How can an investor secure from actions of unscrupulous founders?

Legal issues are usually not that important during the fundraising stage; it is founders, product, financial indicators that come to the fore. At the same time, improper preparation and execution of investments can lead to the loss of investments even before the startup would show a financial result or would be liquidated.

Unscrupulous founders may want to “forget” about the early investors of the project for various reasons: for example, maintaining their stake in the company, creating a more attractive cap table for new-round investors, getting rid of investors from jurisdictions under sanctions. What can be done to minimize such risks?

I.    Preparing to invest: what matters?

When you receive a pitch deck, we recommend paying attention to the following questions:

1.    Personality and business reputation of the project founders

Many startup investors note that in the early stages, the personality and qualities of the founders matter more than the state of the product on which the startup is working. Checking the background of the founders will allow you to understand whether the founders can really be trusted with money when investing.

How to check: analysis of open sources, survey of the startup community, former employers of the founders.

Red Flags: negative feedback and information.

2.    Registration of a legal entity

As a rule, a startup has already registered a legal entity at the time of raising investments. At the same time, some startups register legal entities to formally consolidate agreements and plan to operate through another legal entity (for example, after restructuring). If you invest in a company that plans to become a subsidiary in the future, it is necessary to carefully consider the legal execution of agreements with founders.

How to check: information from the founders; correlation of the country of registration of the company and the countries in which the startup plans to work; business practice of company registrations in various countries.

Red Flags: registration in an offshore, high-tax jurisdiction, jurisdiction under sanctions without connection with the expected clients; plans for restructuring in the future.

II.    Deal and investment documents: how to protect yourself?

1.    Termsheet approval

At the stage of considering a project for investment, the investor usually understands what rights he wants to receive as a result of an investment deal. However, in practice, not all such rights are transferred to the Termsheet. This may lead to disputes on the deal in the future and will not effectively protect the rights of the investor. Also, at the Termsheet approval stage, some founders can react very painfully to standard provisions, and instead of quickly signing the primary document, you can get protracted negotiations.

Recommendation: indicate all significant provisions in the Termsheet, including the recommendations for the protection of rights mentioned in this article.

Red Flags: protracted negotiations on the Termsheet, exclusion of essential provisions at the request of the founders.

2.    Investment instrument

Typically, venture capital deals use standard documents (such as SAFE) that do not provide significant guarantees to investors. At the same time, the choice of an investment instrument should be treated as responsibly as possible: this is a basic document that establishes the rights and obligations of the parties of the deal and affects the receipt of a stake/shares in the future (and, therefore, the investor's profit). In addition, most investment documents can be changed to protect the interests of investors without significant costs (for example, signing a Side Letter to SAFE).

Recommendation: customize documents to match the Termsheet as closely as possible.

Red Flags: founders' refusal to change investment documents, inconsistency of the documents with the Termsheet.

3.    Receipt of information

Investment documents can provide for the right to receive information from a startup on a regular basis (including financial reports, information about contracts concluded, decisions made, etc.).

Recommendation: indicate the period and composition of the information to be provided in the investment documents (for example, the company's quarterly reports).

Red Flags: refusal to provide information, missing the deadlines for providing information.

4.    Supervisory board / right to vote

Investment documents may involve the investor (group of investors) in the management of the company: for example, grant the right to participate in the company’s board of directors with the right to vote (including the right to veto on certain issues) or as an observer. With such participation, investors will be able to receive information about possible unfriendly corporate actions earlier, or be able to challenge decisions made without notifying investors.

Recommendation: obtain the right to vote and the right to veto on key issues related to the target.

5.    Non-competition and non-solicitation

As part of an investment deal, if permitted by the legislation applicable to the target, it is possible to provide for additional obligations for founders related to the non-competition and non-solicitation. Such obligations can be secured by a separate agreement between the target company and the founders. In case of violation of obligations, the founders will be required to compensate the company losses and/or penalties.

Recommendation: conclude a non-competition agreement.

III.    After the deal: what to remember?

1.    Restructuring

The need for restructuring for a startup can arise at any time. It is important for an investor to pay attention to the following:
a)    Startup ownership and management structures should be preserved (changes in the structure should be agreed in advance with all investors and founders);
b)    The shares issued to the investor in the new parent company should grant no less rights than the investor's shares in the existing company;
c)    Startup IP rights should be properly transferred to the parent company;
d)    Agreements of a startup with founders (e.g. non-competition, non-solicitation) should be reconcluded with the new company.

Recommendation: check all documents and information on the restructuring before signing legally binding documents.

Red Flags: change in the ownership structure without the consent of investors, changes in the rights of investors.

2.    Pivot

Startup founders may decide to change the concept of the product being developed. In this case, the investor should pay attention to the following:

Non-competition provisions (if applicable) should apply to both the previous product and the current one. To ensure this, you can make appropriate changes to the concluded agreements.

Recommendation: supplement the description of competing activities in the documents when there is a pivot.

3.    Protecting your rights in court

Even if you take all the measures described above to protect your rights, founders can still act in bad faith: violate the terms of investment documents, non-competition agreements, carry out restructuring without the participation of investors. In this case, in order to protect their rights, the investor has the right to apply to the court (arbitration) in accordance with the law applicable to the violated obligations or to use out-of-court protection of rights (negotiations, mediation).

Recommendation: if it is impossible to resolve the conflict with the founders out of court, apply for protection of rights to the competent court.