editione1.1.4
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Definition An indemnification provision in a term sheet is a commitment by the company to defend and compensate board members in the event of litigation and/or settlement relating to the venture capital financing or the directors work on the company’s board. Indemnification provisions may also include a requirement that the company provide insurance for its directors to cover these costs.
danger Founders and investors should be aware that many states’ corporate laws do not allow companies to indemnify their directors for intentional misconduct. This can include acting in bad faith, acting in a manner that cannot reasonably be considered to be in the company’s best interest, and acting unlawfully while knowing their conduct was unlawful.* Venture capital firms and the board members they designate may be particularly vulnerable to claims that they have a conflict of interest with holders of common stock because of their own interests as holders of preferred stock, and companies generally cannot indemnify board members for this type of misconduct.*
Definition An IPO participation rights (or initial public offering shares purchase) provision in a term sheet specifies a minimum percentage of shares that the investor may have the option to purchase in the event of an IPO. Some term sheets state that the investor must have this option if the company IPOs, while others simply require the company to do everything in its power to provide the option.*
danger Investors may like to see an IPO participation rights clause in a term sheet because it signals the company is headed toward an IPO,* but this clause can cause trouble with the SEC if the participation rights are granted too close in time to the IPO. Before a public offering, a company’s shares are not registered with the SEC and Section 5 of the Securities Act of 1933, as amended, prohibits selling or offering to sell unregistered securities unless an exemption applies. To stay on the right side of the SEC, founders and investors may consider including language that grants IPO participation rights only “if permissible under the securities laws.”*
important If a term sheet is going to include an IPO participation rights provision, founders should generally prefer the “best efforts” provision that stops short of mandating that the investors must have the option to purchase the specified percentage of shares. This is because a company works with other entities, such as investment banks, when preparing an IPO, and the company does not have complete control over how shares will be distributed.*