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Death by Legalese

A common experience by start-up founders is frustration at the overly complicated investment agreements
steeped in legalese that require their consideration as a precondition to investment. Some spend innumerable
hours in deciphering what is being asked and becoming comfortable that they are not signing their lives
away while others simply do not bother and sign what is put forward. These agreements usually are replaced
in 6 to 12 months when the next round is raised. Accordingly, the money and time spent on documentation
at this stage is therefore a colossal waste of valuable resources. Further, we as lawyers have imported private
equity concepts to early-stage investments – perhaps because we understand the document and see risks
where in most circumstances none exist. The cost of such complicated documents cannot be underestimated
by the community – lawyers, management time and compliance. Limited resources result in the pain being
most acute in the seed and angel stages.

Investors in seed and angel rounds in particular invest because they like the idea and trust the founders.
Investments are relatively small and therefore usually not material for investors. Further, the chances of
failure are so high at this stage that all resources (specially time spent by the founders) needs to be directed
towards making the idea a success rather than spending time with lawyers and on compliance. The mismatch
in expectations is usually on valuations – every founder considers his idea to be invaluable.

The US has dealt with this problem through the introduction of safe notes. Money is transferred to the start-
up which coverts at a discount to the next round of fund raise and founders are permitted to get on with the
job of creating value rather than spending time worrying about complicated documents and compliance.

India has also introduced “convertible notes” which are similar to safe notes in the US though the threshold
investment (INR 250k) does cause issues. In our experience given the amount of investment, seeking a full
set of institutional rights appear disproportionate to the risk. If a founder is to succumb to agency issues, he
will no matter what is stated in the investment agreements.

The question is in this backdrop what can be done? Investors and their lawyers need to find a simpler way
of dealing with early-stage funding by only seeking such rights that are commercially important as reflected
in the safe note structure. In our view the rights that are most commercially important are conversion ratio,
anti-dilution, liquidation preference and exit. A large list of reserve matter and other governance rights at
early stages are in our view an over kill.

Accordingly, we recommend that current standard form investment documents be overhauled and
simplified to only cover what is commercially important and use short form provisions to protect against
agency issues. Examples are:

  1. Retain prior consent requirements for any further fund raise. Delete further issue provisions.
  2. Retain right to request for information and appoint board observer. Delete all board and other
    governance rights.
  3. Retain prior consent requirements for any transfer of shares by founders. Delete pre-emptive rights
    and tag provisions.

In conclusion, we as lawyers need to support the growth and development of entrepreneurship and
innovation by playing our part in simplifying legal documents and not cause death of ideas by legalese.

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