We focus a lot in this series on the tougher aspects of a venture investment. You might think this reflects deep negativity or anxiety. It is absolutely the opposite. Scope out any problems at the start. Then fix them. Move on. Succeed.
Warranties are promises made by founders to investors about the state of the business. There are sanctions for misrepresentation. It’s a process that gives confidence to the venture investors, but at what cost to the founders and, quite simply, does it make sense for them to sign up to warranties?
The following isn’t legal advice – we’re not lawyers – and our aim is instead to explain the commercial issues at stake.
Warranties – what are they, how do they work?
An investor will write a cheque based on various representations by the founders and other directors about the company, its business, and its prospects. The investor may do due diligence and check out some aspects themselves, but a few hours or days of review isn’t going to give them anywhere near management’s insight. So, to help fill-in this knowledge-deficit, as well as avoiding outright deception, investors require warranties.
In simple terms, the warranties consist of a series of boiler-plate representations which do not vary much from deal to deal, that apply to a set of unique, company-specific information. If the representations turn out to be wrong, then the warrantors agree to make good the loss (subject to agreed limitations) to the investors. The warrantors are invited to disclose information that might negatively influence the investor’s decision. If fairly disclosed, the investor and founders can agree how (and if) to deal with the problem and, crucially, the investor is fore-warned and has lost the right to claim under the warranties.
The investment agreement will contain a master-clause along the lines of “Acknowledging that the investor is entering into this agreement in reliance of the warranties, each of the managers hereby warrants to the investor in the terms set out below”. This is followed by a series of warranties about specific issues, such as the company’s cap table being true, correct and complete.
Taking that one specific issue: why have a warranty about the cap table? Pretty obvious really. If SaaSco raises £1m for 20% of the equity, and issues 20 shares on top of the (say) 80 shares already held by founders, then the investors is going to be pretty unhappy when they discover that there are another 10 shares under option held by an accelerator that the founders forgot to mention. Suddenly their 20% shareholding has fallen to 18%. Not a great start.
What happens when things go wrong?
In theory, having discovered that a debtor in the pre-completion balance sheet was always looking shaky, and has subsequently folded, the investor could pursue a legal claim, agree their share of that loss, and ask the warrantors to make them whole again.
In practice, this hardly ever happens in venture investments.
Things go wrong all the time for venture investors. SaaSco’s shiny pipeline documents produce minimal actual customers. Its contracted revenue turns out to be flaky. A key supplier was already thinking of hiking their prices to SaaSco.
Venture investors operate in a volatile environment filled with risk. They generally understand that the information which they are fed has limited reliability. That gives them – and us – a pretty wide tolerance. Take that debtor. Quite likely the founders are first-time entrepreneurs, young, and not yet commercially experienced. They did a bad deal with a launch customer. The invoice was beyond payment terms, but they really believed the customer’s bland promises about settling the invoice. Their genuine belief, not stupidly formed, was that the customer would pay the debt. Legally, it might be an arguable claim. Morally, however, there was no deceit. Commercially, do we the investors want to hurt management when they’re already hurt and possibly feeling rather foolish? Economically, as the sums involved in venture-stage investing are so small, does legal action even make sense?
I have made over 100 venture investments in a long career but haven’t pursued any legal claims under the warranties (or, indeed, at all). Almost always, the issues have been flushed out before investment. In a couple of cases, however, investors suffered due to clear warranty breaches, which were both resolved by negotiation.
In one case, the founders did not disclose a shareholding held by an early investor – like the example above. The error genuinely seemed to have risen due to oversight. After the investment closed, and on realising the error, the founders disclosed the problem and also proposed a solution: transferring the percentage from their own shares. The legal agreements weren’t even consulted: everyone already knew what was intended, and a commercial fix was offered and accepted without any fuss.
In another case, the founder had massively and deliberately misrepresented the financial position. We challenged him, he acknowledged what he had done, and gave up his shareholding and his employment with the company. We used the shares and the salary to start afresh with new management. Sadly, the tale did not end well. The founder left the company badly wounded and, despite us recapitalising the business, it failed.
Incidentally, it is worth contrasting the attitude of venture-stage investors against the approach of later stage and private equity investors, and corporate acquirers. In those cases, there is much more at stake. Pricing is fought over keenly. The accounts and legal positions are known with much greater clarity. Warranty claims are more likely in that environment. For venture-stage managers, that challenge lies some way down the track.
What the investor really wants – disclosure
So, we have established that warranties in venture-stage investments hardly ever result in claims. It is pretty obvious why a small, minority investor would not decide to pursue a claim against management, however aggrieved they might be.
In that case, of course, why bother with warranties in the first place?
The real purpose of warranties is to obtain disclosure. As investors, we just want to know what is going on. Tell us, and we can (probably: see the next section) deal with the problem. If not, and in the extreme, the deal may not be worth doing, or may need to be delayed giving time to fix the problem.
