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Demystifying the warranty and disclosure process

Last updated
8th November 2020
Written by
Charles Frank

There is no hiding from it; the warranty and disclosure stage of your funding round can be challenging and time consuming. But it is a vital part of protecting a founder’s position and also ensuring that the investor relationship starts off on the right foot. This blog aims to demystify this part of your funding journey and explain how the FounderCatalyst platform helps and guides you through the process.

What is a warranty?

In short, a warranty is a contractual statement of fact made by you to every investor - it is a promise made by you, to them, that the facts and information you have provided about you and your business are true, complete and accurate. The warranties you give will cover those areas of your business that investors traditionally seek comfort on. Things like the accuracy of your historic financial information, contracts, employees, compliance with legal requirements, tax issues and any disputes that your business may have been involved with. Warranties serve two main purposes:

  1. they provide potential recourse to investors if a warranty you give is later found to be untrue; and
  2. as a result, they encourage you to fully disclose details of any potential warranty breach before the investment closes, to prevent investors from seeking recompense per paragraph 1 above.

The warranties that you give as part of your fundraising journey at FounderCatalyst are listed in schedule 4 (page 26) of your subscription and shareholders' agreement (SSA). You can find this document in your Intelligent Data Room “2. Investment Documentation” folder.

Your warranties in schedule 4 of your SSA covers areas like: 1. the thought you have put into your business plan; 2. the accuracy of your accounts; 3. payment of all necessary taxes; 4. awareness of any legal action against your company; 5. protection of your intellectual property; 6. sales contracts; and 7. any employment contracts.

If an investor discovers after the investment closes that a warranty provided by you is misleading or untrue, you (personally) may then be subject to a financial claim for a loss in value of the investor’s shareholding resulting from that breach. So, for example, if you have not disclosed a bad debt of, say, £20,000 despite you giving a warranty that there are no bad debts in your business, you may be liable to repay to the investor a proportion of that amount. The shares that he has just purchased in your company will be worth less, because the company will not have the benefit of that £20,000 receipt.

A key part of protecting yourself against claims for breach of warranty is your formal “disclosure” exercise.

What is “disclosure”

Disclosure works like this: using the bad debt warranty example above, if you know there is a bad (or even a possibly bad) debt, you have an opportunity to make that clear in a key document for any funding round – your “disclosure letter”. This letter is separate from the SSA, but works alongside it and the warranties you give.

The more information you disclose to investors in your disclosure letter, the less possibility there is that your investors will seek recompense for a warranty breach. A realistic goal for you should be to ensure that there are no warranty breaches at all. To achieve this, you must provide what is called “full disclosure” of all potentially relevant information.

The fuller and clearer your disclosure, the more likely you are to protect yourself against a warranty claim.

How does the FounderCatalyst platform help to protect me?

As you would expect from the FounderCatalyst platform, the warranty and disclosure process is made simple for you. During the “defining” stage of your FounderCatalyst journey, you can add “specific disclosures” into your disclosure letter against any of the warranties in schedule 4 of the SSA. You can enter as many specific disclosures as you need and, once completed, your disclosure letter will be produced and sent to your Intelligent Data Room “2. Investment Documentation” folder.

A tip here: before attempting to complete the specific disclosure section of the journey on our platform, download and read schedule 4 of the SSA (located in your Intelligent Data Room “Investment documentation” folder).

Should you need to add to or change your disclosures at any time, you can easily do this until the point that you “lock” your documents (at which point everything is agreed with your investors for the funding round) and the documents are ready to sign. Your disclosure letter is then electronically signed by you and any other “founders”, plus your company. It is then sent to your investors, who will counter-sign it to confirm receipt.

If you have uploaded supporting information to your Intelligent Data Room Disclosure Folder (see below), don’t forget to cross-reference it when completing the "specific disclosures" section. So, against the bad debt warranty example used above you could say something like: “There is a potential bad debt owing to the company by ABC Limited of £20,000. A copy of the related invoice and associated correspondence is included in our Disclosure Bundle.”

