In this ‘Tricky Clauses’ guide we’re looking at how warranty disclosure works in financing transactions. If you are a founder looking to raise capital for your startup, it’s important to understand what disclosures are, and what information you need to share with your investors. Here’s what you need to know with some tips for founders.
what are disclosures and why are they important?
When a startup is raising capital, it will most likely sign a share subscription agreement. That agreement will contain warranties – statements about the company and its business as at the time of closing. These may be absolute statements relating to issues such as IP ownership, no outstanding claims and compliance with laws. Or they might specifically require further disclosure of information to investors.
If there are exceptions to any warranty, the company should make disclosures to investors to avoid a breach of warranty after the deal has closed.
why is disclosure important?
Disclosure, or disclosing exceptions to the warranties, protects the startup and the founders.
If a founder or its company is in breach of warranty, they may have to pay some money back to investors to settle the claim. But if investors are notified of an issue before closing the deal, they cannot then bring a claim for a breach of warranty after completion.
Warranties are usually qualified by information that is fully and fairly disclosed to investors. By fully and fairly, we really mean disclosed in sufficient detail that investors can clearly understand the issue.
In short, if you know about something, tell the investors before you sign the deal in as much detail as you can. This decreases the chance of facing claims.
types of disclosure to investors
Disclosures are either general or specific disclosures.
Examples of general disclosures include references to the statutory books or accounts of the company, to publicly available searches and to the online data room.
Specific disclosures are facts that, if not disclosed, could result in a breach of warranty, for example, a pending claim that you know about, or where you are aware that a third party is about to terminate a material contract.
how to manage the process
Disclosure is usually made in a schedule to the subscription agreement, or in a separate disclosure letter (download our template disclosure letter). Founders and any key management should review each warranty carefully and consider whether they are aware of issues to disclose.
A list should be compiled cross-referencing to the relevant warranty. If there are underlying documents in the online dataroom which support the disclosures, mention these too. Make sure that all due diligence documents sent over to investors are uploaded to the dataroom.
don’t leave disclosure until the last minute
Whilst disclosure provides significant protection for the company and founders, it is often left until just before closing. Get on top of the process early and send the draft disclosure schedule or letter to investors as soon as you can. If key issues come up late in the day that were not even referenced in the data room, investors may be spooked by this. Investors may also ask questions about the disclosures or request to see underlying documents. Leaving all this until the last minute can slow down the closing process.
is the whole data room considered to be generally disclosed?
This can be a contentious issue. During due diligence, you might provide hundreds of files to investors. However, due diligence is not the same as disclosure. Don’t assume that all of the data room documents are automatically deemed as disclosed. It depends on what the transaction documentation says.
We recommend that the disclosure letter or schedule formally records that the documents contained in the dataroom are deemed as generally disclosed. Otherwise, only issues specifically disclosed (and referenced documents relating to such issues) will count as exceptions to the warranties.
*Note: There is an increasing trend for VCs in Southeast Asia to reject the general disclosure of data room documents. If this becomes the norm, this could have significant implications for financing transactions, including the time and cost that startups spend on the process. We will drill on this in a future blog.
- include a provision which states that disclosures are applicable to all warranties, not just those warranties against which the disclosure was recorded
- avoid disclosures that do not refer to facts – it is likely investors will reject them as irrelevant
If you have a question about what should be disclosed or not, contact one of our corporate lawyers. We know the process inside and out and can steer you in the right direction.