It is common for entrepreneurs to focus all their efforts in the development of their product or service. Due to this, vital legal issues are often left in second place, especially during the negotiation process with investors. To avoid investors taking you by surprise with language not used in your day to day, below you will find the most important issues that all entrepreneurs need to know before entering any negotiation:
Normally, the valuation is a central topic in every negotiation with investors. Because of this, it is important to be careful with terms such as pre-money or post- money valuation. Even though both terms refer to valuation mechanisms, they differ in the moment in which the valuation is done. While pre-money valuation takes as reference the valuation before the round of investment, post-money valuation takes as reference the valuation after the round of investment. This distinction – that seems simple – has implications in the participation percentage of the entrepreneurs after each round of investment. Thus, it is important that you pay attention to this discussion when negotiating the valuation.
Before starting any negotiation with investors, it is important to be clear on the percentage of the entity that you are willing to give up. It is common that an entity issues shares in return for the investment. In consequence, in each round of investment, naturally the founders will lose participation in the entity. Likewise, the investors of early rounds of investment will try not to be diluted in subsequent rounds of investment.
It is common that entrepreneurs and investors agree on liquidation events. These events usually imply either the liquidation of the corporate entity, or the transfer of a determined percentage of shareholding (generally that grants control) to a third party. The most relevant aspect of the liquidation events is the way in which the founders and investors distribute the funds received when the event is triggered. In this sense, as entrepreneurs, you should pay attention to the preference in which such funds will be distributed. For this, be careful with terms such as “participating preferred”, especially because, by granting shares with this kind of rights, investors will: (i) have preference to recover the initial investment (even with a percentage of profitability) and (ii) have a pro-rata participation with the ordinary shareholders with respect to the profits obtained for instance in case of sale.
In the course of the negotiation, most of the entrepreneurs give it for granted that preliminary documents (such as the term sheet) are not binding for the parties. However, this depends in great part of the applicable law and the clauses agreed by the parties. In other words, it is advisable not to assume that the document is or not binding but agree expressly which clauses are binding and which ones are only declaratory (not binding). Normally, clauses such as confidentiality, exclusivity, access to information and distribution of expenses are binding.
The exclusivity clause is particularly important in preliminary documents (such as the term sheet) that are executed during the negotiation stage. According to this clause, the founders are obliged not to negotiate nor to contract with third parties during a specific period, given that it is understood that they are negotiating exclusively with the investors. Exclusivity clauses, in addition to being binding to the parties, usually seek to include penalty clauses with high sanctions in case of breach. This way, investors intend to discourage founders from looking for better deals. Therefore, it is important that the founders explore the different investment options before executing preliminary documents including these clauses. In addition, if you have made the decision to execute these documents, it is important that the exclusivity is limited for a reasonable time.
To receive funds, entrepreneurs usually use debt mechanisms, or issue shares to investors so that they participate in equity. Therefore, it is crucial for the entrepreneur to understand whether the transaction is going to be structured as debt and/or as a capital injection. If the investors are going to participate in equity, it is important to bear in mind that there are corporate vehicles in which it is possible to issue different types of shares. The difference in the types of shares lies in voting and economical rights. Thus, common shares, preferred shares (with and without voting rights) and/or privileged shares may be issued. When it comes to debts mechanisms, convertible notes are the most common.
Entrepreneurs often face foreign investors who want to impose their conditions at any price. Thus, thinking about closing the business with the investor, it is common that entrepreneurs ignore the existing limitations and the effects of agreeing on a foreign applicable law. Regarding this matter, note that agreeing on foreign law as applicable law would be valid only if international elements are proven in the transaction. Also, it is important to bear in mind that, if obligations take place in Colombia, the clauses of the agreement cannot contravene Colombian Law. On the other hand, other than the existing limitations, it is also important to consider that the lack of knowledge of the foreign jurisdiction may interfere with the entrepreneur’s rights and increase transactional costs.