In Part V of this series, we discussed the intricacies of negotiating the SSA in the context of VC funding. Next would be to focus on another crucial document in the investment process – the shareholder agreement (SHA). The SHA governs the post investment inter-se relationship between the shareholders of the startup, including the VC fund. In this article, we will explore important negotiation points in relation to the SHA and how founders can navigate this agreement while safeguarding their interests and minimizing potential liabilities.
One of the early considerations in the SHA negotiation process involves the composition of the board. Founders often weigh the decision of whether to extend a board or observer seat to the VC. It is advisable for founders to negotiate in favour of providing an observer seat rather than a board seat, depending on the stake the VC fund will own. If a board representation is being offered founders should ensure that they retain majority on the board, until such time that they own majority stake in the business.
Furthermore, founders must ensure that key decisions require their involvement by setting a quorum requirement. This ensures that founders remain actively involved in steering the company’s course.
Reserved matters (or affirmative voting matters) are decisions requiring specific investor approval. These matters generally pertain to significant strategic decisions, financial transactions, or operational changes. While it is essential to have some restrictions in place to protect investor interests, founders should be cautious not to accept overly burdensome obligations that restricts the flexibility of founders to undertake day-to-day operations and decisions.
Negotiating reasonable monetary and other thresholds keeping in mind the post investment business operations of the startup on reserved matters can prevent undue delays in closing of the investment round. It is crucial to find a balance between protecting a VC fund’s interest and staying flexible in day-to-day operations.
The liquidation preference is a crucial term that determines the order in which stakeholders receive their returns in the event of a company sale or liquidation. We have already discussed this in detail under Part III of this series. In most cases, a non-participating 1X liquidation preference is the industry standard for such transactions. This means that investors receive their initial investment amount before other stakeholders or they participate in the proceeds of sale pro-rata to their shareholding in the company. Founders should make an effort to negotiate this and secure the VC fund’s agreement on this. Sometimes investors coming at a later stage would demand priority in preference over past investors. This could become subject of heated discussions and such demands should be clarified or negotiated at the term sheet stage rather than allowing it to delay transaction closure at a later stage.
Anti-dilution provisions aim to shield investors from a drop in the value of their shares when new shares are issued at a lower price in the future. The anti-dilution right is essentially the right of existing investors to readjust their conversion price to a revised lower price to factor in the reduction in valuation of the business. The industry standard for this is to use a broad-based weighted average method for calculating the revised price.
Exit provisions define the conditions under which investors can exit from their investment. These provisions should not ideally place a personal obligation on founders to provide an exit; at most founders can agree to provide an exit on a reasonable effort basis. Founders should ensure that VC funds only have the right to drag other shareholders (including founders) after exploring other options (already discussed in detail under Part III of this series), such as an IPO, finding a third-party buyer, or a buy-back of VC fund’s shares by the startup.
Event of Default
An event of default is a scenario where the startup or the founders breach certain specified conditions, leading to remedies for investors such as accelerated exit, removal or suspension of founders from the board and employment of the startup etc. Founders should aim to exclude open-ended provisions and minor breaches from this category. In case of multiple founders, it is also crucial to ensure that the actions of one founder does not trigger a companywide event of default. Founders should negotiate to ensure that there is a fair and independent process for determining an event of default as it is critical to maintain transparency and fairness during the complete determination process.
Lock-in of Founders’ Shares
Founders are typically subject to a lock-in period, during which their shares are not transferable. Negotiating the terms of this lock-in is necessary. Founders can request that their shares be released in equal monthly instalments, offering more flexibility than an annual release date or a complete release at the end of the lock-in period. Additionally, specific instances that lead to the relinquishment of locked-in shares should be carefully examined. In cases where founders are not at fault, measures should be in place to return all shares (locked and released) or compensate founders fairly.
In the negotiation process, founders must approach it with a clear understanding of the startup’s objectives and a keen awareness of potential risks and liabilities. The SHA plays a vital role in shaping the relationship between shareholders and setting the course for the startup’s future. By understanding the key negotiation points and seeking appropriate guidance, founders can navigate the intricacies of the SHA, strike a fair deal, and lay the foundation for a successful partnership with their VC investors.
In our next article, we will shift our focus to another critical aspect arising out of VC funding — executive employment agreements. Founders, poised at the intersection of vision and execution, must navigate the intricacies of these agreements with equal diligence. We will shed light on essential considerations that founders should keep at the forefront when crafting and negotiating employment terms.
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.