During the financing stage, companies look to negotiate with investors. These control terms are often part of the negotiating process, helping to detail what the company will offer and get in return. There are many common control terms sought by financing partners. The control terms on term sheets outline how the company and investors will act to protect the venture investment and all respective interests. Agreeing on any contract requires a full understanding of these terms and their meanings. When you need more clarification, and to ensure your legal and financial rights remain protected, contact an experienced business attorney at Polymath Legal PC by calling (833) 931-6418 today.
Finding Financing Partners
While most startups, companies, and other ventures may look to a bank for financing, some seek out financing partners. With a strategic partner, a company can fund its growth in exchange for access to its products, staff members, distribution rights, and sales. Funding partners act similarly to venture capitalists, with the partner getting a portion of the profits or other benefits. Financing partners allow companies to find someone in the same industry who has an interest in the business. Finding a compatible fit can be challenging and knowing the control terms sought by financing partners is essential to ensure that legal rights are protected. Working with a non-traditional lender has many benefits, including:
- Providing infrastructure help for marketing, IT, finance, and human resources teams
- Offering market credibility by working with an established financing partner in the industry
- Giving overall business guidance with their invaluable viewpoints and advice
- Having a hands-off partnership that allows the company to focus on their day-to-day operations
Common Control Terms in Financing
Companies must learn and understand common control terms to attract the right type of financing partner. First, it is important to understand the two most important terms: economics and control.
Economic provision terms dictate what the company and the financial partner will receive in a merger, sale, or another event. Control provisions allow financial partners to control the business or veto any of its decisions. By understanding control terms, the company can come to the negotiation table with a financial partner and know how these provisions will impact governance policies.
Other common control terms can include the following:
Board of Directors
Oftentimes, the terms will include reference to the board of directors. These individuals set the policies, make major decisions, and structure transactions. Companies and financial partners must agree on how the board will function by detailing all the operating procedures in the term sheet. Typically, a board has three to five seats and are occupied by the founders, CEOs, investors, and other parties. Many financing partners want to maintain a board seat to have an option on company decisions.
Deposit Control Agreement
A deposit control agreement is a binding agreement that requires the financial partner and the company to maintain a deposit account that complies with the agreed-upon terms regarding depositing funds. This deposit control agreement allows the direction of funds without the continued consent of the debtor under Uniform Commercial Code § 9-104. A deposit control agreement allows the financial partner to control the deposit account, providing them with a secured interest in the company.
Protective Provisions
Protective provisions allow financial partners the right to veto or block specific actions. Many investors require these provisions. There are many types of protective provisions, including the ability to change the size of the board of directors, block the company’s sale, or renegotiate stock terms.
Companies should understand all of these terms, especially a protective provision. Without a thorough understanding, the company might lose control of its interests. Talking to a California business law attorney at Polymath Legal PC may help clarify any confusion you may have.
Negative Covenants
Negative covenants provide specific restrictions on the loan agreement with the financing partner. These covenants help establish business operation agreements, allow for a continued assessment of creditworthiness, ensure the borrower can pay back the loan, and identify issues that could lead to a default.
Drag-Along Agreement
Drag-along agreements outline the threshold of shareholder votes required to create a company action. As a result, the minority shareholders could be “dragged along” to participate in these actions. There are two types of drag-along agreements. The first type prevents minority shareholders from obstructing the liquidation or sale of the company. Usually, when a shareholder’s vote on a liquidation or sale meets the required percentage, those reluctant shareholders must agree to the sale or liquidation.
The second type is a more recent occurrence. When a founder leaves the company, the stock will be “dragged along,” forcing a shareholder vote. The agreement prevents former founders from disrupting the voting in the company.
Duty To Act in the Ordinary Course of Business
Another common control term is the limiting and narrowly created phrase “duty to act in the ordinary course of business.” With the incorporation of that term, the agreement prohibits certain actions of the borrowers. This restrictive phrase allows the debtor to operate their business, but not in a way that exposes the financial partner to undue risk of loss. There is much subjectivity included in these types of terms.
Conversion Rights
Financial partners are issued shares of preferred stock, not common ones. That preferred stock will have many preferences, including the right and ability to convert those shares from preferred stock to common stock.
Typically, there are two types of conversion rights. The first one includes optional conversion that gives the preferred shareholder the right to convert their preferred stock shares into common ones at any time. Often, this type of right is executed on a one-on-one basis. The second form is an automatic conversion, also known as mandatory conversion. Preferred shareholders must convert their shares into common stock during an initial public offering.
Contact an Experienced California Business Law Attorney Today to Learn More
By understanding these common control terms sought by financial partners, you can make better legal and financial decisions for your company. These control terms help borrowers to find investors in the business without violating any contractual agreements. These terms are complex and come with many challenging complications. When you reach out to an experienced and dedicated business attorney at Polymath Legal PC you can get answers to your questions and better understand these terms as it relates to your specific situation. Schedule a consultation by calling (833) 931-6418.