For investors after identifying the Start Up Company, concluding its due diligence, negotiating the broad terms and encapsulating the same in a term sheet; comes the most crucial stage of drafting the Definitive Agreement between the Investor and the Start Up. Even though the broad terms are outlined under the term sheet, the said terms have to be dealt with in details, for its various nuances, in this Definitive Agreement and which might ensue another round of discussions between the parties. It is through the lens of this comprehensive document that the relations between the Investor and the Start-up company is seen, understood and governed.
The clause of this comprehensive document governs matters pertaining to exit strategy for the investors, closing mechanism of the entire investment process, protection from anti dilution Drag Along and Tag along rights, entitlement on the Board, if negotiated, restriction on promoters and founders, disputes resolution mechanisms etc.; all these concerns need to be addressed before making any financial commitment for a smooth and enjoyable experience as an Investor. Even though every concern in future cannot be pre-empted and guarded for and sometimes not even advisable as the same may defeat the whole purpose of investment in the first place on account of rigid and obsessive issue finding; however, some of the ‘must have’ clauses for the most basic and germane of concerns in order to protect the investor should be included and negotiated, if required. Illustrative list of such clauses from an Investors prospective are as follows:
1. The Tag Along and Drag Along Right:
A Tag Along and a Drag Along right, both enforce disinvestment in the Company. A Tag Along right offers the minority holders the right, but not the obligation, to exit on the same price and terms along with the majority shareholders when they offer their shares for sale to a third party/ prospective investor. Whereas in case of a Drag Along right the majority shareholders have the right, but not the obligation, to require the minority shareholders to sell their shares if there is an offer from any outsider /third party for complete buy out of the Company. ‘Tag Along’ right clause works as an exit strategy for the investor to offer its own share for sale by partaking in such sale in proportion to its holding in the company. This helps them liquidate their holdings and book their profit if any; thus, it is favorable to the investor and usually insertion in the Definitive Agreement is preferred by the investor. On the other hand the ‘Drag Along’ right enables the founder and majority share holders /investors to go ahead with a complete sell-off of the Company to a third party requiring minority shareholder to be on board compulsorily; thus avoiding any obstacles and obstructions from minority shareholders, which might cause the deal to fall flat.
2. Anti dilution Protection Clause:
‘Stock Dilution’ generally occurs when a Company allots new equity shares upon infusion of capital; resulting in increase in total paid up capital and corresponding total outstanding shares, which in turn reduces and dilutes the percentage ownership of the non-participating existing shareholders. Stock Dilution’ is not always bad for the investor, unless maintaining a minimum shareholding percentage in the company is of prime importance. However, in the case of a ‘Down Round’, few investments can sideline the existing investors, angel investors, founders and seed investors in terms of their percentage ownership and voting rights in the company. Anti dilution protection clause can prevent this avoidable scenario.
3. Pre-emptive and Right of first Refusal Right:
A Pre-emptive right or the right of first refusal affords an existing investor in the company the right, but not the obligation, to acquire fresh shares issued by the Company, in the same proportion as their existing holding before such fresh issuance of equity. This allows existing investors to maintain their percentage ownership as before and prevent any dilution by way of follow-up investment and participation in future funding. This is usually, consider as an Anti – dilution protection mechanism as well.
4. Right to Appoint Directors:
Shareholders and management are two separate classes, though sometimes comprising of the same set of people; where ownership of the company lies with the shareholders and management of the affairs and operation of the company is entrusted on the Board of Directors of the Company. Usually a big investor in Start Up would prefer to have some form of supervision or would want to play an active part in the operation of the Company, to ensure protection of her investment, which can be achieved by being a member on the Board of Directors; thereby participating directly in the decision making of the Company. Even though it is imperative that an investor must include the aforementioned clauses; the form and content of such clauses may vary and need to be seen in context and entirety of the circumstances surrounding the transaction. Also additional clauses might be required depending upon the nature and purpose of the transaction and understanding between the parties.
5. Closing Mechanism Clause:
It is imperative that a Shareholder Agreement provides for a specific clause detailing the closing mechanism for the transaction; which clearly states out the closing deliverables for the parties i.e. the Investor and the founder / company, as an obligation. The deliverables would include schedule of payment of investment amount by the Investor, the simultaneous issue and allotment of the Shares to the Investor by the Company and documents that each party need to file with the authorities and provide upon the closing of the transaction. Inclusion of such a clause is to remove any vagueness from the required acts to be performed by the parties for a successful closing of transaction; thus removing confusion and any point of dispute in future. A word of caution – mere inclusion of clauses and protections in the definitive agreement sometimes would not be enough to cloth it with the power of legal enforceability; as under Indian laws, in case of any inconsistency between the Agreement and the Article of Association, the Article of Association would prevail, in such an event it requires an amendment in the Article of Association, which in turn need to be consistent with the provisions of the Companies Act, 2013.