How To Write a Disclosure Letter?
Imagine such a situation: you have found an investor, received your first draft investment agreement, and now see a long list of representations and warranties the investor wants you to give about your company. Some of these "promises" about your business are inaccurate. Here, you have a choice: either immediately admit that not everything is "smooth" in the company or hide it, but at the risk of losing everything later: the investor, money, and reputation.
You are unlikely to be interested in such an outcome, so it is better to honestly explain why something on the list does not apply to your business. Disclosure Letter is used in investment transactions for this purpose.
What is a Disclosure Letter?
Disclosure Letter is a document in which you list everything that does not match the representations and warranties in the investment agreement and explain why those 'non-matching' things are the way they are and the reasons. This document is drafted before the main transaction documents are signed and sent to the investor on behalf of the founders and the company. Usually, it has two parts:
- Introduction (background information) – a description of the transaction and purpose the letter is being written for;
- List of disclosures – explanations of why a particular representation or warranty stated in the investment agreement is untrue.
Disclosure Letter provides the investor with a complete and transparent picture of the company’s state of affairs. For you, it helps to minimize liability for breach of representations and warranties. The transaction documents typically provide for liability for misleading representations and warranties. But if you disclose these in the Disclosure Letter, you have not made any false representations and warranties, and no liability will arise.
How do you make disclosures?
The script to follow: carefully read each representation and warranty in the agreement and determine if it is true for you.
- If it is correct and you have nothing to disclose, proceed to the next one. The Disclosure Letter does not duplicate representations and warranties from the agreement. The fact that these are in the agreement and you do not disclose a breach thereof in the letter confirms that they are correct.
- If some facts do not "fit" a representation or warranty or doubt its accuracy, you disclose them. In this case, you state in the Disclosure Letter which representation or warranty you refer to and then explain why it is untrue.
Here's an example. In the investment agreement, you may see a warranty:
| There are no loans made by the Company to any of its shareholders |
However, you know that the company has entered into a loan agreement with one of the founders. You need to disclose that in the Disclosure Letter. You may use the following wording:
| The Company has concluded the Loan Agreement with [*] dated [*] |
Details of the contract
There may be other sections in addition to the disclosure of misleading representations and warranties:
- non-misleading disclosures (e.g., list of powers of attorney issued by the company, list of domains registered by the company, etc.);
- public resources where information is available to the investor;
- a table for the systematization and numbering of disclosed documents.
Disclosure Letter is about the disclosure of misrepresentations and the documents you disclose to the investor. In other words, you need to show the investor the documents you refer to in the letter, even though the investor has probably already seen them during legal due diligence.
The format for storing such documents depends on the investor's requirements. This may be cloud storage or an archive that the parties will retain.
Who should write the Disclosure Letter?
Disclosure Letter should be drafted by someone aware of everything that is going on in the business (if the investor has conducted legal due diligence, ideally, a person who has been involved therein on the company's side). They should be immersed in the company’s current operations and be aware of any pitfalls (debts, IP issues, litigation, and other facts that may need to be disclosed). Typically, this role is assigned to the company's in-house legal counsel, accountant, or chief operating officer.
As representations are often written in complex legal language, it may not always be clear what is meant and what facts of the company's business could constitute a breach of representations. It is advisable to seek external legal advice to understand what is behind each representation and choose appropriate wording for the disclosures.
The investor’s involvement in the negotiating and drafting the Disclosure Letter varies from deal to deal. Generally, it is assumed that you prepare the Disclosure Letter yourselves, bearing the responsibility to disclose everything you believe is relevant and worth disclosure in good faith. The investor looks through the final document. However, we see a trend toward more active investor involvement in preparing the Disclosure Letter. For instance, the investor may suggest amendments, ask clarifying questions, or request that disclosures be narrowed or detailed.
Remember, when preparing the Disclosure Letter, you must provide complete and accurate information. We recommend you pay attention to details that may contradict the representations and warranties. If you have doubts about the accuracy of representations and warranties, it is better to disclose facts that may constitute the breach. Otherwise, there is a risk of liability to the investor.
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