Key Terms in Venture Capital Transactions and Protection of Legal Interests of Startups

author A&A

calender August 5, 2020

Key Terms in Venture Capital Transactions and Protection of Legal Interests of Startups

Growth during the early stages of a startup’s cycle requires substantial funding, and banks usually abstain from investments which are considered high risk. Venture Capital Transaction is a type of financing that investors or venture capital firms provide to startup companies and/or small and medium enterprises - which would require financial assistance to attain their intended full potential. This kind of venture capital investment is indulged into by investors, investment banks and other financial institutions. To acquire the said venture capital, the businesses need to show extraordinary growth potential.

There are Three Principal Types of Venture Capital

Early Stage Financing: This stage includes Seed Financing which is a small amount that makes an entrepreneur eligible for a startup loan, Start-Up Financing is procured for companies for the purpose of development of products & services and First Stage Financing is procured to begin business activities at full scale.

Expansion Financing: This stage includes Second Stage Financing which is acquired for the purpose to start business expansion and Bridge Financing is acquired for short term interest-only finance.

Acquisition or Buyout Financing: This kind of finance is for assisting a company to acquire certain parts or an entire company.

Legal Considerations

Entering into a Venture Capital Transaction by a Startup/ SMEs with a Venture Capitalist or a venture capital firm can be a very overwhelming process including high risk, legal implications, a lot of paperwork and formalities. Funding round transaction documents have over time grown in length and complexity. A term sheet now can easily exceed 10 pages, with transaction documents much longer. Having the support of a legal counsel/ law firm to manage the tedious and gruelling task of protecting interests in a venture capital transaction can be beneficial. This is where corporate commercial law firms step in to take care of the tedious process with their legal expertise and creating an airtight contract. This Venture Capital Contract is then drafted with extreme diligence so that the interests of the contracting parties are secure, every term is clear and precise. Legal advice on any funding round is an absolute must; a bad call on a key funding provision could prove to be a costly and destructive mistake for a founder, an investor or even the business in the future.

Steps Towards Obtaining Venture Capital Financing

Term Sheet

Every venture capital transaction starts with the term sheet. A term sheet can be referred to as a non-binding document which serves as the foundation on which all other (binding) transaction documents are drafted. The investors and founders must reach a consensus before a (binding) document are created. It is not uncommon for investors and founders to reject any term in the (binding) transaction documents which does not reflect the provisions of the term sheet.

Subscription Agreements and Subscription Letters

Binding subscription agreements setting out key terms of the investment are prepared to lock-in the investment. A simple subscription letter confirming the investment amount per investor is signed by investors, other than lead investors.

Subscription agreements are usually entered into between the company, its founders and lead investor (co-lead investors). This includes more comprehensive provisions normally centered towards protecting the lead investors’ interests.

Shareholders’ Agreement

This is the key binding agreement of the terms agreed upon in the term sheet. It sets out the rights of the investors and the founders and contains provisions that govern the management and operation of the startup.

Protection of Founders Interests

Founders of the company seeking Venture Capital Investment need to come up with ways to protect its intellectual property and increase its wealth in the process of growing the business. There are a few ways by which the Startup Founders can protect their interests:

Board Rights: It is important to maintain the board size comprising of small, tight knitted and trustworthy people. This helps the company to restrict corporate fulfillments.

Affirmative Vote Rights: These are crucial and usually inflexible investor rights, but the range and purpose may be limited to provide founders with operational flexibility. In successive fundraisings, founders may restrict the number of investors depending on their percentage holding in the company or the founders can seek veto rights over certain matters.

Transfer Restrictions: The Founders can suspend share transfers. Having this safeguard will permit to sell to late-stage investors and provide them with much-needed liquidity and safeguard the startup from equity reduction.

Exit Strategies: Investors do look for timely exit approaches depending on internal and external aspects, the exit plans should be flexible to the founders to choose from.

Final Considerations

Once the decision to enter Venture Capital Contract is made, the most common issue with Startups is that there are disputes about equity ownership. We at Ahlawat & Associates assist these Startups to avoid the conflicts right from looking through the term sheet and providing valuable inputs which protect the rights of each party to drafting of various Shareholder Agreements and important provisions to be included seeking the company’s best interests. These agreements make sure that there is no uncertainty for subsequent investors. We ensure that a clear chain of title to the company’s intellectual property is maintained and confirm that intellectual property is not infringing on third-party intellectual property. All the written contracts/ agreements are vetted before entering to make sure that no one-sided clause is included against the company’s interest. Also, we will investigate confirming that the business plan is not endangered due to regulatory concerns and even lookout for future potential regulatory issues.

In Conclusion, as the company expands and invites Venture Capitalists/ firms to invest, the interests of the Founders deviate. It is therefore essential that entrepreneurs and investors familiarize themselves with industry practices and engage legal counsels/ law firms to assist in the process of a Venture Capital Transaction to gain appropriate knowledge of how these transactions work.

Frequently Asked Questions

1. What is VC law?

Many financing and M&A transactions are involved in venture capital (VC) law, including public/private and private/private mergers, acquisitions, and large strategic partnership deals.

Many non-VC financing arrangements involving the private and public sale of debt and equity securities fall under this category of law.

2. What is a VC term sheet?

The VC Term Sheet specifies the terms and conditions of venture investments made by a venture firm and an early-stage startup.

The VC term sheet is a non-binding legal document that serves as the foundation for longer-lasting, legally binding contracts like the Stock Purchase Agreement and Voting Agreement.

3. What does a term sheet include?

All term sheets include information on the assets, the original purchase price, as well as any contingencies that may alter the price, a response timeline, and other important details.

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