Founders and management may be reluctant to disclose bad news. That is understandable, given that it could blow the deal, or prejudice pricing. So, the warranty mechanism is there to focus the minds of all the founders and management. This is a serious process. Serious monies are being invested. Serious thought needs to be given to what the investor needs to know. If there’s bad news, it needs to be shared.
Disclosure can be in the narrow sense noted above – where founders and management table a list of exceptions as part of the legal process. More helpfully, we prefer to see the issues either highlighted when we are in negotiation, if they are major issues, or at least clearly pointed out early in due diligence.
It is worth stressing that it undermines trust if the investor finds out about a massive problem only by following up on some seemingly trivial loose end. Would management have told us this is we hadn’t found out ourselves? What else have they not told us?
What can the investor do with disclosures?
Given time and opportunity, smart venture investors can work through – or even just take a view – on most problems. Here are just a few examples we have accumulated over the years:
|The business is based on the value of its data, but the ownership of the data is unclear.||Scope out how much of the data is affected and how seriously it affects the company’s value. Get comfortable with the residual risk but renegotiate supplier contract terms as soon as possible post-investment.|
|None of the development team are under contract. They could all claim ownership of the company’s IP.||This needed fixing before investment so that management could use the funding round as a lever to encourage sign–up to standard terms by employees and contractors.|
|Massive supplier vulnerability with no contract in place.||Assess the vulnerability including availability of existing stock; accept vulnerability at point of investment. Develop plan for multi-sourcing.|
|Suspense account is very material and has never been reconciled; could be an asset, could be a liability, not sure of exact amount.||Work with company to close down the value of the account to within an acceptable zone of uncertainty. Hire additional finance resource. Complete reconciliation post-investment.|
How to get comfortable with giving warranties
There is a risk to giving warranties. There is no getting away from that. I would personally be very cautious about giving these kinds of undertakings, despite being very familiar with the process. But that is the point, really: to make management stop. And think.
So that leads on to two headline fixes.
Firstly: understand and work diligently through the process:
Management should get good quality, fairly-priced, and pragmatic legal advice. Be guided by a professional. Understand the detail of what you are being asked to sign up to. Negotiate if the draft investment agreements seem genuinely unfair. Bear in mind that investors tend to propose boilerplate wording and it may not make sense to challenge vanilla clauses.
Management’s efforts are best focussed on what level of confidence they are attributing to which information. So, factual statements in the business plan such as our technology analyses patients’ blood within five minutes might be warranted as true and accurate in all material respects. In contrast, matters of opinion such as we will revolutionise the global blood testing industry might be warranted to a lower degree of confidence, maybe as honestly believed by the Managers to be reasonable.
We do not expect management to give a warranty about the achievement of forecasts. The investor wants the company to have a vision and knows that the future is unknowable. They just need to be sure that management did not just make the whole thing up.
Second way of sleeping well at night: disclose:
If management are in doubt, they need to get specific legal advice. If still in doubt, play safe and disclose. Disclosure needs to be fair, so no dumping gigabytes of data in a Google drive. That does not work. Point out the issue clearly, ideally with context to allow the investor to assess its impact. If possible, lay out how the issue can or is being resolved.
And as noted above, break bad news early. Even if momentum gets a troubled deal over the line after a late disclosure of bad news, investors will hate management for being held over a barrel and are likely to send in the bill at a time of their choosing.
Who gives warranties?
This is not set in stone. Usually, founders and key directors are asked to give warranties. Exceptions might be made for founders who aren’t in the business anymore, or late joiners who have little equity. They have got much less to gain, so why should they be in the firing line for everyone else’s benefit? Non-executive directors and advisers are normally off the hook unless they are major shareholders. External investors very rarely give warranties. Venture investors never give warranties. No-one even asks any more. It is just a thing.
To make matters a bit more tolerable, there are limits for individual liabilities. The usual is two times salary. I am not exactly sure why it’s that particular formula. It just is.
And eventually the warranties come to an end, generally two years after the investment completes.
When do warranties kick-in?
Most start-up funding is from founders themselves, friends and family, or individual angels. Generally, the investment is based on relationships and gut-feel. Equally, everything about the venture is in the future, unknown, or unknowable. To the extent that there are factual records – financial accounts, say – they are probably a mess. So, there is little point even discussing warranties.
Most Seed and Series A (and beyond) investors, in contrast, will ask for full warranties.
Somewhere between Start-up and Seed (and the definitions are over the place, so this is going to happen) there is a grey area. The more experienced and involved the investor, the more likely they are to ask for warranties. DSW Ventures ask for institutional-grade warranties. It works well, both for us and our portfolio companies.
Any successful management team will need to get their heads round warranties sooner or later. A rite of passage almost. They are a challenge, but a combination of good advice, diligent analysis, and transparency with the investors will make them manageable.
Partner, DSW Ventures