Wednesday, February 28, 2007

Why VCs should not ask for Founder Indemnities

A Boston VC sent me an email agreeing with my last post, adding, " I always find it funny when co-investors insist on founder indemnities. What? Are they going to sue the founder for money he/she doesn't have? Just leaves a foul taste in everyone's mouth."

The founder indemnity is largely a creation of certain VCs here in the northeast. What is it? Let me explain by putting it in context:

In a typical financing, a VC (or its lawyers) will ask a company to represent and warrant various matters about the Company's business and its share capital structure. A long laundry list of representations ensues. This is necessary, the VC will argue, because VC investments are not the kind of deals in which extensive legal due diligence is done. Instead, your VC wants to use reps and warranties to act as confirmatory due diligence, by requiring the Company to disclose what it knows.

What is the legal significance of this? In certain circumstances, if any of the representations or warranties are wrong, it maybe considered a material breach of the investing agreement,entitling the VC to rescind the investment commitment and to ask for all of its money back. More likely, the VC would be able to sue for damages for breach of contract.

Happily for you, contract law is generally a fairly balanced body of law. The VC can't recover damages until he/she proves: (a) that a breach occurred, (b) that the damages claimed relate to the breach, (c) that the loss claimed is recognized as damages recoverable under contract law (not all are). The VC would also have to establish that he/she tried to mitigate any losses suffered, among other matters. Any damages are only paid out after the matter is disposed of.

Because of these variables, some VCs (or their lawyers) take the position that more of a stick is needed.Enter the indemnity.

You are probably more familiar with indemnities as part of your commercial contracts, where customers take the position that they should never be out of pocket as a result of selecting you as their supplier. Adding an indemnity to the contract allows them to bypass contractual remedies and be reimbursed for any losses the minute they are suffered (rather than at the end of a lawsuit). Customers can be reimbursed for any losses suffered as a result of its dealings with the other party. "Losses" can include expenses and costs that would not necessarily be recognized as damages in a breach of contract dispute. The events which trigger the right of indemnity also are defined so that they include events which fall short of a breach under contract law.

The potential impact of an indemnity on the cash flow of a company is huge, which is why it is typically given to customers for very limited circumstances (most often, when a product your customer bought is found to infringe someone else's patent).

In a financing, some VCs argue that it is not enough to rely on contractual remedies or to a receive an indemnity from the Company. Payout would simply come from the VC's invested funds. They want the founders to provide an indemnity and have skin in the game. What "skin" is at stake here? Sometimes it is simply the founder's stake in the company - the VCs would be able to take the founder's shares as compensation for any losses. Other times, VCs require that the indemnity be unlimited. In other words, they want the ability to seize any personal assets of the founder if there is a problem down the road.

Here's the fundamental flaw in the whole premise: much of the risk of an early stage company is unknown, and no amount of investigation will reduce the risk that, for example, there is unpublished prior art that creates an infringement problem. Why is a founder bearing the entire liability for what is the essence of high risk early stage investing?

Which takes me back to the VC's comment above. When is a founder indemnity ever a tenable or good idea? There are a number of ways to negotiate this provision so that it may be manageable - we can detail them in a later post if you want - but at the end of the day, companies should ask, is this the kind of deal that makes sense for me? Is too much risk, and too little accountability, being shifted to the founders of the company (who, incidentally, are not receiving any cash from the financing themselves)? More importantly, what kind of harbinger is this for your relationship with your VC going forward?

My two cents.

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