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August 02, 2024
Term Sheet Tactics: VC Steering Start-up Governance
Term sheets outline
the basic terms of investment transactions,
setting expectations for governance. VCs now insist on stricter
governance rights due to increased start-up
competition and governance issues Negotiating a term
sheet is a critical step in the investment process,
serving as the foundation for the final investment
agreement between the start-ups and investors
BACKGROUND:
In recent years, the start-up ecosystem has emerged
as a catalyst for innovation and economic growth.
Fuelled by entrepreneurial vision and often supported
by Venture Capitalists (“VC”),
start-ups play a key role in shaping industries
and disrupting traditional business models. However,
despite their tremendous potential for success,
several start-ups are failing due to lapses in
corporate governance.
In the context of start-ups, effective governance
is essential, not solely for regulatory compliance
but also to build trust among stakeholders, manage
risks, and sustain long-term growth. Governance
often serves as the foundation for start-ups to
build credibility and attract investments. Investors,
including VCs and institutional funds, prioritize
transparency, accountability, and ethical conduct
while evaluating potential investments. In an environment
characterized by uncertainty, volatility, and an
unbridled growth rate, robust governance frameworks
provide stability and confidence to investors, thereby
facilitating the capital infusion necessary for
expansion and innovation.
Despite the imperative of sound governance, VCs
frequently encounter governance lapses in the companies
that jeopardize their credibility and viability.
These lapses can manifest in various forms, including
financial mismanagement, conflicts of interest,
inadequate disclosure, and non-compliance with regulatory
requirements. Several such instances have been seen
lately in the Indian economy, wherein companies
such as Byjus, BharatPe, DeHaat, Zillingo, GoMechanic
have been alleged of indulging in several malpractices
such as related party transactions,1
fund diversion, falsified invoices,2
undisclosed debts, inflated revenues, non-transparent
accounting practices and internal corruption.3
Such malpractices eventually lead to failures of
the start-ups, attracting legal and reputational
risks and thereby, undermining the confidence of
the investors.
GOVERNANCE DURING TERM SHEET
NEGOTIATIONS:
The prevalence of governance failures in start-ups
necessitates a proactive approach to address underlying
vulnerabilities and promote a culture of governance
excellence. Regulatory frameworks serve as benchmarks
for governance practices, guiding start-ups in adopting
policies that align with industry standards and
best practices. Furthermore, establishing a diverse
and independent board of directors is crucial for
effective oversight and decision-making. Independent
directors bring diverse expertise and perspectives,
reducing the risk of conflicts of interest and enhancing
governance credibility.
In response to discovering shortcomings in the
companies late in the investment cycle, resulting
in losses, VCs now negotiate various rights and
powers early on, during the term sheet stage. A ‘term
sheet’ is a non-binding legal document
that outlines the basic terms and conditions of
an investment transaction between two parties -
typically between an investor and a start-up seeking
funding. A term sheet plays a crucial role in the
negotiation process. It allows both parties to establish
an understanding of key deal points before investing
time and resources in detailed legal contracts and
due diligence. Term sheet negotiations offer an
opportunity to clarify VC’s involvement in
the business of the start-up and sets the expectations
for all parties.
Negotiating a term sheet is a critical step in
the investment process, serving as the foundation
for the final investment agreement between the start-ups
and investors. The term sheet outlines the key terms
and conditions of the investment, including governance
provisions that dictate how the company will be
managed and controlled post-investment. In recent
years, certain governance clauses have gained prominence
due to evolving market dynamics, lapses in governance,
regulatory changes, and the increasing complexity
of start-up ecosystems.
Previously, the term sheets heavily favoured
the founders as the VCs were eager to invest and
as a result would only ensure there are sufficient
clauses protecting their exit. However, with increased
start up competition and governance issues leading
to failures, investors now wield significant negotiating
power by insisting for several rights, to an extent
that they may walk away from the deals if their
demanded rights are not met. We note that recently
there has been a considerable delay in closing deals
between the VCs and start-ups due to VCs’
increased involvement in deal negotiations and alignment
of interest with founders on the matters of governance.
