In Part IV of this series, we discussed that the SSA records the terms and conditions of issue of shares to the VC fund, and the obligations of each of the parties to facilitate the conclusion of the investment. When negotiating the SSA, it is crucial for founders to understand the obligations they take upon themselves and their startup. It is common for founders to agree to overtly onerous obligations in the SSA in the interest of quickly closing the investment round. We have discussed below some of the important heads that are usually covered in an SSA and the nuances that founders should keep in mind.
Conditions Precedents a.k.a. CPs, are a set of conditions, imposed by a VC fund, that must occur before closing (allotment of securities to VC fund) of the investment round. CPs mostly arise out of statutory conditions prescribed under applicable law and issues identified by a VC fund from the diligence conducted on the startup. There could be various types of issues identified by a VC fund during a diligence process which may range from missing licenses, incomplete registers, non-compliances, etc., which could all find their way in the CP list. This is where founders can play an active role to try and understand the time that would be required in satisfying the action items from the CP list, as these action points will directly affect the closing timelines. Post identification, founders can negotiate with the VC fund to move certain unimportant CPs to ‘Post Closing Actions’ (set of actions to be completed post-closing) or limit the amount of work to be undertaken for a specific action item by restricting it to a specific stage.
By way of an example, a CP to obtain an approval for certain activities from Reserve Bank of India where that activity is not the primary business of the startup. In this case, it might be reasonable for the founders to negotiate the CP to ‘making application to RBI’, rather than ‘getting approval from RBI’ as the process of getting an approval from RBI may take some time. This will save a lot of time and will speed up the process of closing the investment process without any delays.
Any VC fund would want the founders/startup to give certain representations and warranties in relation to the business operations of the startup. A VC fund relies on these statements to gain assurances from the founders that the business does not have any undisclosed liabilities or issues. These warranties could vary from warranties in relation to financial aspects, licenses & compliances, employees, litigations, etc.
Sometimes founders rely heavily on deal lawyers to review and finalise the warranties schedule. A lawyer can try to understand the business of the startup and make edits. But this exercise works best with the active involvement of the business teams. This is where founders can actively participate and review the warranty schedule with their advisors to limit the scope of warranties keeping in mind the practical aspects of the business operations. Also, in the first investment round, it could make sense to avoid marking up the warranty schedule extensively and make detailed disclosures in the disclosure letter (as explained below).
Especially in the first investment round, it is a general trend in the market to seek warranties from both founders and the startup and make them liable for breach of such warranties. Post the first investment round, founders should negotiate to try and get themselves out from personally providing warranties.
Disclosure letter is prepared by the founders and consists of specific disclosures against the representations and warranties given by the startup/founders. Founders should try and prepare a detailed disclosure letter as information disclosed in the disclosure letter is excluded from any liability arising out of any claim from the breach of representations and warranties. If a claim is received in relation to information already disclosed in the disclosure letter, founders can defend their position and be clear of any liability by relying on the information disclosed.
In simple terms, indemnity means to make good the loss. Warranties, indemnity and specific indemnity (as explained below) are a package of obligations. If founders are giving warranties, they would be required to back it up by providing indemnities/specific indemnity in case of a breach. Just like in the case of warrantors, in the first investment round, founders along with the startup agree to protect the VC fund from liabilities arising from breach of warranties. Post the first investment round, founders should try and distance themselves from providing an indemnity in their personal capacity. In practice, the actual claim of an indemnity is theoretical and is rarely used by a VC fund. But it is a worst-case scenario against which founders should seek to insulate themselves.
Founders can also restrict their and the startup’s indemnification obligations towards a VC fund by capping the maximum liability up to the VC fund’s subscription amount. A de minimis amount i.e., a minimum threshold which a single claim must exceed in order to become eligible for indemnification can be introduced. This restricts and protects the indemnifiers against trivial and minor claims. A tipping basket i.e., a threshold which the aggregate amount of all claims must exceed before a party can bring any claim for indemnification is generally paired with the de minimis amount. This restricts the VC fund from raising repetitive claims unless it reaches the set limit and helps founders focus on developing the startup’s business without being very concerned about addressing claims regularly.
Specific indemnities are used to protect a VC fund against specific concerns that may arise from the due diligence conducted on the startup or upon review of the disclosure letter (as explained above) shared by the startup. These are generally an exception to the limitations agreed in relation to indemnification obligations in the SSA.
Depending on the practical and on ground knowledge about the business activities, founders can explain the practical aspects to the VC fund team in relation to a specific indemnity demand. Founders can explain how a specific item can be considered an inherent risk that has to be assumed as part of the startup’s business. To that extent, it would not make sense to provide a specific indemnity against that item or subject matter. Founders should try to keep the list of specific indemnities to a minimum.
An employee stock option plan is an employee benefit plan which offers employees an ownership interest in a startup. Ordinarily, a VC fund would invest with a condition that founders should set aside a fixed % of share capital for ESOP before the investor invests in the startup. This is requested by a VC fund as any investor would want the startup to attract and retain able and talented employees. This fixed % of share capital for ESOP comes from diluting the founders. The VC fund does not get diluted as the pool is created before the allotment of shares to the VC fund.
It is fairly common for a VC fund to demand this. However, founders can try and negotiate a lower percentage for the ESOP pool as founders are taking the dilution for the ESOP pool. If in the future, ESOP pool is required to be increased, then all the shareholders (including the VC fund) will need to dilute shareholding.
Cross-default is a provision that deems a person to be in default under a specific document when that person defaults on his obligations in another document. Founders should ensure that no cross-default provisions exist between the SSA and the SHA. SSA governs the investment to be made by a VC fund into the startup and SHA governs the inter-se relationship between the shareholders of the startup (including the VC fund) post investment. Defaults and consequences under a particular document should be restricted to that document and no cross-default provisions should be entertained by the founders.
It is standard for an SSA to have provisions for termination of the investment round upon mutual consent. Further, parties do agree upon a date by which all CPs shall be completed by the founders and the startup (as applicable) before issuing shares to the VC fund. If CPs are not completed by the designated date or the extended date as may be mutually decided by the parties, parties shall have the option to terminate the agreement at no cost and walk away.
The SSA has other customary provisions which need to be checked for any deviation from the market practice. In the subsequent parts of this series, we will cover important negotiation points in relation to the SHA and how founders can avoid overtly onerous responsibilities and liabilities on themselves and their startups.
Anshul Pandey | Senior Associate; Ajay Joseph | Partner
Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.