Legal-ese for Startups

Bye Bye Bob!

I recently wrote a post about the importance of Reserved Matters (also called Affirmative Rights), and folks asked a few questions about the types of rights, importance and whether they are Founder friendly or Investor Friendly.

In my view, the right balance of rights are Company friendly, as they act as guardrails, especially for first time Founders. In this post, I’m going to explain the broad rights a VC asks for, as well as ones Founders should care about.

A necessary disclaimer, I’m not a lawyer, this isn’t legal advice, the best thing you can do for yourself is get GREAT lawyers to help work on your SHA/SSA

Before we go into terms, I need to explain how shares are issued in startups. When an investment happens and there’s the word ‘dilution’, it doesn’t mean you as a Founder are giving your shares. It means that you are increasing the share capital of the company, reducing the % of the company you own. The image below should explain better

Here, the total shares held by the Founders don’t change, but their % ownership does with the Angels being issued new shares

Jumping in:

A few key terms that every founder should know (not alphabetical, stop being pedantic) are:

Term Sheet: This is a non-binding document that VCs issue when they’re keen to invest in a company. It covers the broad terms of the investment, and can be ultra-light (couple of pages) to extremely detailed (~20+ pages). The more you cover at term sheet stage, the easier it gets to draft the Shareholders Agreement (SHA) since all the key terms have been covered.

The key terms that must be in term sheet are -

• Valuation — What’s the company being valued at pre-money (present value) and post-money (after the investment)
• Investment amount — Self explanatory?! The amount the investor(s) are investing into the company
• Stake — The percentage the investor(s) are receiving in exchange for their money
• Securities — The kind of securities the investor is buying, typically compulsory convertible preference shares (CCPS), and the conversion ratio for these shares (standard is 1:1 , can change for more complex agreements), also what are the conversion terms for these securities (usually at Investor discretion and at an Exit Event)
• Timeline — Term sheets usually come with an expiry date post which they aren’t applicable, and must be signed within that time frame

The purpose of a term sheet is to act as a guideline for the final terms by locking in on key provisions, showing a level of commitment between VC and Founder on the investment and helping the documentation process speed up.

Terms that I feel must be included in an agreement include -

• Board Composition — What will the Board look like post investment, who gets how many seats, is there a minimum ownership threshold for investors to maintain their board seat? This is critical because Boards act as final arbiters for disputes (before going to actual arbiters) and decision making.
• Voting rights — What rights do the investors get to vote on decisions in the company
• Liquidation Preference — Fancy term to decide how the pie gets split in case of a liquidation event, which could be the acquisition of the company. This is another critical clause as it determines what happens when money is going to come to the Founders and Investors. Typical clause here is a 1x liq pref, which means Investors are first repaid every $ they put into the business, then the remaining is split.
• Liquidation Preference (cont) — There are two types of liq pref. Participating and Non-participating (second one is Founder friendly). To explain really simply, in non-participating, Investors have to pick between receiving their investment amount only or proceeds based on their shareholding percentage. In participating, Investors get their money back and a percentage of the proceeds. In great outcomes, this doesn’t matter but in average/distress sales, this could have a big impact on Founder returns.
• Anti-dilution Provisions — In case the next round happens at a valuation lower than the one the Investors entered, then the Investors will be issued additional shares for free, thereby maintaining their percentage ownership. This obviously means the ones who are getting diluted are the Founders. This clause is neutral, neither Founder or Investor leaning, since the Investor took the risk of investing in the company believing it will grow, which means valuation would grow as well. This one is VC critical
• Promoter Lock-In — Founder/Promoter shares are usually subject to a period when they can’t sell. This duration is negotiable. There are also Liquidity Carveouts, which is usually a % of shares the Founder is allowed to sell so they get some real $$$ in hand (typically 5–10%). VC critical

The next set of terms that I feel have to be included are Protective Provisions / Reserved Matters / Affirmative Rights. This is going to be a large and important one so before we start, here’s a cute puppy

PUPPPY!!!!

