This weekend a friend of mine called me up, as he was completing – as a leading seed investor – the first round (series A) of a company that I have a minority stake in. He told me that the round being negotiated was just short of Signing, as all main deal elements had been agreed with the investor (a large and well-known VC Fund), but there was one last point of contention left, and – big surprise! – that was Reps and Warranties.
That made me think once again about the peculiar habit of venture capitalists to turn Reps and Warranties almost as much a difficult topic as in M&A. If you think about the term “Venture Capital”, the whole concept is that you venture into something and there is no precisely NO guarantee of success.
Of course it makes full sense to commit founders to proper representation of the state the company is in and to also make them liable for the so-called Title Guarantees, in effect making sure that the shares being transferred to the investor are free of third party rights, are indeed constituted legally and are not subject to any limitations. However, I do not understand why these Reps and Warranties so often go to the core of the risks of the business model, thereby in effect giving the venture capital investment more the character of debt financing, disguised in the Reps and Warranties clause.
Why do I say this?
Because if a founder signs up for – say – a 3 Mil. Euro investment and the company fails due to an event that is at the core of the typical risk of the business model, this may create a warranty case that in the worst of all contract agreements may include full damage to be paid by the founder. This then means that the investor may get up to the total sum of that investment in damages from the founder because of an event that constituted the essence of the typical venture risk.
So put very bluntly, by enforcing Reps & Warranties covering business risks, the investor covered his venture risk by making the founder liable for failure of exactly that risk.
We all know that founders who may be otherwise admirable do not like to focus on legal details and may have bad luck in a choice of their attorneys.
That can be a deadly mistake.
When founders find themselves in such a contract situation, it is not just a reflection of poor negotiation skills on the side of the founders, who – one might argue a bit unfairly – therefore would not deserve anything better.
Such contract clauses are also always a case of misguided priorities on the side of the investor.
While as an investor I have full sympathy for contractual rules that prevent an irresponsible founder from walking away, as in the old adage “with my time and your money to waste, we have nothing to lose”.
However, it is equally unfair to put the investor of a venture in a position where his investment becomes more a case of debt with higher returns and higher default risk than of real venture investment. Moreover, discussions and probable litigation about business risk damage retribution by the founder can divert vital energy from surviving the damaging event, since both the founder and the investor will bes spending considerable time hedging their risks or enforcing their rights. THat can ultimately be much more damaging than the damaging event itself.
Here is my advice to founders in any negotiation about Reps and Warranties:
1) Before negotiation of deal terms, identify the natural risk of your business model
2) Prepare to describe and argue to the investor what the typical risk of the venture is and make it clear from the outset that that risk cannot will not be carried by the founder(s).
3) Make the investor acknowledge these risks early in the process of negotiating the terms
4) At term sheet level make sure that the basic principles guiding an equal distribution of reps and warranties rights between founder and investor include the following
a. Liability of founders is limited to willful behavior and gross negligence
b. There must be a cap of a certain percentage of the investment, in my opinion not more than 50% of the investment sum.
c. For all cases of non-willfull behavior the warranty term should be at most 12 months
d. Each founder is only liable for the fraction of the cap that corresponds to his fraction of shares in the entire company, so a co-founder who has 20 % of shares in a company shall only be liable up to 20% of the cap.
e. All shareholder managers with shares smaller than 7% should be exempt from any liability unless there is a specific reason for that.
f. Damages should be paid only to the extent that the Founder / Manager liable had best knowledge of the Warranty issue.
g. Retribution of damage should be limited to the damage that is incurred directly by the damaging event, confirmed by court ruling and could be reasonably expected. There should be no damage retribution for a loss of valuation of the company, which should be explicitly excluded. Valuation loss is usually covered by downround protection clauses.
h. Retribution of damage should be limited to such damages as cannot be corrected or “repaired”.
i. No damage retribution should be given for damages that are incurred due to lack of cooperation on side of the investor. This could include anything ranging from late payment of investment funds, lack of cooperation in litigation cases, failure of the board members dispatched by the investor to agree in litigating to avoid the damage, and so forth.
k. The most important advice that can be given to any founder signing Reps and Warranties is to put a large amount of energy into the due diligence and disclosure process and the documentation of that due diligence and disclosure process. THis is where attention to detail is a very necessary evil. The contract must include a clause that no events or fact about the company that were or could reasonable have been expected to be known to the investor at the time of the investment can lead to a claim of the investor against the founder. Thus claims are excluded if the the facts that led to the damage were known to the investor.
l. Negotiate all these points, then focus on disclosing well all risks that are part of the business model or lie within the company.
Often investors will present the founders with tough Reps and Warranties basically to incentivize them to puta significant amount of energy in thinking through the risks of the company and the development stage the company is at.
However, founders should rate their investors on the basis on their willingness to accept clauses that correspond with or at least resemble what I advise.
Good Luck!
