VC Series: Part IV – The Investment Process!

Once the founders are done negotiating and signing the term sheet, the transaction moves to the process of subscription. The subscription process essentially starts with the due diligence and proceeds with signing the detailed transaction documents.

Broadly speaking, closing of an investment round is subject to satisfactory completion of a ‘due diligence’ exercise by the VC fund and signing of the transaction documents such as share subscription, shareholders’ and employment agreements. Immediately upon execution of the term sheet, a VC fund commences its due diligence process – legal, tax, financial, technical, as they deem fit. Along with conducting the due diligence, the negotiations for the transaction documents are also commenced.

Due diligence

Due diligence is essentially a review conducted on the startup’s business and operations to find out any material issues that the investors need to be aware of before making their investment. Some of the important tasks in a due diligence include legal counsels searching for any potential legal issues, tax professionals reviewing the tax compliances and filings, technical diligence teams taking a deep look at the technology etc.

Shareholders’ Agreement (SHA)

The SHA, although a material document, seldom has much connection with the due diligence exercise and is essentially a futuristic document. It details the rights and obligations of the VC fund and founders for the management and governance of the startup. It also deals with share transfer restrictions, exit rights of the investor and certain other similar aspects.

Share Subscription Agreement (SSA)

The SSA records the terms and conditions of issue of shares to the VC fund, and the obligations of each of the parties to facilitate the conclusion of the investment. This document also has the closest link to the due diligence process and the findings from the diligence are addressed in the SSA, to the extent necessary.

The process

How are the findings of the due diligence exercise dealt with by the VC fund/founders? How to negotiate the major issues? And when to rectify the minor ones? Depending on the materiality, the issues must be categorised as major or minor issues. Rarely is an issue highlighted by the due diligence teams a deal-breaker or a walk-away point for the VC fund. Most often, the issues are manageable in one way or the other. The issues highlighted by the due diligence teams are negotiated and dealt with in the SSA.

The issues arising from due diligence merit a discussion between the founders and the VC fund / their counsels. The discussions are primarily to understand the rationale of the VC fund for determining materiality of an issue. It is in the interest of all concerned parties to achieve a quick and smooth closing. To that extent, it only makes sense to categorise the issues as conditions precedent or post-closing actions based on the materiality of each issue. Of course, some issues could become indemnity related items to be included in the SSA. However, such instances are rare in the initial funding rounds and should be thoroughly negotiated.

What is a condition precedent?

As the name suggests, conditions precedent are the obligations to be completed by the startup and the founders prior to receipt of funds, i.e., closing of the transaction. What is the obligation on the startup and the founders with respect to these conditions? Simple; to rectify all the issues highlighted by the diligence teams and ensure that there is no liability or loss faced by the startup or the VC fund. Once the SSA and SHA are signed, completion of the conditions precedent under the SSA are the only obligations to be completed prior to receiving funds in the startup’s bank account.

Negotiating the conditions precedent

Quite often it is suggested by the diligence teams to slot all issues under conditions precedent. This is doable but is not useful for anyone. The objective is to ensure that the funding round is closed as soon as possible. So, the rectification of major issues could be categorized as conditions precedent. If such a condition precedent is a time-consuming matter or something which is not in the control of the founders or the startup, it is fair for founders to request that such items be included as a post-closing action. Any action that can be managed without regulatory approvals can be completed as a condition precedent. For example, procuring a certain license should not be a condition precedent. The founders and the startup can be obligated to complete all application formalities as a condition precedent. The post-closing actions may prescribe an outer timeline to procure the final license. This could be a longer timeline since the founders have no control over the timelines by when an authority may issue the final license.

Additionally, founders and the startup will do well for themselves by being proactive. During the stage of negotiations, they could initiate rectifying certain issues. This will help to ensure that the final list of conditions precedent is a short one. Plus, they will stay ahead of the curve and ensure that the conditions precedent get completed soon; helping in a quick closing of the funding round.

Post-closing actions & ensuring completion

As opposed to the conditions precedent, post-closing actions are obligations to be completed by the founders after closing of the funding round. The rectification of minor issues and completion of compliance related matters are usually categorized as post-closing actions. All post-closing actions should be dealt with in a time bound manner, after closing of the funding round.

One occurrence which is generally seen amongst founders is the casual nature of dealing with the post-closing actions after the funding round is closed. Just because the funding round is closed does not mean that the items slotted as post-closing actions are of any less importance. It is negotiated in good faith; they should keep their end of the bargain. The founders should ensure that all post-closing actions are completed in a time bound manner. Where they face any difficulty in adhering to the timelines, they must inform and update the VC fund. What founders do not realise is that a casual attitude on this aspect could sometimes put them on the backfoot in subsequent rounds. It is not a good sign for the VC fund / subsequent round investors to notice that post-closing actions of the previous round are outstanding. As a consequence, future investors prescribe stricter timelines and harsher conditionalities. At times, the investors may link any liability flowing from such non-compliance to the founders.

In the subsequent parts of this series, we will cover other important negotiation points within the SSA, to avoid overtly onerous responsibilities for the startup and founders. We will also discuss the founders’ liabilities under the SSA and how founders can minimize such liabilities.

Authors: Arun Mohanty, Principal Associate; Ajay Joseph, Partner | Veyrah Law

The authors can be reached at arun.mohanty@veyrahlaw.com.

Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.