Founders’ liability when raising capital – representations and warranties
Article by Peeter Aleksander Paju, junior lawyer at TRINITI, edited by attorney-at-law Valter Võhma
Intro
Founders face numerous challenges when raising capital, one of which is taking responsibility towards the investors. What exactly are those responsibilities? What happens if things do not go the way as promised to the investors? Are founders liable if the company fails to achieve the goals set during fundraising? In this article the authors will dig into the provisions regulating representations and warranties in investment agreements and comment on the liability associated with it. This will be the first article in the series dedicated to founders’ liability.
What are representations and warranties?
In short, representations and warranties are confirmations given by the company and the founders related to a fact about the company, its business activities and/or the founders. For example, the company stating that it has all the rights to the intellectual property it is developing, it is not in breach of any material agreements, etc. Their main role in investment deals is to provide transparency and protection to the investors, with the logic being that the investors are making their investment based on these confirmations (and expect them to be correct). The content and detail level of the representations and warranties list varies from deal to deal. As a rule, the bigger the investment, the more detailed the list required by the investors. Regardless of the detail level, the general framework of the list in tech sector deals is quite similar.
If all representations and warranties are correct, then the company and the founders have nothing to worry about. However, what happens if a warranty is breached? In case of breach of warranties, the liability of the company and the founders may arise for the damages caused related to such breach. Considering this, the founders should take extra care when reviewing the representations and warranties list and the sections of the investment agreement regulating their liability related thereto.
Founders’ liability incurs if there is a breach of one or more warranties set out in the investment agreement. This usually results in the investor being in a worse position compared to what he/she would have been, had the representation been correct. Therefore, the liability of the founders for breach of warranties generally serves the purpose of putting the investor (or the company) in the position that he/she would have been had the breach not occurred.
In case the company and founders discover that one or more representations and warranties which the investor requires is not true, it is possible for the company and founders to make disclosures against such matters prior to signing the investment agreement. Usually, the investment agreement includes a disclosure letter meant for listing all such items which indicate deficiencies in respect any specific matter provided in the representations and warranties list. Indicating any such deficiencies prior to signing the deal helps, as a rule, avoids the liability.
In this article, we will give an overview on the liability regulations related to representations and warranties found in investment agreement templates most commonly used in Estonia, Latvia, Lithuania, Finland, Sweden, UK, Germany and Switzerland.
Estonia
The Startup Estonia investment agreement template (https://startupestonia.ee/resources) is probably one of the most common investment agreement templates used in Estonia for pre-seed, seed and A round startup and venture capital investments. It includes a quite extensive representations and warranties list covering all material items necessary to be covered when investing into a tech startup. This means that the founders should thoroughly review the list before signing in order to make sure that they are not giving any misrepresentations, which might trigger liability.
The general compensation mechanism in the template foresees that in case of a breach of representations and warranties, either the warrantors (founders) pay the company (the startup into which the investment was made by the investor) compensation in the amount necessary to put the company in a position in which it would have been in case the breach of warranty had not occurred or pay the investor compensation in the amount necessary to put the investor in a position in which it would have been in case the breach of warranty had not occurred. Basically, the template’s general logic is to put the investor, either directly or indirectly, into the same position it had been, had the breach not occurred.
For the protection of the founders, the template also includes mechanisms to limit the liability connected with representations and warranties. The best way to avoid any liability is to disclose any deficiencies known to the founders (in respect any matter listed in the representations and warranties list) The precise amounts are negotiated between founders and investors and thereafter included in the template. According to Valter Võhma, associate partner and attorney-at-law at TRINITI (Estonia): the liability provisions in pre-seed, seed and A rounds in Estonia in most cases follow the principles provided in the Startup Estonia investment agreement template. As always, the exact sums, percentages and fine tuning differs from deal to deal and depends on the circumstances. In most cases, the maximum liability of a founder does not exceed 7,5%-15% of the investment amount and the basket usually is set between 1%-2,5% of the investment amount. In later stage deals sometimes more detailed regulations are provided for liability but the general logic is more or less similar across the board.
Latvia
According to Zane Bormane, partner at TRINTI (Latvia), in practice you can limit the founder’s liability only in the contract between the founder(s) and potential investor(s), which is subject to negotiations. Therefore, model documents or template from a friend won’t solve the issue if you want to limit your, the founder’s, liability.
Lithuania
The Startup Lithuania model share subscription agreement (https://www.startuplithuania.com/legal-documents/) does not regulate founders’ liability and is very minimalistic (compared to, for example, the Startup Estonia model investment agreement). According to Giedre Ciuladiene, partner at TRINTI JUREX (Lithuania), several years ago, there was a more founder-friendly attitude from the investment funds regarding the liability of the founders under VC investment agreements. However, recently the tendency has been to expand the liability of founders, which, arguably, shows deviation from the nature of venture capital. Lately investors seldom agree to limit founders’ liability for representations and warranties, which may result in the lack of initiative in business. Hence, we would encourage the parties to seek a more balanced approach.
