Making Sense Of Term Sheets And SHAs

Signing a shareholder agreement is a daunting task for the first time entrepreneur because it’s full of legalese. These are foreign terms which he’s never come across and he’s not sure how to make sense of the jargon.

What’s scary is that the term sheet and shareholder agreement are usually drafted by the investors, and they are worried that all the Greek and Latin they are stuffed with are designed to protect the rights of the investors, and hand over control of their company to them.

Every entrepreneur has heard horror stories about how greedy investors are, and that they are out to take over the business, because of the disproportionate power which the agreement gives them. They are petrified that the investors will kick them out of the company which they have spent their blood, sweat and tears on building up.

Now we need to understand that an agreement is precisely that – it’s a legal description of the terms you agree on. This is why the entire approach has to be one built on trust – you have to trust that the investors you’re going to take money from have your best interests at heart, and want your business to grow.

The reality is that investors are in the business of investing money so they can grow their capital – they are not in the business of running your business because they have other things to do. Ideally, they would want you to run your startup in such a fashion that they don’t need to worry about what you’re doing. Their dream is to find an entrepreneur who will continue growing his startup so well that they will become progressively wealthier without having to worry.

However, the fact remains that entrepreneurs sometimes don’t do a very good job of managing a growing business, because this is outside their area of competence, and investors need to monitor them to make sure their capital is being protected.

The truth is that after the cheque has been deposited, all the power is actually in the entrepreneur’s hand. He is the one who manages the company on a daily basis and makes the 101 decisions which are required to run the business. The investor has very little say – and this is as it should be – we don’t want to micromanage the founder.

This is why it’s so important for an investor to clearly specify what things he wants to be involved, in so that the entrepreneur doesn’t run the company into the ground. Now, these are pretty standard terms and include things like the terms under which new funds can be raised.

They are designed to restrict the ability of the entrepreneur to mismanage the company and drive it to the ground, causing the investor to lose all his hard-earned money – it does not affect the ability of the management to run the company’s routine business.

The purpose of the agreement is to protect the interests of both the parties and create a win-win situation – one where the entrepreneur has the freedom to do what needs to be done on a daily basis to make sure the company is growing, while also giving the investor the rights to stop the entrepreneur from doing anything stupid which would cause the company to implode.

Having said all this, legal agreements have very limited value in India, because we all know how effective ( or should I say ineffective ) the judiciary is. If things go sour and there is a dispute, there is little effective recourse the parties have. This is why the agreement is often more of symbolic value – that the investor and the entrepreneur trust each other.

However, it’s a very useful legal document as you continue to grow, and need to raise fresh funds – this SHA will form the bedrock of the relationships you have with future funders as well.

Some entrepreneurs shy away from the agreement, saying they don’t understand what terms such as voting rights, protective provisions, and conditions precedent mean. This is not a good argument. No one wants you to become a lawyer, but as an entrepreneur, you need to learn lots of things on the job, and one of them is making sense of a shareholder agreement, and understanding the rationale behind all the terms and clauses which a shareholder agreement has.

To help you make sense of the SHA, so you can understand more about both the entrepreneur’s perspective, as well as the investor’s, the site is helpful. You can also generate your own term sheet. Talking to other founders is helpful, and you can hire your own lawyer to draft a term sheet for you.

Reading the right book can help you immensely because it will explain to you how the shareholder agreement ensures that everyone’s interests are aligned, and I would suggest you spend time understanding Brad Feld’s book, Venture Deals. This will give you a lot more confidence in your ability to make the right decision, and will help you trust the investor more when you will realize what he’s doing is in the best interests of your business.

Instead of worrying about all the things which can go wrong, try to focus on what will go right, so your partnership with your investor starts off on the right foot!

[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]

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