Ok back to work. Reserved Matters, these are terms a LOT of Investors prefer to deal with at the Shareholders Agreement (SHA) stage, because it involves a high level of negotiation and it’s in the Investors favour to get into this towards the end of the process, when Founders have already spent so much time, they’re pretty much locked in (and running out of runway).

• Economic Rights — The key one here is approving the budget. This is usually tied to a board seat/shareholding %. This is one of the first ways to create guardrails without impeding the Founder’s ability to run the company. The board comes together to approve a budget for the year, with a decent variance tolerance (10–15%). Spends apart from this are usually capped, like taking debt, capital expenditures etc. This is a great guardrail to ensure company funds are used prudently
• Governance Rights — These are broadly around creation and issuance of new securities (can’t create a new class of shares), enter into agreements on the key IP or trade secrets of the company, engage in business outside the norm (an enterprise SaaS company can’t start making sex toys), amend the Articles/Memorandum of Association (AoA/MoA), change the Auditors, accounting policy of the company, create a subsidiary (and many more)
• Human Resources — Compensation of the Founders and Key Employees, definition of Key Employees (usually by $ salary or % ESOP), hiring/firing of Founders/Key Employees
• Information — This is usually another clause entirely but equally important, the Investors have the right to receive regular updates on the company (typically monthly, called MIS), proof of all statutory dues being cleared, the right to request the company for any information, up to and including bank statements, contracts etc

Other terms commonly seen in a term sheet are -

• Founder Vesting — No you aren’t being gifted a vest. This means that the shares that you owned, are now technically the company’s. The most typical clause here is 4 year vesting with a 1 year cliff. This translates to, if you leave 364 days after the investment, you leave with 0% shares. If you leave 366 days after, you take 25% of your shares. Then every day/month/year (negotiable), you unlock more of your shareholding. If you leave before your shares are fully vested, that stock will revert to the company.
• Exit Rights — These are largely to ensure there’s a timeline on which a Qualified Exit (means NICE exit) is offered to investors. Typically 5 years.
• Drag-along Rights — This means that after a time period (usually after the exit period), Investors have the right to force Founders to sell their shares along with the Investors to any buyer they find. This becomes highly relevant as any acquirer would want to buy the entire company, which means ALL shares.
• Tag-along Rights — Once the Founder lock-in period expires, if the Founders are selling shares anywhere (apart from agreed upon Secondaries), the Investors have the right to sell an equal % of their shares at the same terms.
• ESOP Pool — This is a critical one, almost ALL initial round term sheets will require the Founders to create an Employee Stock Option Pool (usually 10%) before the investment. The VC will also want all this dilution to happen from the Founder’s shares, before they come on the capitalization table (cap table).
• Representations & Warranties — This basically means that the Founders and company agree that they are conducting lawful business and fully protect the Investors if the Founders do end up doing anything illegal. Also, if the Founders breach any of the Reserved Matters, they indemnify (protect) the Investors and can’t claim compensation from the company. This is a critical clause for Founders to understand, but it’s a standard clause.
• Arbitration, Exclusivity, Confidentiality — Arbitration covers what happens in case of disputes, Exclusivity means the Founders can’t shop around this term sheet and Confidentiality is self-explanatory. Confidentiality is always a binding term in a term sheet, despite the rest of the term sheet being non-binding (this means you need to follow it).

TOOOOO MUCHHHHHHH!!!!

Phew, that was a lot. And by no means is it an exhaustive list of things that get covered in a term sheet, and later get codified into a Shareholders Agreement.

These documents are really really really really ( xInfinity ) important to the future of your company so it’s important to understand them well.

One note I will offer, as a former Founder, a long-time operator and Investor, is that these terms are supposed to be like Weapons of Mass Destruction. If the relationship between you and your Investor has broken down to a point where they’re citing clauses on email, you have bigger problems.

Which is why it’s super important to pick the right Investors in the first place, be absolutely open with them, align on growth and budget numbers that are realistic (and not just chasing a massive valuation), which will allow you to build a real business with great support.

Feel free to reach out to me on LinkedIn if you have any questions, happy to help (once again, I am NOT a lawyer)

AVIK OUT YO!