Protection of founder interests in VC transactions

By Nisha Mallik and Neha Mirajgaoker, Samvad Partners
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Before the outbreak of COVID-19 pandemic, startups and the founders had a healthy infusion of funds, with multiple investors ready to assist them to achieve their revenue and customer acquisition targets. The chain from founders, through startups and investors down to customers clearly reiterates that the capitalist system works.

protection
Nisha Mallik
Partner
Samvad Partners

The recent dispute between WeWork co-founder Adam Neumann and Softbank demonstrates the raw and sometimes tenuous relationship between founders and investors. There has been much discussion about the protection of investors and the robust provisions to be written into shareholder agreements to ensure protection of investors and their limited partners. Similar protection for the founders, however, is often lacking. As investors receive good returns with these robust protections in place in subsequent funding rounds, it is imperative that the founders and the startups also look to create a back-up plan for protection of their intellectual property and increased personal wealth due to the startup boom.

protection
Neha Mirajgaoker
Senior Associate
Samvad Partners

In the initial stages of venture capital (VC) investment in India, many entrepreneurs accepted onerous provisions. But today, seasoned promoters seem to push back against the one-sided investor protection provisions. Enlisted below are a few vital ways in which founders may protect their interests in VC deals.

Board rights. Investors usually ask for a board seat along with an observer nominee, even if such nominees are not appointed. Although corporate law allows up to 15 directors on a board, it is critical to keep the board size small and tight. This helps the company to limit corporate compliances and associated logistical issues. A crowded board may lead to friction between different investors looking at varied growth trajectories which may impact the founders’ visions for the startup. To ensure smooth day-to-day management, appropriate language may be included to restrict notice and quorum requirements of investors only for affirmative vote matters. Appropriate insurance should be obtained for all board members, not just for nominees of the investors, as is the usual demand.

Affirmative vote rights. These are critical and usually non-negotiable investor rights. Although the items may not be negotiable, the scope and extent of each item may be curtailed to provide founders with operational flexibility. During subsequent fund raisings, the founders may also limit the number of investors that enjoy these rights depending on the percentage holding or an acceptable percentage or number threshold. In later stage fund raises, to maintain balance, founders may also seek veto rights over specified matters, which usually relate to operational matters, or to investors’ exit options or future fund raises.

Transfer restrictions. As founders are instrumental to the business, one of the ways for investors to retain them is by freezing share transfers. Founders may argue for limited free transferability of their shares apart from the usual share transferability for tax or estate restructuring or inter-se transfers between promoters. Usually investors are not keen to permit free transferability. However, having this protection will allow founders to sell to late-stage investors (usually at a discount to the primary price) and supply them with much-needed liquidity and protect the startup from further equity dilution. In growth stage startups, founders may also seek a tag along right to participate in partial exits alongside with investors thus achieving equality of opportunity.

Founders usually restrict investors from transferring shares to named competitors, but overlook to periodically revise the competitor list which will deny newer competitors to invest in their company.

Exit strategies. Every investor looks for a timely exit which is dependent on external and internal factors. Exit strategies should not be set in stone but allow flexibility to the founders to choose the exit options to be offered to the investors. Another consideration is process and determination of valuation at the time of exit especially since there are regulatory provisions for initial public offerings or buybacks, or for exit of non-resident investors.

All these rights may be meaningless if they are not supported by strong personal bonds and a commonality of vision between all the founders. An example of this is where the co-founders of Snapdeal, were able to block a merger with e-commerce giant Flipkart proposed by Softbank, one of Snapdeal’s biggest investors. It is helpful if the founders have an inter-se agreement setting out the principles underlying the business in order to negotiate effectively with investors.

Nisha Mallik is a partner and Neha Mirajgaoker is a senior associate at Samvad Partners.

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