Venture Capital Investment: What will the investor demand from the start-up in return for the funding provided?
- Reserved Matters (matters of exclusive competence)
- Right of first refusal and pre-emption right
- Liquidation preferences (entitlement to priority payments upon sale or liquidation of the company)
- Representations & warranties
- Non-compete и non-solicitation
You have developed a new product and a business model that have caught the attention of an investor. After a series of negotiations, you have negotiated a considerable amount of funding for your start-up. It would seem: the deal is almost in your pocket. But in reality, it's more complicated than that.
In this post, we have outlined the top 5 conditions that an investor is likely to want in return for the investment, which are also usually negotiated and further enshrined in binding documents for the parties.
Reserved Matters (matters of exclusive competence)
When investing in a start-up, it is first and foremost important for the investor to control key decisions that directly affect the success of the business. In fact, these are issues on which the investor has veto rights.
For example, reserved matters are the most important issues that can only be decided upon with the consent of the investor.
The list of reserved matters is usually provided by the investor, negotiated by the parties and then recorded in the binding documents of the transaction. As a rule, reserved matters include issues related to changes in the company's articles of association and share capital, liquidation and reorganisation of the company, conclusion of major transactions and transactions with intellectual property (IP) of the company, change of business direction (pivot).
Right of first refusal and pre-emption right
Right of first refusal (ROFR) – the pre-emptive right to purchase current shares on the sale by existing shareholders.
Pre-emption right – the pre-emptive right to acquire newly issued shares.
Either right is a way for an investor to control the composition of the participants in a company and to retain their share in the business. The investor is highly likely to demand, when entering into a transaction, that:
- if the founder intends to sell its shares/part of them to a third party, the founder has first offered to acquire such shares to the investor (ROFR),
- and if the company issued additional shares, the pre-issued shares were also first offered to the investor (pre-emption right).
| By the way, similar conditions can be imposed on the investor if the founders are interested in maintaining a steady shareholder structure. |
Furthermore, it is possible to establish a certain sequence for the exercise of these rights: first, the shares are offered to the investor, second, to all other shareholders, and then to other third parties. An offer is made to each successive queue if the priority shareholders refuse to acquire the shares.
Liquidation preferences (entitlement to priority payments upon sale or liquidation of the company)
Liquidation preferences are another basic condition in transactions that gives the investor the right to receive priority payments over other shareholders (in particular the founder) in the event of the sale of the business or liquidation of the company (event). In effect, such a clause is a guarantee of a return on the investment made.
The content of liquidation preferences can vary depending on the transaction. For example, there are the following types of liquidation preferences:
- Participating – the investor is refunded the amounts invested and the investor participates in a pro rata division of the remaining profits/property of the company upon the occurrence of events.
- Non-participating – the investor is either refunded the amount invested or given the right to participate in the distribution of the company's profits/property upon the occurrence of events (i.e. the investor chooses whichever is more beneficial to him in a particular case).
A coefficient (multiplier) can also be applied to the type of liquidation preference chosen. For example, a 2x non-participating condition: if the company is to be sold, the founders will have to provide a return to the investor of x2 of their investment (as an example: if the investor contributed 2M, there will be 4M to be refunded).
Representations & warranties
Representations and warranties (R&W) are statements made by the founders that there are no adverse circumstances with regard to the company in which the investor is making an investment. The representations and warranties provided by the founders predetermine the investor's entry into the transaction, so it is important that all of them are accurate.
As a rule, the list of representations and warranties is prepared by the investor and depends on the results of the Due Diligence. Traditionally, an investor wants guarantees that the company is legally established and operating; that there are no tax liabilities; that there are no legal disputes; and that the company has all validly registered rights to the IP used.
It is important for founders to analyse in detail the list provided and not subscribe to anything that is not true, as the investor will usually impose liability for breach of representations and warranties (ranging from material to termination of the entire transaction). If a situation occurs in which the founders realise that they cannot provide a number of representations, a disclosure letter should be prepared to the investor, reflecting all those circumstances and facts that do not comply with the basic list of representations.
Non-compete и non-solicitation
Non-compete и non-solicitation – instruments that impose a prohibition on competing activities and the solicitation of key employees or clients of the company. A prohibition on competition is a more extensive obligation and is usually imposed on the company's founders and key individuals. A prohibition on solicitation is a mirrored and less extensive obligation, which can be asked to be signed by an investor as well.
| The purpose of these conditions is to protect the investor from outsourcing a similar business to a founder and to retain a steady team of professionals in the company. The duration of these terms is most often 2-3 years from the time the investor enters into the transaction. The area of validity can range from the entire world to a specific region (it all depends on the type of business). |
It is important to analyse that the documents detail what constitutes a competitive activity and what actions would constitute solicitation. If the wording is extensive, you should try to narrow it down and be more specific, as there may also be serious liability for breach of these provisions - recovery of damages, penalty option (redemption of defaulting founders' shares at a predetermined price).
Thus, founders should realise from the outset that once the price is agreed, negotiations with the investor do not end and more conditions relating to corporate governance, profit distribution and other matters will need to be negotiated before the transaction can be completed. However, it should not be forgotten that negotiations are a two-way road; everything can and should be discussed, offered and agreed upon mutually beneficial terms and rules for "living together" in a company.
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