Founder indemnities balance risk against investor comfort

By Sindhu Nayak, Bharucha & Partners

Indemnities from founders of investee companies have always been heavily negotiated at the time of venture capital investments. With venture capital investments becoming increasingly common, the framework for the indemnities that investors expect from founders is reasonably well defined. However, there is always scope for negotiation between any group of investors and the founders of companies in which the group is considering investing.

Sindhu Nayak
Bharucha & Partners

Indemnity clauses must be carefully negotiated and drafted, as founders are liable in their personal capacities. To the extent that founders are providing indemnities, they should ringfence their assets from the obligations they will owe to investors.

Where investors insist on indemnities from founders, it is common for founders to restrict their liability to situations in which the company’s funds are inadequate to meet its indemnification obligations. The founders will then only be liable for the difference between the amounts claimed and those the company is able to pay. Founders may also negotiate to limit their liability for indemnity claims to the value of their shares in the investee company. This is usually the fair market value as determined at the time of the claim. Founders can then arrange funds equivalent to the value of their shares to satisfy the claim. Tying the founders’ liability to the value of their shares could, however, be problematic for investors if a lengthy period elapses between invocation of the indemnity and satisfaction of the claim by the founder. In these circumstances, the value of the shares may have depreciated significantly.

If a founder has to sell their shares in the investee company in order to meet indemnity obligations, this could result in the triggering of other provisions in the investment agreements. Founder shares are subject to a number of transfer restrictions and where the founders propose selling shares to satisfy an indemnity claim, the investor’s tag along right is likely to crystalise.

Other monetary limitations that a founder would typically negotiate are de-minimis, that is the minimum value of an individual claim, and basket, that is the minimum aggregate value of claims, thresholds. The investor will be prohibited from making a claim unless both the de minimis and basket thresholds have been met.

These monetary limitations on liability, whether for founders or the target company, do not apply to fundamental representations and warranties; matters of fraud, misconduct, or gross negligence. In certain instances, these limitations also will not apply to specific indemnities. Liability for these matters is either uncapped or subject to a specific monetary amount that is separate from or outside the ordinary cap of the fair value of shares.

In addition to being liable to indemnify the investors for the acts and omissions of the company, founders are jointly and severally liable for any acts and omissions of the other founders. The monetary limitation on the liability of the founders is usually the aggregate value of the shares held by all the founders in the company, rather than each founder’s liability being limited to their individual shareholding. This means that if an indemnity claim arises because of a failure by one founder, the other founders will be liable for such failure and the aggregate value of the shares collectively held by them in the company will operate as a cap. This position is exacerbated by the fact that extenuating circumstances such as fraud and gross negligence are not capped, and each founder will therefore be jointly liable for the acts of the other founders.

It is imperative that venture capital investors protect their interests, and founders’ indemnification obligations will continue to be a condition for investment. However, investors and founders alike must recognise that, unlike a case of acquisition or disposal, their relationship will continue after the investment is made. Both parties should therefore approach negotiations intending to create a symbiotic relationship post-investment. While founders must accept some level of risk when entering into indemnities, venture capital investors should not impose onerous indemnification obligations on founders. This gives founders adequate flexibility and offers them incentives to work towards the growth of the investee company.

Sindhu Nayak is a partner at Bharucha & Partners

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