When investors make an investment in your company, it's on the basis of promises that you made to them. Some of those promises are already clear - e.g. you sent them a pitch deck describing your business, their expectation is that you're going to stay with that vision and not pivot into something completely different without talking to them first.
But besides the pitch deck and any business plan that you sent to your investors, there are a whole host of less apparent things that they're going to be assuming are the case. That includes things like:
- the company has no outstanding debt
- there is no litigation pending
- the company owns, or has a right to, all the IP that it's using
The investors are going to expect all these to be true, and if they're not they may want to make a claim to get their money back. For example, if an investor invests in your £200K seed round, only later to discover that the company has an outstanding loan to the founder for £200K and all the money is instantly gone and the company has no money to continue operating, well, they're going to want their money back because they were mis-sold on the company being a going concern.
So, the way this has evolved over thousands of funding rounds is a clever, though at first glance confusing, two-step dance routine, as follows:
- The Shareholders Agreement contains a long list of representations (the "Warranties") that the company makes, a greatly expanded set along the lines of the list above. The company and the founders are all warantying that every one of these representations are true. If any turn out not to be true, the investors can make a Warranties Claim against the company and the founders (they're usually limited to a filing a claim within 12 months from the funding round).
- Then - and here's where the clever but confusing bit comes in - it's totally okay that some of these warranties aren't true. For example, the company may indeed owe £5000 to the founders as repayment of a founder loan, even though the Warranties wording says it doesn't. And that's where the Disclosure Letter comes in.
The Disclosure Letter is the get-out-of-jail-free card. It's the place where you describe every Warranty that isn't true, or where more detail is needed.
For example, one of the Warranties is that "the Company owns all its IP". But, if like most companies you use open-source software or 3rd-party libraries, in the Disclosure Agreement you would disclose that. In most cases the disclosure wording for this example would be as simple a saying "We own all our IP, except for a range of open-source modules where the open-source license allows for redistribution without needing to open-source our own code". Then, the investors know about this and can ask more questions if it turns out to be potentially an issue that affects their decision to invest (in this open-source example, had it turned out that you had unwisely used a GPL-license software module, and now needed to open-source your entire codebase - potentially a disastrous thing to have done - this is where your investors would have the chance to be told about this, before they invest).
Unlike founding round term sheets and shareholders agreements which are fairly well standardised, when it comes to the Warranties there's no standard, investors can ask for you to make warranties on just about anything relevant to their investment decision. So, at SeedLegals we've gone ahead and create our standard in Warranties, which have now been successfully used, without change, across hundreds of funding rounds. They're designed for early-stage startups, usually tech companies, but they'll be just fine for food, fashion and other companies.
Carefully go through each of the Disclosure Letter questions on SeedLegals.
- If you agree with each statement and it's a true statement (e.g. "The company has no debt") just leave the answer blank, easy.
- If the answer isn't true, or if there's more info to add (e.g. "The company owes £50,000 to Jimmy's Mobile Apps") then list that in the answer box.
You'll be asked to sign this Disclosure Letter as well as the Shareholders Agreement
- Carefully check each of the statements made in Schedule 6: Warranties of the Shareholders Agreement.
- Then, take a look at the Disclosure letter to see if there's anything that adds to, or discloses more information about, each of those warranties.
- If all is good, sign both the Disclosure Letter and the Shareholders Agreement.