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2 Clauses That Can Torpedo Your Funding

Entrepreneurs are just beginning to realize that they do need to understand the nitty-gritty of term sheets. Here are two protections you don't want to miss.

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When was the last time you heard an entrepreneur wax poetic about a ROFR?

Certain topics elicit enormous enthusiasm from entrepreneurs: product, customer service, maybe even recruiting. The intricacies of stock purchase agreements—as opposed to “getting funded”—don’t usually make that list. However, if neglected, these legal agreements can undermine the success of even the most innovative startups. As angel investments proliferate, and as secondary markets such as Second Market and SharesPost become more liquid, it becomes harder for start-ups to control who owns their stock.

The solution? Think ahead, says Ed Zimmerman, Chair of the Tech Group at Lowenstein Sandler and founder of the First Growth Venture Network. Investors, management and employees rarely agree about critical decisions such as when to sell a company. One common way to make sure everyone gets on the same page in a crisis—or opportunity—is to restrict some shareholder rights so that a minority of shareholder don't have undue influence over the outcome.

The key is to do this before any shares are issued. Otherwise, says Zimmerman, “You face the much more difficult challenge of convincing every shareholder to expressly agree in writing to accept the restrictions [which can prove an impossible task in the heat of the moment].”

With your first round of funding (no matter how small), Zimmerman suggests you include the following:

Right of first refusal, typically referred to as a ROFR. This requires any investor interested in selling shares to offer those shares to the company before approaching third parties on the open market. This ensures the company maintains control over its cap table.

Drag along rights. These rights establish an agreed-upon threshold for investor consent on certain issues, such as the sale or merger of a company. When that threshold is reached, any shareholders who disagree have to go along with the majority decision. This prevents stragglers from blocking or otherwise undermining a deal that the majority of shareholders support.

In many instances, these provisions govern only preferred shareholders. However, Zimmerman is a fan of a so-called  “housekeeping drag along.” This includes a threshold for shareholders of common stock (including employees who have exercised stock options) as well as preferred shareholders.

If you’ve already issued shares without including these provisions, but now realize you need them, you need to be upfront with your investors. Be transparent about your concern and offer something in exchange, says Zimmerman. That could be the right to buy back shares, or an offer to issue more stock. The key, says Zimmerman, is to understand that this is a political discussion, not a legal one. Even if your investors don't like the proposed restrictions, it's important to nurture your relationships with them so they don't feel neglected, or worse, betrayed.

Last updated: Jun 13, 2012

SCHUYLER BROWN is the host of Founders@Fail. He currently works at High Peaks Venture Partners, where he sources and evaluates potential investments. Brown holds a B.A. from Columbia University and an M.B.A. from Columbia Business School.




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