for each stage of investment.
For example the start-up could have minimum representation and warranties backed by the maximum indemnity being restricted to half the size of investment while the same terms would be far more elaborate and indemnity restricted to the entire amount of investment if not more for a PE-backed company and somewhere in between for a VC investor.
What are the clauses to be wary about? What potential pitfalls should start-ups be mindful of?
Generally, while negotiating any investment agreement (either involving fresh share issuance or share sale), the promoter and the company carefully take into account affirmative voting matters; the anti-dilution protection of the investors; obligations being imposed on the promoter by the investors for their exit; and the extent of indemnities being asked by the investors for any breach of representation and warranties and covenants of the promoter.
The way each stage of investment defines a liquidity event is a telling clause on the exit expectations and the ability of the founder to fulfill those, based on this is interwoven the restrictions on transfer of shares the parties agree to. For example if the liquidity event is defined as a series B round for a start-up then the investor may require the founder’s entire shares be locked in until such an event happens. However, if the liquidity event is defined as a strategic sale in five years, the founder maybe permitted to dilute or sell a small percentage of his holding for him to enjoy some liquidity until a strategic sale happens down the timeline.
Startups would do well to be mindful of clauses relating to:
Voting – founder veto rights
Valuation – does the number work for benchmarking for series B;
ESOP – is the ESOP dilution out of the founder stock or post investment stock;
Board control – majority control on the board to be balanced with the investor veto rights and operational control ;
Liquidity events – the range of what constitutes a milieu of true foreseeable liquidity events;
Exit – a future issuance round, strategic sale, merger etc.
Is there a standard template for legal contracts of this nature in India? What are the advantages/disadvantages of the template, if it exists?
There are no standard templates for contracts between start-ups and investors. Depending on the nature of investment and the commercial understanding between the parties, the terms and conditions can be drawn up. However, as discussed above, it is customary for any private equity investment/venture capital investment involving an Indian company to contain certain standard clauses pertaining to corporate governance, anti-dilution, exit, and liquidation preference among others.
Each deal should be driven by its nuances and commercial expectations, if the investor is telling a founder something is market practice or something is standard, founder would do well to not buy such an argument and independently see if it works for him/her. However, these calls are a combined question of commercial requirements and legal protections.
Please decode the exit clause.
Typically, the exit clauses in any investment agreement are drafted keeping in mind a number of scenarios, such as performance of the company over a period of time, strategic sale, investor seeking to cash in on its investment. Typically, in any investment agreement, the modes of exit will be:
Put option clauses: A ‘put option’ usually refers to the investor’s right to sell its securities at a pre-agreed price to the promoter/other shareholders, who have the obligation to purchase such securities at such pre-agreed price.
Buyback of securities: The term ‘buyback’ and ‘put-option’, although used inter-changeably in commercial sense, are different in their operability and enforcement. While on the one hand ‘put-option’ is a right that an investor has against a shareholder, on the other hand ‘buy-back’ is a right that an investor has against the investee company.
Apart from the above there are certain other exit clause such as the right of first offer (Rofo)/right of first refusal (Rofr)/tag along/drag along right, which are commonly used in the investment agreements based on the commercial understanding of the parties. These clauses structure how each party will seek alternately to sell their shareholding within themselves or to an outsider, third-party purchaser.
Initial public offering (IPO): Usually, seen as a reasonable expectation in grown mature companies that gain the confidence of the public markets. Although India has now energised the institutional trading platforms for SMEs the true test of those platforms are yet to be seen for smaller companies.
Investment agreements contain an IPO as part of the exit mechanism available to an investor. Depending on the agreed terms and conditions, an IPO is generally agreed to be undertaken upon the investee company, ‘on a reasonable efforts basis’, upon completing certain pre-agreed milestones (such as crossing minimum revenue and valuation parameters) or upon completion of a specified time-period, from the date of investment. In India, matters governing IPOs are governed by the regulations prescribed by the Securities and Exchange Board of India.
An exit is an investor-favoured clause. It is imperative to strike a balance between investor concerns and promoter concerns while structuring an exit provision. Private equity investments usually have a horizon where the promoters agree to provide an exit for the investors on predetermined terms. Where the promoters have failed to provide the investor with the agreed exit from the company, “drag” provisions in favour of the investor are useful. A few points to be borne in mind while structuring an exit are:
(a) Sequence of the exit (typically there is a waterfall mechanism incorporated providing an exit for an investor involving a combination of Rofr/Rofo, drag along right, tag along right, IPO, promoter/company put option, strategic sale);
(b) Fixing a time period throughout the sequence of the exit;
(c) Fixing the IRR that is required to be met by the target company; and
(d) Deciding the amount to be returned to the investors in case of a liquidity event, which is typically expressed as a multiple of the original investment.