Indemnification rights in venture deals

While the venture market still seems flush with cash, a number of recent litigations involving venture firms (such as the Hummer Winblad case now in seemingly constant discussion) are driving the market to seek additional protections from their portfolio companies upon investment and afterwards.

In particular, some investors are now asking for indemnification from the company akin to the measures in an acquisition agreement. Companies looking to oppose these provisions should know that they are generally rare. While an indemnity is market where the deal presents some liquidity to the founders or other investors. this is not common in the venture context. The VC investors typically have board seats, observation and information rights and strong covenants, so they are in a position to see how the money is spent. If they don't have then, this presents a bargaining chip for the company in exchange for the indemnity being sought. They also have the right to sue the company for breach of the reps or fraud while there is still money to pay the claim. Unlike an M&A deal, venture round docs usually don't have exclusive remedy clauses.

A later stage financing certainly is more likely to give concern to the investor about the unknown that cannot adequately be tested through due diligence, but it would be unfair to shift that risk to the founders. If I am a VC asking for this provision and getting it regularly, I have to ask kind of company (and founder team) am I investing in if they will accept those terms. The
better the terms for the VC, the more apparently becomes the adverse selection problem.

One way to deal with the issue is to ask the investors their specific concerns. If there is a known problem, such as a litigation, a 409A problem, etc., that can be dealt with through traunches, escrow etc, without personally impinging on the Founders . The NVCA model docs address this issue parenthetically by having certain reps be made by the Founders, where the "Founder's liability for breaches of any provisions of this Section 3 shall be limited to the then current fair market value [as determined in good faith by the board of directors of the Company and such Founder [may, in his sole discretion, discharge such liability by the surrender of such shares or the payment of cash] (note FN1 and FN2 below from the docs). The NVCA docs are intended as a fair starting point for a Series A round, and they do not contemplate an indemnity. Finally, another approach may be to allow the indemnity, but to limit all recourse to the Founder's shares. The risk here, of course, is the precedent for the next round.


[1] Founders' representations are controversial and may elicit significant resistance. They are more common in the Northeast and counsel should be warned that they may not be well received elsewhere.
They are more likely to appear if Founders are receiving liquidity from the transaction or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution
or the Founder was formerly with another Company whose business could be deemed competitive with the Company). Founders' representations are not common in subsequent rounds, even in the Northeast, where risk is viewed as significantly diminished and fairly shared by the investors rather than being disproportionately borne by the Founders.

[2] Investors should consider whether cash is an acceptable remedy; the cash value of the shares is likely to be low, particularly if there has been a breach of a rep or warranty. In addition, if the Investors require the surrender of shares rather than cash, they should also consider whether to include Preferred Stock, as well, if the Founder owns shares of Preferred.