We tell you what you need to know about different aspects of venture agreements.
When structuring a deal
Early-stage startups rarely combine different legal entities under one parent company. When concluding a venture deal, the founder (founder) of the project must understand the consequences for other “related” persons. For example, whether the investor will have the right to participate in the management of other companies of the group or what will be the procedure for concluding transactions with shares (shares) of each of them.
I do not recommend leaving these questions at the level of conceptual agreements: this is the ground for possible conflicts. It is better to draw up additional corporate agreements. This will help establish individual rules for interaction, protect the interests of third parties (creditors of the company or those who intend to become a member) and build a corporate governance system. You can prescribe a condition under which the founder cannot resell the company without consulting the investor. Choosing an investment instrument
Venture capital investment vehicles are determined not only by profitability or risk level, but also by jurisdiction. In some countries, certain tools are simply not possible. Instruments
● Convertible loan or sale agreement for future equity (SAFE). This is actually the purchase of the company's obligations to transfer shares in the future, and the parties agree in advance on the price or on the procedure for determining it. The moment of issuing securities is determined by the occurrence of some event: the next major round of investments, the launch of a product, etc. Why: the instrument is often used when the investor and founder cannot agree on the price of the company, as well as to finance the company between rounds .
● Preferred shares of the company. Preferred shares give the investor two important rights - a liquidation preference and a fixed dividend, but voting rights are limited. Liquidation preference is the right to demand payment of a certain amount upon liquidation of the company in priority order (in relation to other shareholders). This is a kind of protection for the investor in case the company fails to achieve the declared business indicators. For what: this type of securities gives the right to a fixed dividend that can be accumulated (cumulative dividends). Depending on the applicable law and the provisions of the articles of association, holders of preferred shares may participate in the distribution of the company's property upon its liquidation on an equal basis with holders of ordinary shares. As a rule, preference shares can be converted into ordinary shares - the ratio for conversion is determined by the charter or issue resolution and may change (for example, if the dilution protection works).
● Ordinary shares or equity interest. The holder of such securities has the right to vote in the management of the company. The owner of ordinary shares or a member of an LLC does not have any guarantees of return on investment, unlike the owner of preferred shares. An investor acquiring ordinary shares or a share in the authorized capital of an LLC bears the same risks as the founder. In budgeting and financial reporting
The views of investors and founders on budgeting and reporting often do not coincide. Young innovators make a clear financial plan only for a month or a quarter, approximately “throwning” cash flows for a year, or they generally neglect budgeting and reporting. Investors are accustomed to detailed budgets, reporting, and to the fact that any significant deviations from the budget are agreed in advance.
When agreeing on regular disclosure of financial information, it is better to immediately show the investor how this process is established in the company and synchronize expectations. At a minimum, it is necessary to explain how often budgets and reports on their execution are prepared, what indicators are reflected in them, and how much resources the company is willing to spend on financial accounting.
Should the investor be given the right to participate in the management of the company?
This issue needs to be carefully considered. Venture deals differ in many respects in that the investor acts as a mentor, investing not only money, but also connections, knowledge, and experience. In order to coordinate work and reduce risks, the boundaries of influence of each participant are described in the shareholder agreement. It can change as needed (usually with the involvement of new investors). What should be written in the shareholder agreement:
whether the investor has the right to vote at the meeting of shareholders or the board of directors (and in what matters);
whether he has the right of veto - the ability to block a particular decision. If so, does it depend on the size of the investor's share?
If there are many shareholders (at least more than 5), it makes sense to think about creating a board of directors (BoD). This form of management has several advantages:
Faster approval of transactions. Especially if one of the investors is a foreigner, which is difficult to contact promptly. Usually, a representative is assigned to the council for direct work.
what circle of communication.
It's easier to make decisions. There are usually fewer requirements for meetings of the Board of Directors, or it is easier to comply with them - for example, the period for notification of a meeting may be shorter.
The disadvantage of the SD is that, depending on the applicable law, the residency of directors may affect the tax residency of the company itself, so it is worth considering who exactly will be the director, whether the director is required to pay remuneration and who will pay it.
How to manage project shares
To avoid conflicts related to the ownership of the company, it is necessary to regulate the possibility and method of transferring shares (or parts thereof) between participants or third parties.
The simplest scenario for the takeover of a company is the formation of a controlling stake (more than 50%) as a result of the purchase or transfer of shares of several holders. A new participant may have a completely different vision for the development of the project, and if he has weight in decision-making, he can radically influence the company's activities.
The size of the share of each of the shareholders of the company is gradually eroded with the attraction of new investments. For example, the initial investor's share may decrease from 20% to 12% after several rounds. If the value of the company has grown significantly, this situation may suit the participants. However, it is important to agree on the following from the outset: How will the issue of new shares proceed - for example, when attracting a new round of investments. Will the investor have blur protection and how will it work? In what cases can an investor block the next round of investments?
Lock-up period (blocking period), when all or part of the shareholders cannot sell their share.
The right of the investor to demand the redemption of his share if the company has not been sold or has not entered the IPO within several years.
To address the issue of dilution protection, one can resort to the “pay or play” format, when the investor is obliged to participate in the next investment round in order not to lose certain privileges (for example, dilution protection or the right of veto).
The obligations of the founders to the company
It happens that the founder abandons the project halfway through. A well-known example where frequent management changes affected the quality of a product is the MySpace social network. Despite the fact that the service is still active, at one time it lost to Facebook, and after that to other platforms, although it was one of the pioneers in the social-media industry.
Investors increase the motivation of the founders to stay in the project through reverse vesting of shares: the return of the founder's share to the company in case he leaves before the set time.
It works like this: the vesting period is determined (for example, three years) and the share of the founder (for example, 30%). If he leaves the company after only a year, according to the agreements, he owns only 10%, and the remaining 20% is obliged to sell the company at a set price. Thus, in order to dispose of the full package of shares, he must work for three years. Unlike conventional vesting, in reverse vesting, the shareholder immediately has full voting, economic and information rights.
Other protective tools for investors in relation to founders:
obligations not to poach employees (non-solicitation covenants, NS);
obligations not to compete with the company (non-competition covenants, NC).
It is important to remember that such obligations should not limit the right to work. The effectiveness of these terms varies by jurisdiction.
To summarize:
think over the structure of the transaction at the initial stages, as well as evaluate its impact on related legal entities;
when choosing an investment instrument, consider the jurisdiction, the level of risk and ways to generate income;
when agreeing on financial reporting, consider both options (yours and your partner) and try to reach a compromise;
clearly define the rights of each shareholder before starting cooperation;
establish rights to dispose of shares, they must protect both parties;
discuss the obligations of the founders and the terms of work in the project.