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Pitfalls Of Fine Print In Investment Agreements

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This Space is For Sale

Pitfalls Of Fine Print In Investment Agreements

Lola Omotosho

Likening the relationship between an investor and a business-owner to a marriage is no exaggeration. It is an intricate relationship and, as it is with marriages, careful assessment and consideration must be made before venturing into such a relationship.

Business owners raise capital because it is integral to the creation, operation or expansion of their businesses; the prospect of raising capital could be just as exciting as it is daunting. Rather than creating value, the wrong deal can leave a business owner clutching at straws. In the midst of the excitement of a capital raise, it is easy to miss out on the details of the fine print of the agreement. Recipes to this colossal misjudgements are:  

  1. Raising funds when desperate: Founders should avoid raising funds when the company is in dire need of it. Being cash strapped may cause the founders to be so anxious that they ignore the red flags and overlook unfavourable terms of an investment. Understand your metrics and cashflow. Raise funds ahead of when you run out of cash.
  1. Neglecting due diligence on prospective investors: iIt is important to conduct background checks on investors. When raising capital, “it is NOT always all about the Benjamins”, as the wrong investor could bring with them a baggage that can pile on the reputational risks associated with your company. An investor with a lot of red flags such as money-laundering or, fraudulent convictions may not be the best for your company if you want to attract follow-on investors and wish to be taken seriously.

It is recommended that you take a magnifying lens when reviewing and negotiating terms on which an investor is investing into your company, and this is not solely as a result of distrust. Investors usually mean no harm but simply seek to capture as much value for themselves, and as you can imagine anyone investing funds (especially a lot of it) in a company, would want to incorporate safeguard measures to protect themselves and their funds. The extent of the safeguard measures is what should be examined to ensure it is not detrimental to the company. Some investor protection terms include drag-along rights, tag along rights, pro-rata rights, anti-dilution, affirmative rights, and liquidation preference.

Most of these rights are common and serve as reasonable protective mechanism for the investor when drafted fairly. Founders must bear in mind that they may not always have their way at the negotiation table. Therefore, it is important to understand all the terms and resulting impact on the company, as well as negotiate fairly, weighing the implication of such terms. A full understanding of all terms determines the next line of action – walk away or shake hands – whichever way, the founder(s) will be making an informed decision.

I will only explain one of the most contentious rights commonly negotiated – Affirmative Rights. The affirmative right is a right granted to an investor stating that the investor must affirm to certain matters pertaining to the company before the company can take an action. This implies the founders/shareholders are obliged to seek approval of the investor on matters covered by the affirmative right, and where the investor does not affirm to the request, the company is bound by the decision(s) of such investor(s). 

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The need for an investor to be fully aware of matters pertaining to the company (as such matters may affect the investment) is understandable; however, it may not be in the best interest of the company to leave certain decisions of the company in the hands of a single investor. Such decisions are better referred to Board of Directors which usually will include the investor, the business owner and other independent directors.

Finally, raising capital is serious business and it is important to have an experienced lawyer review the legal documentation and determine the contractual implications of the agreements. Lawyers are trained to act objectively and critically analyse legal documentation. With experience from having drafted and reviewed legal documentation involving raising capital, coupled with the fact that more often than not, experienced lawyers have been on both sides of the aisle (investors and founders) and are able to offer the best opinions on these matters.

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