Insights
When founders and investors face off
July 30, 2022As a key player in the growth story of start-ups, venture capital involvement not only brings in capital but also market expertise, business contacts and strategic advice to create sustainable and profitable businesses. Thus, VC participation in profits is often envisaged as ‘investor-shareholder’. Due to the nature of their involvement, VCs tend to become interested in the governance and executive policy of their investees, as that would invariably have a bearing on the value of their investment (returns) and profits. Therefore, VC participation in start-ups is accompanied by governance mechanisms and investment protection measures.
This could, however, be a problem if entrepreneurs, in the long run, end up feeling squeezed out of control and excluded from decisions concerning the very enterprise they conceived through their ingenuity and hard work. The problem becomes more acute where parties, in their eagerness to ‘strike the deal’, overlook the nuances of legal documentation.
Read More+
The practice of VCs negotiating shareholders’ agreements (SHAs) and investment agreements (IAs) with governance measures (and investment protection) evolved around the need to check founder-opportunism and preserve value for investors.
The nature of the investment itself is speculative due to factors such as market uncertainty, lack of sufficient data on performance and/or profitability for fool-proof diligence, and the resulting information asymmetry.
Hence, VCs steer clear of majority participation, while securing the benefit of protective provisions to square off their minority positions.
The prevalent governance mechanisms are: a) Board participation by VCs, which is ensured by incorporating into the SHAs and IAs the provisions for appointment of investor directors or nominees. This can be enhanced through inclusion of quorum conditions for participation by investor or nominee directors. b) Special voting provisions, which are incorporated in the SHAs and IAs, either by means of veto powers or through affirmative voting rights in the case of certain reserved matters.
These powers or rights enable VCs to block transactions involving the investee company even when they are backed by majority shareholders.
Micro-management worry
Indian courts have held that SHAs or IAs between shareholders would be enforceable so long as they do not exceed or contradict the Article of Association (AoA) of the investee. Special voting provisions engrafted into the AoA have also been upheld by Indian judiciary. Besides, courts are averse to interpreting SHAs or IAs in a manner that defeats the purpose of the investment and its benefit to investors.
The inclusion of governance mechanisms in the SHAs or IAs is not ‘illegal’ but may breed disgruntlement in founders by giving investors room for ‘micro-management’. From VC board-participation stems the problem of dual fiduciary capacity when a nominee director participates in the investee company’s decision-making.
Affirmative voting rights of investors encompass strategic business decisions, transfer of vital assets, and appointment or removal of key managerial personnel and others that is sensitive to both VCs and founders.
Therefore, the controlling rights of investors are among the most hotly negotiated terms of SHAs and IAs. The framework of the SHAs or IAs vesting ultimate decision-making with the VC is a bone of contention between the VCs and the founders or early-stage investors. Divergence in ideologies, operating styles, and aspirations is an additional stumbling block to the VC-start-up alliance. The potential conflicts can range from boardroom battles to full-blown lawsuits, with the latter taking the form of proceedings for oppression and mismanagement, corporate governance disputes and actions for declaratory or injunctive reliefs.
Litigation avoidance
Entrepreneurs as well as investors must be wary of the legal implications of SHAs and IAs, and refrain from signing standardised legal documents without an independent legal dispute-risk assessment.
Equally, VCs should not, in their haste to close a lucrative deal, overlook potential litigation scenarios. They should not take pro-investor SHA or IA terms lightly because these may lead to disputes on crucial issues of control and governance, with founders alleging ouster, oppression and so on. The image of a litigious investor may hamper the VC’s future fund-raising capacity.
To avoid and mitigate such concerns, the SHA or IA terms should be vetted from a business point of view, as well as litigation exposure.
Running a “worst case scenario” simulation with litigation lawyers would better equip the investor as well as the investee before they sign on the dotted line.
This article was originally published in The Hindu Business Line on 30 July 2022 Co-written by: Lalan Gupta, Partner; Mrinalika Devarapalli, Associate. Click here for original article
Read Less-
Contributed by: Lalan Gupta, Partner; Mrinalika Devarapalli, Associate
Disclaimer
This is intended for general information purposes only. The views and opinions expressed in this article are those of the author/authors and does not necessarily reflect the views of the firm.