Finland
In the Startup Tools FI model subscription agreement (https://www.seriesseed.fi/), the founder’s aggregate liability in case of breach of representations and warranties is limited on a pro rata basis to 30% of the aggregate subscription price paid by the investor, subject to liability basket of EUR 20,000 and the claim will not be subject to liability basket if the loss does not exceed a certain amount (de minimis), in this case de minimis is at EUR 5000. In addition, liability of a founder shall in no event exceed the value of such founder’s shares at the time the claim is settled, unless the claim is based on circumstances which have been misstated or omitted by a founder intentionally or through gross negligence. Furthermore, no liability of a founder in respect of any breach of a warranty shall arise for any loss due (to a breach of a warranty), if the loss is attributable to conditions which the investor should have had knowledge of, provided that the information about the relevant conditions had been presented in reasonable detail in the subscription agreement or in disclosure letter issued by the founders and the company to the investors.
According to Jaakko Lindgren, partner at Dottir Attorneys Ltd: “In most cases every investment round differs from one another. This means that the founders’ liability always depends on the negotiations of the parties involved in the process, as well as on the general nature and size of the investment round itself. For instance, the wording set out in the Finnish Startup Tools FI model subscription agreement may work in smaller investment rounds (pre-seed/seed). However, the wording may not work in larger investment rounds (series A ->), where the investment amounts are higher. The same rule applies when negotiating not only the founders’ liability, but the investment documentation as a whole: it is in the best interest of all parties to come up with solutions that strengthen the company by creating clear and genuine paths going forward.”
Sweden
In the Startup Tools SWE model subscription agreement (https://startuptools.org/se/), as a default setting, the liability of the founders for breaching representations and/or warranties is set to 100% of the investment amount, subject to liability basket of SEK 200,000 (please see the explanation on the liability basket under subsection Estonia) and de minimis of SEK 50,000 (please see the explanation on the de minimis under subsection Finland). In addition, it is stated that a founder’s liability shall in no event exceed the value of such founder’s shares (in the company) at the time the claim (arising out of breach of a warranty) is settled, unless the relevant claim is based on the circumstances which have been misstated or omitted by a founder intentionally or through gross negligence. The founders’ liability is exclusively limited to liability for breach of the warranties and no other liability under any other agreement or statute. The founders will bear no liability for any loss, if the loss is attributable to conditions which the investors should have had knowledge of.
Great Britain
The British Private Equity and Venture Capital Association (BVCA) has set out in its model early-stage investment agreement (https://www.bvca.co.uk/Policy/Industry-guidance-standardised-documents/ Model-documents-for-early-stage-investments) financial limitations on a founder’s liability for warranty claims (together with the proper and reasonable costs of recovery), subject to liability basket and de minimis (excluding interests, costs and expenses) as a fixed amount which the parties can agree upon. In addition, the founder has an option to settle the liability, in whole or in part, in shares held by the founder, by transferring the relevant amount of the shares to the investor, who made the claim. No liability of the founders in respect of any breach of warranty shall arise, if such breach occurs by reason of any matter which would not have arisen but for the coming into force of new legislation, to the extent that specific reserve has been made, or to the extent that claim arises as a result of any change in the accounting bases in accordance with which the company values its assets.
According to Jon Snade, partner at Browne Jacobson LLP in London: “In practice the liability for a founder under the warranties would be limited to an amount equal to 1 x the founder’s annual salary. That is typically viewed in the market as being an amount sufficient to focus a founder’s mind when considering the warranties and to incentivize the founder to make full disclosures against the warranties in the disclosure letter or schedule. Anything greater than this would usually be considered a fairly aggressive position. It would be quite rare in the UK for a founder to be able to satisfy a warranty claim through the transfer of their shares to an investor. This is due to issues which would then arise, such as the need to value the founder’s shares in those circumstances; negotiations on whether the founder’s ordinary shares should convert automatically to the class held by the investors (with the various consequences that may have on decision making, voting and shareholder economics, etc.); and the general preference of investors to receive cash in the event of a warranty claim (rather than illiquid shares in the company). For these reasons the optional wording included in the BVCA template for satisfying warranty claims in shares of a founder is not often included. Finally, it is also important to remember that (i) the financial limitations only apply to warranty claims (and not other claims an investor may have against a founder – e.g. breach of restrictive covenants or of a positive contractual obligation imposed on the founder); and (ii) that it would be a standard position for no financial limitation (or other limitations – such as time periods, etc.) to apply to a founder for warranty claims in the event of the founder’s fraud or dishonesty.“
Germany
The model investment agreements in use in Germany (https://standardsinstitute.de/finanzierungsrunde/) limit the liability of the guarantor (a person who gives representations and warranties to the investor) to the nominal value and the premium paid by the investors to the company, basically this means that the liability of the guarantors is limited to the amount invested by the investors. However, the investment agreement states that the liability of a single founder may not exceed a certain amount (liability cap) and liability arises if the claim exceeds the certain amount (de minimis) for one or more claims (liability basket). Losses more than the founder’s liability limit must be remedied by increasing the share capital resolved by all shareholders. In such case only the investors shall be admitted to subscribe new shares for their nominal amount to such an extent that they are placed in a position as if they had invested on agreed pre-money valuation minus the exceeding damage amount. The founders are liable for the amount to cure the breach, including consequential damages. However, all other statutory claims, i.e damages, reduction of price, or breach of contract, are excluded.
