The Term Sheet: Co-Sale and No-Shop Agreements
3 Things to Know about the Co-Sale and No-Shop Clauses
No contract can eliminate the risks of venture capital investment, but the right clauses can at least create a level playing field and avoid unnecessary risks. A no-shop agreement will stop company founders from looking for other investors for a specified amount of time, while a co-sale clause guarantees venture capitalists a chance to sell their shares in a company if the founders sell their own. The country's top venture capital firms never sign a contract without these clauses in order to:
1. Allow for Due Diligence
One of the greatest paradoxes of the venture capital industry involves due diligence. Venture capital firms perform due diligence in order to assess the risks of investing in each potential company. A thorough due diligence process lets them make sure they are putting their money in a safe place, and not exposing funds to unwarranted dangers. This act of risk assessment, however, creates new risks of its own, namely the danger that the founders will look for other investors and end up taking their business elsewhere. Venture capital firms are thus forced to choose between a rushed due diligence process, which may cause them to overlook serious problems, and losing the investment opportunity entirely.
With a no-shop agreement, however, this paradox does not arise. Venture capital firms can negotiate as much time as they want to perform due diligence, secure that the company's founders will not go looking for a new investor during the process. The founders may demand a short no-shop period, but this is evidence that they have something to hide, indicating that the investment is a significant risk. The combination of a no-shop agreement and VC firms thus ensures safer, better investments.
2. Respond to Changes in Ownership
Even the best due diligence process can't protect venture capitalists from future changes in the company they're investing in. After the deal is finalized, the founders may later decide to sell their remaining shares to another investor, and that investor may institute company policy changes that create new risks. The venture capitalists may decide that these changes are unwise and want to get out of their investment. Unless they can quickly find someone to buy their shares at a good price, however, they may be forced to stay with a potentially sinking ship.
Co-sale clauses are designed to give venture capital firms a way out. If the company's founders decide to sell their shares, the venture capitalists must be able to take part in the sale in proportion to the number of shares they own. This makes it easier for them to quickly find a good price for their shares in the event of a change in ownership.
3. Make Time for Negotiation
When selling their company to a venture capital firm, founders will sometimes try to keep venture capitalists in the dark about their prospects for finding another investor. If the founder implies that other firms are keen to buy a piece of the business, venture capitalists will feel pressured to quickly come up with terms for their purchase. The term sheet they offer may later prove to be a bad deal, and a little more negotiation would have yielded a much better settlement, but they felt pressured to cut negotiation off early. In reality, the founders may have had no other prospects for selling the company, and were just bluffing their way into an unfair deal.
No-shop agreements eliminate the pressure to cut off negotiations prematurely. Venture capitalists know exactly how long they have before the founders can go to another company, and will thus refuse to end negotiations prior to that point unless they are offered terms they like. There is thus less incentive to bluff, encouraging an honest, fair discussion. Both parties will take the time they need to reach a mutually beneficial arrangement.
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