Decoding the Term Sheet: Chapter V (A Few Common Terms)
When a founder is negotiating with investors, they like to weigh their options and continue to seek out the best deal for themselves.
As we write the concluding chapter of this series, we will try to explore topics not covered so far, including some common and standard terms.
PROPRIETARY INFORMATION AND INVENTIONS AGREEMENT
This clause has evolved so that a company legally knows its intellectual property. Broadly, proprietary information includes, brand name, trade secrets, confidential knowledge, data, ideas, processes, formula, programs, inventions, designs and techniques, discoveries, other works of authorship and the likes. All employees, founders, contractors or vendors must sign a legally binding agreement whereby they agree to assign over all intellectual property rights conceived during the course of the person’s work with the company.
Proprietary Information and Inventions Agreements are important to venture capital investors as they would be crucial in the event of the eventual sale of the company. The term sheet typically requires such agreements from all present and former founders, employees and consultants. Companies should ideally build this into their hiring process to avoid scampering at a crucial time.
A Co-sale agreement prevents founders from selling their stock without notifying the company and investors, who, in turn, must receive the first opportunity to purchase their stake on a pro rata basis. A typical Co-sale agreement may read as:
The shares of the Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange their stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis. This right of co-sale shall not apply to and shall terminate upon a Qualified IPO.”
The co-sale agreement only matters if the company is held privately. If it goes public, co-sale agreement does not remain valid.
NO SHOP AGREEMENT
When a founder is negotiating with investors, they like to weigh their options and continue to seek out the best deal for themselves. When they are closer to finalizing a lead investor, such an investor is most likely to seek a no-shop agreement which applies even before the Term Sheet has been signed and sealed. This is because investors spend a great deal of time and resources on due diligence, legal fees, etc. and do not like it if the company stalls the deal to “shop” for better terms, stalling the present one. A standard no-shop agreement usually lasts for 45 to 60 days. During this time, the company and its founders cannot solicit any offer of investment from a third party other than the investor. The agreement also applies in case of acquisition, lease or similar. The company is required to work in “good faith expeditiously” towards closure of the deal.
While a no-shop agreement is standard and not worth negotiating too much, founders can discuss the tenure for which it remains in force to bring it down. For instance, a no-shop agreement for 90 days may be too steep and not agreeable to most founders.
The term sheet provides for indemnification of the board members appointed by the investor. Sometimes the Venture Capital Fund itself is party to the agreement in addition to the director(s) appointed by it. This is a contractual obligation whereby the company is required to limit board member’s liability and exposure to damages to the broadest extent permitted by applicable law. A sample indemnification clause can be as follows:
The bylaws and / or other charter documents of the Company shall limit board member’s liability and exposure to damages to the broadest extent permitted by applicable law. The Company will indemnify board members and will indemnify each Investor for any claims brought against the Investors by any third party (including any other shareholder of the Company) as a result of this financing.
A company cannot expect to get funded without agreeing to the Indemnification agreement. It is now standard practice for businesses to purchase formal liability insurance to be able to meet these requirements.
REPRESENTATIONS AND WARRANTIES
In the early rounds of financing, investors often require a company to make certain representations and warranties. Sometimes, they may even require the founders themselves to make representations personally.
In a securities purchase agreement, representations and warranties are a series of statements through which an investor gets clarity on the condition and operations of the company they are investing in. They are also crucial inputs to the investor’s due diligence process. They encompass both assertions about factual matters and promises that the facts are truly stated, as on date. Areas covered in this section could include details on organization, authority, conflicts, licenses, approvals and filings, constituent documents, capitalization and voting rights, liabilities, litigations, accounting practices and intellectual property, to name a few.
For instance, typical language when a Company gives a representation about litigation reads as:
• There are no proceedings by or before any Governmental Authority or by any Person pending against, relating to or affecting the Company or Promoters or any of its assets and properties.
• There are no facts or circumstances known to the Company or Promoters that could reasonably be expected to give rise to any actions, suits, proceedings, arbitrations or any investigations or audits by any Governmental Authority that would be required to be disclosed pursuant to sub clause above.
• There are no orders outstanding against the Company or Promoters.
• There are no claims pending against the Company or Promoters arising out of any dispute relating to the IP Rights of the Company.
If there is litigation pending, the company will have to qualify the above statement. Any qualifications to the representations and warranties are listed in disclosure schedules that become an integral part of the closing documentation.
Representations and Warranties also aid in risk allocation. There are certain warranties that the company may not be able to give with the highest degree of conviction, such as Intellectual Property. For example, in case of a startup with limited resources, it is likely that they may not have performed an exhaustive search for awareness if they were inadvertently infringing on intellectual property. The Company can, at best, furnish information “to the best of their knowledge”, since no investor will agree to a deal without an unqualified Intellectual Property representation. For the investor, with such a representation, the risk is shifted to the Company, so they proceed further.
Atal Malviya is the Chief Executive Officer of Spark10.com – India’s first European Accelerator. Atal is a successful entrepreneur and an angel investor based out of London. He has founded and exited VC funded technology startups and invested in handful of technology startups in Europe and India. He writes and speaks about Tech Startups, Startups investment, Accelerators and Incubators, Tech innovations and Big data analytics.
She is Content Manager at Spark10.com. Swati has joined Spark10 Blore last month from Goldman Sachs.
PS: This article is for information purposes only and meant for tech startup founders or aspiring entrepreneurs. Examples used are fictitious. Please take professional advice when you make your funding decisions and Spark10 will not be responsible for any decision that you take or conclusion you draw from, based on this article.
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