Following completion of the due diligence stage of an early-stage investment transaction, what follows will be the final and most important stage in terms of company and founder protection: disclosure.
In this article, the third in a series focused on the key considerations for the founders of a company during the course of an early-stage investment transaction, we offer some tips for founders navigating the disclosure phase of the deal.
What is disclosure?
Disclosure is the process by which the warrantors (i.e. certain specified persons, usually the founders and/or the company, but sometimes the existing shareholders where they are selling shares as part of a secondary round) will be given the opportunity to disclose any details as to why certain statements of fact (warranties) contained in the relevant or investment/subscription agreement or share purchase agreement (where there is a secondary) and otherwise purported to be given by the warrantors, are untrue.
The warranties will usually be included within a separate schedule to the investment/subscription agreement, and their specific detail (and number) will be a matter for negotiation throughout the data room and due diligence stage.
Depending on the scale of the transaction (except for the case of any simple investments), the number of warranties is likely to be quite high, covering matters such as the company’s corporate standing, general compliance history, data protection policies, ownership of assets, intellectual property, real estate and details of employees or contractors.
Why is the disclosure letter important?
If any of the warranties later turned out to be untrue, then the investor(s) would theoretically be entitled to bring a breach of warranty claim against the warrantors.
Whilst such claims are rare in practice, given the presence of limitations in the relevant investment/subscription agreement (including time limits, caps and financial thresholds, all subject to negotiation), as well as the hesitation for an investor to sue a company whose success they are betting on in the future, an investor will not be able to bring a warranty claim if the warrantors have first provided sufficient details of any matters contradicting the warranties (i.e., a disclosure) within a disclosure letter, delivered in accordance with the transaction.
The disclosure letter therefore provides both an opportunity for the warrantors to shield themselves from a potential breach of warranty claim and reassurance for the investor(s), confirming its understanding of the company and its affairs to be correct, with the warrantors willing to ‘stand behind’ the promises made.
What does the disclosure process involve?
This will usually take the form of a long call (a disclosure call) between a representative for the warrantors (often, the company’s management team), and the company’s legal advisors. The aim of this call (or series of calls) will be to go through the warranties schedule together and in detail, with the aim of discussing any potential disclosures against the warranties.
What else should I consider?
Depending on the size of the business and level of the warranties, input may be needed from different stakeholders in the company, ranging from the HR and IT departments to any data protection officer (if appointed). Founders should ensure that representatives from these teams are readily available. Similarly, legal advisors may also co-ordinate across teams for any specialist warranties.
Even if the investor was previously made aware of facts contradicting a warranty (perhaps in the course of commercial discussions or the due diligence stage), details should once again be provided wherever possible in the disclosure letter.
How much detail is needed for a disclosure?
The first reference point should be the investment/subscription agreement, as this is likely to contain a definition for ‘Disclosed’, setting out the detail required for a disclosure to be accepted (otherwise known as the ‘disclosure standard’).
The disclosure standard is therefore a point for negotiation between both the investor(s) and the company, but if the deal is particularly investor friendly, expect that for a disclosure to be valid, any disclosures made against the warranties should be made fully, fairly and accurately, allowing an investor to identify the nature and scope of any matter disclosed.
Will there be "general disclosure"?
Any statements in the disclosure letter which do not provide enough detail and consequently fall short of the standard of disclosure discussed above risk leaving the warrantors open to a breach of warranty claim.
Accordingly, disclosures must include references to supporting documents. In the majority of cases, individuals are able to provide cross-references in your disclosure letter to the disclosure bundle, formed of documents from the virtual data room that are being specifically referenced in a disclosure.
If the contents of the disclosure bundle are generally being disclosed to the investor(s), this would mean that the warrantors could rely on any of those documents in rebutting a potential breach of warranty claim, on the basis that the documents were generally disclosed to the investor(s).
Whilst general disclosure of the data room is very unlikely to be accepted general disclosure of the disclosure bundle is increasingly being recognised as market standard in the early-stage investment context. Therefore, a thorough disclosure exercise, with the help of a legal team, will be in both parties’ interests, ensuring a smooth and positive outcome for all.