According to Dr. Christian Rodorff, partner at Lupp + Partner (Munich): “In most cases the liability of the guarantors consists of a joint and several liability of the target company and the founders, whereby the personal liability of the founders is limited (capped) to an amount equal to the sum of 1 to 2 years’ gross salaries. In case of a breach the founders are sometimes allowed to transfer all or part of their own shares to the investor(s) instead of payment of a cash compensation. The limitation period is normally 1 to 2 years for guarantees for business operations and 5 years for title guarantees. These rather founder-friendly practices, however, are currently changing due to the economic circumstances (Ukraine war, supply chain problems, inflation). In the months ahead we will presumably see a revival of more investor-friendly terms.”
Switzerland
The Swiss Private Equity & Corporate Finance Association (SECA) has produced two sets of model documents – one for late-stage startups and one for early-stage startups (https://www.seca.ch/Templates/ Templates/VC-Model-Documentation.aspx) For founders of early-stage startups, the model investment agreement states that the amount of liability, for breach of representations and warranties, shall be the sum of the damaged investor’s investment plus reasonable costs incurred in connection with misrepresentation. In addition, the liability for a breach of a warranty is excluded or reduced if the investor has failed to use reasonable efforts to mitigate its loss, the investor has actually recovered from any third person any sum in respect to which the claim was made, a specific provision or reserve has been made resulting in a misrepresentation of breach of warranty, or the claim arises as a result of any legislation which was not in force at the date of signing the investment agreement. To summarize, the liability cap of the founder is the investment amount invested plus reasonable costs related to the breach of representations and warranties. If the loss of the investor related to the misrepresentation is recovered or the representation becomes false after the signing of the investment agreement, then these are basis for reducing the liability cap of the founder.
For late-stage startups, the model investment agreement states that the liability cap for founders is equal to the sum of a percentage of the investment of a particular investor and reasonable costs incurred in connection with the misrepresentation. The liability for a breach of a warranty is excluded or reduced on the same basis as in case for the early-stage startups (as described in the section above). In addition, the liability is excluded or reduced if the liability is attributable to any act of the investors and any tax payable by the company is reduced as a result of a matter giving rise to a claim for breach of warranty. With this template the remedies under the statutory law are excluded and waived, i.e the liability mechanism under the template is exclusive for compensating the loss caused by breach of warranty. To summarize, the founder is liable for damages caused by misrepresentation and breach of warranties in an amount of a certain percentage and reasonable costs related to such misrepresentation. However it is good to look out for the basis for the reducing of liability of the founder.
Conclusion
In conclusion the liability of the founders for breach of representations and warranties varies from country to country, but is usually related to founders salaries or a percentage of the amounts invested by investors or a particular investor. Also, it is customary to limit the liability (for warranty breaches) with a “basket” (meaning that the liability only incurs if the aggregate loss exceeds a certain amount) and de minimis (meaning that the claim will be a subject for a liability basket if the loss exceeds this amount). In addition, the model documents in few of the countries (reviewed) foresee an option for the founders to compensate the damage with shares instead of money. Even though it is in the templates, in practice it is not usually accepted by the investors.
As a general rule, in almost all countries reviewed, liability of the founders is not limited in case of knowingly giving misrepresentations and intentional breaches. In these cases, there are no basis for reducing the liability of the founder. Therefor the founder who misrepresented or breached warranties, has no other choice to compensate the loss related to such misrepresentation or breach of warranties.
Overall, if the founder gives correct representations and warranties or discloses the deficiencies in the disclosure letter, then there will be no reason for the liability to occur. Therefore the founders should put extra care into reading the clauses about representation and warranties and making sure that the company’s situation is really like represented and warranted.
* TRINITI startup and venture capital journal is a digital journal created to give an overview on topics, including legal topics, relevant to the startup and venture capital sector. The executive editor of the journal is Valter Võhma, attorney-at-law at TRINITI. TRINITI is a pan-Baltic law firm and your trusted guide in the startup and venture capital world on legal matters.
