It is common for every investor to be concerned about the level of risk associated with the investment to be made in any company, despite conducting due diligence before deciding on the investment. One way of protecting investor interest is by signing a “term sheet” with the promoters of the company.
A term sheet is one of the basic documents that lists out the nature and scope of various rights, preferences and privileges that will be granted to the investors. This term sheet is derived after thorough analysis of financial and structural factors with respect to risk, reward and control and key relationship between the investors, promoters and the company. One such right demanded for by an investor in the term sheet is affirmative rights.
In simple words, affirmative rights are nothing but protective rights or veto rights granted to investors on certain matters pertaining to the company. Such rights create an obligation on part on the promoters and company to seek prior approval from the investors before taking decisions on matters covered under affirmative rights granted to the investors. Such rights are considered to be the most burdensome by promoters and hence are the most negotiated terms in the any agreement. This is perhaps considered so because these may be negative covenants that govern and restrict the working of the company.
Affirmative rights are generally demanded by the investors over matters that affect the investor’s interest in the company and may include any of the following:
- Any change in the share capital structure of the company;
- Any change in the charter documents of the company;
- Any appointment or removal of key personnel;
- Anything with respect to issuance of capital;
- Any matter with respect to dilution of shares;
- Any matter with respect to suspension of business activities;
- Appointment or removal of auditors;
- Issuance of debt in excess of a pre-agreed amount;
While the above mentioned are matters that concern material aspects that may affect the core working of the company, certain investors may demand for affirmative rights over issues concerning the day to day working of the company as well.
It becomes essential for every promoter to ensure during negotiations that every instance listed in the affirmative rights do not prohibit the company from carrying out those activities but merely require the promoters to seek approval of the investors to carry out those activities.
There may be circumstances where investors wish to interfere and demand affirmative rights over matters concerning day to day affairs of the company. Such demands must not be acceded to by the promoters of the company. Promoters must ensure that the list of affirmative rights over matters do not contain any negative covenant concerning the day to day working of the company.
One must understand that by providing affirmative rights to investors, one does not provide the control of the company as defined under law. SEBI Takeover Code defines “control to include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.”
The SEBI Appellate Tribunal in the case of Shubkam Ventures ruled that, if an investor is a mere financial investor, then providing of affirmative rights to such investors does not essentially mean that such an investor is being vested with the control over the company.
One may wonder if investors must be granted the affirmative rights. As a general practice, all investors or shareholders for that matter are concerned about their interests in the company. As a result, they require some assurance from the promoters to safeguard their interests. Affirmative right is one such way of safeguarding their interests/ investment in the company.
If the promoters deny providing affirmative rights thinking granting of such rights might result in restriction on the working of the company, then the same will become a deal breaker and no investor will be willing to invest in the company.
One may wonder if there is any way to limit the affirmative rights granted to the investor. One way of limiting affirmative rights is by capping it with the percentage of shares held by the investor. For example, if investor A holds 10 percent shares in a company and demands affirmative rights over certain matters of the company, it may be acceptable to grant him affirmative rights over such matters when he holds 10 percent of the company shares. Let us assume that, at a future date, the company issues further shares and as a result of pro-rata dilution, the shareholding of the investor A drops to 4 percent. The question is, should he still be entitled or granted veto powers over matters? Promoters must aim to negotiate an agreement wherein affirmative rights are capped based on the shareholding of the investor in the company. This will allow them to maintain control/independence over the functioning of the company.
What one needs to realize is that, a term sheet is the first basic document signed by the promoters and investors that defines the relationship between the parties. A term sheet may contain many clauses which may prove to be adverse to the interests of the company and its promoters. While promoters may assume to have understood all clauses contained in the term sheet, a professional eye will always make a difference and may protect the promoters in matters unknown to the promoters. One may be confident about his understanding of the term sheet, but it is always advisable to get professional help just to get that extra edge.