Few years back, VCs would insist only on minor rights
such as observer seat, information rights, exit
of the founders due to fraud, exit due to initial
public offer or sale of shares by founders. However,
recently the investors have begun to insist on inclusion
of several rights in the term sheets, such as:
Voting rights of the
directors as against the observer rights demanded
earlier. Expanded definition
of ‘bad leaver event’ –
Earlier the VCs would insist for termination
of the founder’s employment and exit only
if founders committed fraud, wilful misconduct
or moral turpitude. However, lately, the definition
of ‘bad leaver event’ is undergoing
changes and being made comprehensive to include
several reasons such as any criminal complaints
against the founder, breach of investment documents,
breach of non-compete provisions as a ‘bad
leader event’. Comprehensive modes
and procedure of exit. Automatic renewal of
the exclusivity period, if the same has lapsed
due to the delays caused by the promoters/ company. Earn out/ deferred
payment instead of upfront payment, depending
on the growth of the company and milestones
achieved by the founders. Some VCs also establish
key performance indicators (KPIs) that are tied
to governance and compliance metrics. Performance
on these KPIs is regularly reviewed and impacts
future funding decisions of such VCs. Inspection rights satisfactory
to VCs, replacing earlier negotiated information
rights. Appointment of independent
directors, chief financial officer to oversee
the functions and monies of the company and
conducting independent audit by firms acceptable
to the investors. Creation of audit and
compensation committees to review salaries,
especially of the founders and key managerial
personnel, and compliance with global standards.
Audit committee is also tasked with overseeing
adherence to corporate governance norms, ethical
standards, and regulatory requirements. Approval of the VCs
for hiring of any key managerial personnel of
the company and their tasks, responsibilities
and salaries. Covenants by founders
on compliance by the companies with global anti-corruption
laws and environmental, social and governance
norms. Disclosure of income
sources of the promoters and their participation
in other start-ups/ companies as mentors or
directors. This includes insertion of explicit
clauses addressing conflict of interest. Start-ups
are now required to disclose any potential conflicts
and have clear policies on how these will be
managed. Undertaking rigorous
due diligence instead of a high-level review
of issues in the company and insistence on resolving
all regulatory and legal issues prior to the
closing of the transaction. This also includes
periodic checks on compliance, financial reporting,
and operational transparency. Emphasis on establishing
robust ethics and whistle-blower policies.
CONCLUSION:
Corporate governance is paramount for start-up
sustainability, investor trust, and operational
integrity. Start-ups face governance challenges,
including financial mismanagement, conflicts of
interest, and inadequate risk management, which
impact their viability and success. In addition
to being vital for the operational stability and
longevity of start-ups, robust corporate governance
practices are equally crucial for VCs. As the start-up
ecosystem continues to evolve, certain governance
provisions have become increasingly relevant, reflecting
the need for greater control, transparency, and
alignment of interests between founders and investors.
The binding nature of certain clauses, despite the
overall non-binding declaration of the term sheet,
requires careful consideration and strategic foresight.
Effective governance frameworks mitigate investment
risks, enhance transparency in decision-making,
and safeguard VCs’ interests throughout the
investment lifecycle.. As such, prioritizing governance
excellence not only safeguards investor interests
but also nurtures a thriving ecosystem where innovation
can flourish, and businesses can scale responsibly.
However, VCs’ increasing insistence on
stringent governance standards has presented challenges
for founders. Start-ups often struggle to balance
investor expectations with maintaining operational
autonomy. Excessive interference from VCs in day-to-day
operations or strategic decisions can hinder agility
and innovation, crucial for start-up success. Founders
often spend time navigating complex governance requirements
and compliance burdens, thus diverting attention
from core business priorities. This dynamic can
strain founder-investor relationships and, in some
cases, lead to disagreements or the breakdown of
deals. Therefore, while governance frameworks are
essential for investor protection and sustainable
growth, achieving a balance that respects entrepreneurial
vision and encourages collaboration between founders
and investors remains crucial for long-term success
in the start-up ecosystem.
Authors:
–
Sapna Kataria
and
Maulin Salvi
Governance Team:
Nishith Desai, Global Business Strategy
Sahil Kanuga, Head of Practice, Governance Team
Maulin Salvi, Leader, Governance Team
You can direct your queries or comments to the relevant member.
1A
funding winter’s tale: Corporate governance
failures hold many lessons for startups, accessible
at
https://www.moneycontrol.com/news/business/startup/a-funding-winters-tale-corporate-governance-failures-hold-many-lessons-for-startups-10883941.html.
2BharatPe
Co-founder Faces Allegations Of Generating Fake
Invoices, EOW Reveals, accessible at
https://businessworld.in/article/bharatpe-co-founder-faces-allegations-of-generating-fake-invoices-eow-reveals-499191.
3Zilingo
case: How a celebrity CEO Ankiti Bose’s rule
of fear helped bring down hot startup Zilingo, accessible
at
https://economictimes.indiatimes.com/tech/startups/how-a-celebrity-ceos-rule-of-fear-helped-bring-down-hot-startup-zilingo/articleshow/93335057.cms?from=mdr.
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