Governance Considerations on Term Sheets – Part II

Wednesday 28th September, 2022

In Part 1 of our article on term sheets, we explored some of the financial terms found on a fundraising term sheet. Founders can also expect to find governance-related provisions. Who can appoint the Board? Can a founder exit without anyone blocking it? How much information does a company need to provide to its investors? In this Part II, we explore some of these governance terms.

1. Board

A term sheet will often stipulate whether the investors want the right to appoint individuals to the board of directors of your company.

The Board is responsible for the day-to-day management decisions of a company. In the early stages, your Board might have comprised only the founders and decision-making has probably been quick and easy, and relatively informal. As your company grows, and especially when your company fundraises, it is likely that the composition of your Board will change, eventually swinging from founder-managed to investor-managed as you reach Series B+ fundraising rounds – investors in a priced equity round will often ask for some sort of representation on your Board.

As such, it is an important consideration and a right you should not necessarily give away easily.

Representation could be in the form of an observer, who can attend Board meetings and receive materials privy to the directors; however, the observer doesn’t have any voting rights. Founders should ensure that observers are not in direct competition with the company. More typically, especially on later rounds, investors will ask to appoint an investor director, who will take on a non-executive role. There are pros and cons to this for founders – investor directors can be very useful mediators and/or provide experience and expertise in the relevant industry; however, having more directors on your Board also increases the administrative burden. Always consider who has a majority of votes on your Board and beware of unruly large boards, which can make decision processes slower and clarity of vision harder to find. You also want to avoid setting a precedent in early investment rounds by giving away board seats to investors – conduct a cost vs. reward analysis on the term before agreeing it.

2. Reserved Matters

Reserved matters in a fundraising context refer to a particular set of decisions reserved for the approval of an investor or group of investors.

Some control over certain important business and operational matters relating to the company, such as an exit event and the composition of the Board, is important for investors, who are usually minority shareholders in the business and as such, don’t control the Board so they don’t otherwise have an automatic say over passing shareholder and director resolutions.

The composition of the group from which consent is required is usually negotiated and linked to the final share cap table following the investment – if possible, companies should avoid allowing any one investor to have control of veto but ensure they know what combination of shareholders can reach the threshold; being able to get there in a couple of different ways is usually beneficial. Note that where you have one lead institutional investor it is likely that they will have a de facto veto on these key matters.

Founders ought to know when the investors can exercise these rights and seek consent at the relevant time. When negotiated correctly, reserved matters can be positive for both the investor and the company – offering some protection for investors over the conduct of the business and therefore the value of their investment and ensuring good governance by the company. Usually in this context, the interests of the company and the investors are aligned – everyone wants the company to succeed, grow and make money. As such, these rights are designed to ensure investors are involved in important decisions, rather than a way for investors to be difficult or obstructive.

3. Drag

Drag-along rights protect against minority shareholders holding up the sale of a company – if a certain group of shareholders (the composition of this group being up for negotiation) – want to sell their shares, they can effectively force the other shareholders to sell at the same time.

As mentioned above, when negotiating the drag-along rights, investors and founders will consider the minimum threshold, i.e. the percentage of shareholders which would trigger the provision. This is often linked in some way to the negotiated threshold for reserved matters, e.g. an investor majority plus the founders.

It is important to consider who the drag group should be, making sure you understand who can block a sale and who can be required to sell without their consent.

The provision also protects the minority shareholders by ensuring that the price, terms, and conditions of a share sale are equal for all shareholders.

4. Information Rights

Investors will want access to certain financial information relating to their investment to monitor progress – this is particularly important where investors do not have representation on the Board. The pack of information to be provided to investors typically includes management accounts and annual accounts, along with updates on any proposed future fundraising rounds or exits. There is also usually a catch-all clause for any other information an investor reasonably requires. Some investors might have other requests depending on their specific fund-related reporting requirements, e.g. an audit on environmental impact.

These provisions can be relatively uncontroversial, so long as the requests are not overly burdensome on the company – consider the type of information requested and the regularity with which it needs to be provided. Founders should also consider what is reasonable and achievable from a practical perspective, i.e. don’t promise to deliver monthly management accounts if you won’t actually be preparing those accounts and it would not be proportionate to do so. In line with these provisions, consider the confidentiality obligations in the investment documents and whether any restrictions should be put in place where there might be a conflict of interest or information could be particularly sensitive. (especially if the investor is strategic and/or may be a competitor or future acquirer).

5. Pre-emption

A pre-emption right gives an existing shareholder the right to participate in a future financing round to protect their shareholding percentage in a company by being given the opportunity to subscribe for a proportionate part of any new shares that are issued.

This can be beneficial for both founders and investors – investors get the opportunity to follow on in successful companies, and founders get additional support, funding and a positive signal for their subsequent financing round.

While it is still most common in the U.K. for all shareholders to have pre-emption (or ‘pro rata’) rights, increasingly companies only grant this right to a smaller group of larger shareholders or major investors. This is to reduce the administrative burden on future rounds and set expectations; it is not always appropriate for angel investors who hold a small percentage of the company to invest a small amount when a large fundraise is happening.

It is also important to understand how pre-emption can be waived and by whom. Generally, this is by a group of investors, and this allows new investors to come in on the next fundraise.

Summary

Founders should seek advice early in the fundraising process to ensure they are agreeing to appropriate terms with the right investor, and to set up the company in the best possible way to scale and achieve success. The right lawyers, who are experienced in venture capital transactions, will see a lot of term sheets and will be able to guide you on market trends, how to get to where you want to be and which battles to fight (or not). For a further discussion about how we can help with your fundraising term sheets, please contact David Strong or Frances Spooner.

Articles by Frances Spooner