Venture Capital Shareholder Agreements…Don’t Sign on the Dotted Line Just Yet

Venture Capital Shareholder Agreements…Don’t Sign on the Dotted Line Just Yet

Starting a new business is a stressful and exciting time in an entrepreneur’s life.  Finding funding for the venture can be one of the most critical steps to getting a start-up company up and running.  Venture capital funding has continued to grow as a means to fund start-ups.  According to the National Venture Capital Association, the first quarter of 2018 saw a record-setting $28.2 billion in venture-backed deals, the largest amount in one quarter since 2006.  While it may be tempting to seek out these funds and sign on the dotted line immediately when you receive a venture capital term sheet or other type of agreement before they change their mind, it is best to schedule a meeting with a knowledgeable attorney to review the proposal in detail to evaluate what it is you might be signing away.

Terms

A venture capital (VC) term sheet includes an outline of the major terms to be included in the investment documents including provisions that will have major implications on how you will be able to run your business and just how much control you are turning over to investors.  The venture capital shareholder agreement exists to provide the investor with rights above what it would otherwise be entitled to by virtue of a percentage of ownership in your company.  The terms in an agreement with a venture capital investor typically come with three main issues that need to be carefully evaluated and considered before signing on the dotted line.

  1. OwnershipLike any investor, venture capitalists want to know who they are doing business with and that they are investing a stable situation that will not have ownership or partners coming and going.  Some venture capital term sheets will include specific provisions restricting the transfer of shares of the company without prior approval from the VC.  Some term sheets will allow for carve-outs allowing the founders to transfer shares to trusts and other estate planning tools, but these will not be included unless the founder asks.

    Sometimes the restrictions venture capitalists include in term sheets or other contracts outright prohibit shareholder transfer of shares in the company.  Other times the restrictions are complicated and can require the founders to provide the venture capitalist with a right of first offer or right of first refusal that may permit transfers, but only AFTER the venture capitalists or other shareholders are first given the right to buy the shares, or both.

    While it may be tempting to skim through the details of a venture capital term sheet and assume you will never want to transfer ownership or shares of the company, it is important you approach it with a mind to the anticipated possible tensions between investors, founders, and shareholders down the road.  Working with a knowledgeable attorney will assist you to consider many of the most common scenarios entrepreneurs face both good and bad when it comes to ownership and venture capitalist term sheets.

  2. Control of BusinessAll venture capitalist term sheets and contracts provide for some level of control for the VC over the business to protect its investment.  Basic controls include a provision allowing the VC to appoint board members and/or a right to veto certain specified actions.  It is important for entrepreneurs to work with their attorney and the VC to find the right balance between the VC’s desire to protect its investment and the founder’s ability to conduct business in a dynamic market.

    Attorneys are in the best position to assist entrepreneurs with negotiating shareholder agreements with the worst-case scenarios in mind.  Experienced business attorneys have typically seen things go terribly wrong and can utilize that experience to help entrepreneurs read the fine details of VC agreements and anticipate issues that may arise and how to avoid those issues through negotiation and restructuring of agreements to come to mutually beneficial terms.  Another important consideration when negotiating terms is to ensure you retain enough control to be able to effectively run your business even if a VC exercises its veto rights or rejects proposed initiatives.

  3. Exit StrategyOne of the last things people think about when starting a new venture is how to get out of it.  However, this is another critical element of the VC term sheet entrepreneurs need to carefully evaluate.  One  common right in VC term sheets and agreements is called a drag-along right.  This provision enables the VC, if it is a majority owner, to force minority owners to participate in the sale of a company if it finds a buyer.  Such provisions may have a threshold price above which a shareholder must sell.  If the VC is a majority shareholder, drag-along rights ensure it will be able to sell the entire company on terms and conditions favorable to the VC. It is critical founders and other minority shareholders have skilled attorneys negotiating the terms of drag-along rights to ensure such a sale would not be detrimental to minority owners.

    What to do

    Venture capital term sheets and subsequent agreements can be extremely complex and confusing.  While one company has actually created a plain English non-jargon term sheet, such contracts are not the norm.  Rather, these contracts are typically nuanced and complex.  Engaging the assistance of a skilled attorney as soon as you receive such a term sheet will better equip you to fully understand what is being proposed and what you are giving up in exchange for funds the venture capitalist is offering.  Before you sign on the dotted line, send a copy to your attorney for review.  In the long run, you will be glad you did.

 

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