Clauses to protect founders in private equity and venture capital deals
The recent squabbles between Health Plus Limited and Alter Semper Capital, with regard to the agreement to inject $18 million to expand the pharmaceutical branches of Health Plus Limited, and the resulting legal actions have indeed inspired the need for more thoroughness in considering terms more favourable to founders in private equity or venture capital deals.
In 2018, there was a 5-year investment agreement between Alta Semper Capital and Health Plus Ltd to secure the expansion of the latter’s company operations with a pledge of $18 million. However, only $10 million had been dispensed, with Alta Semper’s refusal to disburse the rest. Mrs. Bukky George of Health Plus Ltd then brought legal action against Alter Semper Capital. When legal action is brought, obviously it is no longer pleasant with the parties, so things like the attempted/alleged removal of the CEO from the day to day running of the Health Plus Limited could easily have been anticipated, given the participating rights of Alter Semper Capital.
This present saga shows the importance of negotiation and due diligence stages in venture capital/private equity investment deals as well as properly ascertaining whether you can count on the investor to operate in good faith at all times. Where one perceives that they cannot count on this good faith, it would be better for a founder to hold out for an investor they are more comfortable with and vice versa In addition, the financial transactions that have occurred in the last few years have shown an influx of start-ups toward venture capital investment.
Before going further into the discourse, it is important to have a working understanding of private equity and venture capital. Private equity investors usually invest in established companies and take at least 50 per cent or even more of the equity stake in the company that needs the investment. They therefore have substantial control. Sometimes, private equity investors come into established companies to tweak certain things with the goal of making the company efficient to generate more profit.
Venture capital investors on the other hand usually fund start-ups that have the potential for massive growth, with the investors obtaining a minority stake, which might become even more diluted, following additional series of funding. Now imagine if Health plus started as an application programming interface (API) that wanted to solve a pharmaceutical problem, like fill the gap with regard to the provision of a unique drug that a substantial percentage of Nigerians require, and their process was scalable, the founder’s start up could possibly be ripe to attract venture capital investment.
Where a founder decides to proceed with an investor, there may be certain clauses that should be inserted in the investment agreement to ensure founders are protected. Yes, it may seem that a founder’s company’s expansion possibilities are at the mercy of an investor’s funds, but founders need to have a clear head to recognise and prevent themselves from getting into situations where they are backed into a corner. It is therefore important that certain clauses are inserted into their venture capital closing. We will look at some of them below:
You must also ensure that in your investment agreement, the investor or partner must provide working capital and cash injections at specific dates, and where that fails, mediation/arbitration should kick in before litigation so as to preserve the atmosphere of the partnership. Now, how can you do this? With an escrow clause. The escrow clause could specify the particular payment systems to be used for the transfers and ensure the mandatory use of those escrow facilities (an escrow account) to ensure that every penny promised by the investor automatically comes in as and when due. This means that the investor’s funds would be held by the payment system in escrow, waiting the disbursement date to the founder’s company.
Normally, indemnity clauses protect investors from misrepresentations made by founders. But an indemnity clause may be used in the reverse to protect founders from losses suffered where the investor fails to make the pledged cash and working capital injections. This will also make it easier where a founder chooses to take the litigation route. It can be provided that should the investor fail to provide the equity injections, the founder is to be indemnified for any loss suffered by the business.
NO COMPETITION CLAUSE
A clause must be inserted into the agreement with both parties that the investor shall not directly or indirectly get into any agreement or business arrangement that competes with the investment project.
PARTNER PARTICIPATION RIGHTS
To determine this, the founder must ascertain the level of comfort they have with the prospective investor to determine whether the investor will have full, capped or non-participation rights. This will also apply to the voting rights. The investor must ensure that whatever special purpose vehicle is created to merge the interests of the parties does not disfavour the founder in terms of percentage Vis a Vis control. The percentage of equity the investor can acquire could be capped in a way that provides for the percentages to begin to shift in favour of the founder even within the duration of the investment. That is, as the investor is being repaid, their shares are gradually being bought out. In venture capital investment, shares of investors are watered down following subsequent series of investment.
It is important to ensure that no clause gives the investor unnecessary control over decision making in the company, so much so that it could grind the company’s operations to a halt. It would be better for the situation where the founder has voting control, which is more than 50per cent.
Another solution would also be a good idea to publicly list the company, if the company is able to fulfill listing requirements, so the founder is not at the mercy of one or a few investors. It is however critical that you get a legal adviser when deciding the financing options for your company when you want to expand.
Where the founder has no choice but to start with the only investor they have got, the pro-rata rights clause could be inserted into the investment agreement to provide an option (the right, but not an obligation) for initial investors to invest in future rounds in order to maintain their ownership, which would be diluted otherwise. This means that the founder’s company or going concern will be open to subsequent rounds of investment injections by other prospective investors.
Ensure that no party may transfer or assign any of their shares/stock without the knowledge and consent of the other party until the investment period is over.
REPRESENTATIONS AND WARRANTIES
Ensure that the focus is not only on the founder to give warranties. The investors should also give representations and warranties as to the contributions he or she will make to the business being bought into and the time frame for that.
A term sheet is a non-binding summary of terms negotiated by the investor’s counsel and the start up company’s counsel, which will be a foreboding of what will be contained in the closing documents. This is the simplest way for a founder to understand the agreement they are getting into. They contain terms like capitalisation and valuation, stake to be acquired, conversion rights, asset sale, corporate governance, financial structure, liquidation etc. Though a term sheet is generally non-binding, certain terms would be binding, such as non-disclosure, exclusivity and costs.
Where a founder is not comfortable with or clear on any of the terms in the term sheet, he should point the same out to his counsel.
Now, with all said and done, the investor might still have the upper hand, as he may not be willing to sign such an agreement, leaving you at their mercy. In such cases, other financing options such as crowd funding and listing on a local or international stock exchange might be worth considering.
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