We cannot stress enough how important the disclosure process is. The more time and care you put into it, the more comfortable you should be that potential warranty claims by your investors have been neutralised. So, you need to download and spend time reading all the warranties written in schedule 4 of the SSA and, where necessary, enter specific disclosures against them on the FounderCatalyst platform and upload any supporting information.

...and “general disclosure”?

The standard disclosure letter produced by the FounderCatalyst platform allows you to capture specific, written disclosures (as described above) against as many warranties as necessary.

Also included in your disclosure letter is another standard element known as “general disclosure”. This covers several points that you can reasonably assume the investor has included in its due diligence process on your business. General disclosures on the FounderCatalyst platform include:

  1. certain information publicly available at Companies House; and
  2. all information you have uploaded to your FounderCatalyst “Intelligent Data Room”, excluding any items placed in the "Undisclosed Items" folder.

The intention of general disclosure (as opposed to specific disclosure) is that it discloses information that is either publicly available (e.g. at Companies House) or contained in the information you have uploaded to your Intelligent Data Room.

DO NOT rely upon general disclosure if a specific disclosure can also be made in relation to a risk area. By its nature, general disclosure can be viewed as not “full and fair”. General disclosure is still commonly used in fundraising transactions, which is why it’s on our platform. However, a full and fair specific disclosure (with cross-references to information in your Intelligent Data Room (see below)) is always the best solution. ALWAYS make a specific disclosure on any issues you are aware of.

Your Disclosure Folders

Within your Intelligent Data Room, there are two distinct folders to help you with your warranty and disclosure exercise.

Note: these folders are only shared with investors when you grant them, by invitation, enhanced access rights on our platform. This will be after they have signed the term sheet and committed to invest. Investors who have entry level access will not be able to view this folder.

1. Disclosed items

You should use this folder to upload any supporting information that you wish to share with, and disclose to, your investors. Where possible, cross reference anything you put in this folder into the specific disclosure section of your disclosure letter on the FounderCatalyst platform.

Examples of information you may include in this folder include anonymised employee and salary details, customer and supplier agreements and details of future plans.

2. Undisclosed items

This folder will only apply to information about you or your business that is not relevant to your formal disclosure process. Examples include previous versions of your business plan or out of date financial information. The role of this folder is as a depositary for old information that has been superseded, or become irrelevant.

A further example

If you've not been through a disclosure process before, here is another worked example to help: A market standard warranty contained in schedule 4 of your SSA is: "There are no circumstances known to any of the Warrantors likely to lead to any claim or legal action, proceeding or arbitration, prosecution, investigation or inquiry."

If this assertion is true, then you don't need to do anything. There is no disclosure to make, so you can move onto the next warranty.

However, if you know of anything at all that may lead to a claim, legal action etc against your company, then now is the time to declare it by providing details in the specific disclosure section of your disclosure letter on our platform. Upload and cross-reference any supporting evidence within the “Disclosed Folder” in your Intelligent Data Room.

Below are some example specific disclosures that could be made against this warranty in your disclosure letter:

  1. "We are aware that an employee who was made redundant in March 2020 has threatened us with an employment tribunal. Please see the related information in our Data Room".
  2. "We have received a 'pre-action' letter from a supplier, XYZ Ltd, provided within our Data Room. They are threatening court action due to an unpaid invoice, however we are disputing that they have delivered the services they have invoiced for".
  3. "HMRC have written to us to request a meeting to review our National Insurance payments. A copy of the letter from HMRC is disclosed in our Intelligent Data Room along with our response".

You may be worried that being “too open and honest” could put your investors off, but not being open and transparent enough when taking on investment is a very risky strategy and not a recommended approach.

Summary

In short, you will be giving a lot of warranties in respect of your company and its business. For investors, it is a key protection. The disclosure process is also an important part of your journey and thoroughness is key.

Your FounderCatalyst Intelligent Data Room “Disclosed Items” and “Un-Disclosed” folders make it simple for you to disclose and manage information, in conjunction with the specific disclosure section in your disclosure letter.

We strongly recommend that you over rather than under-disclose. You should provide as much detail as possible and restate any disclosures, even if you've already told investors orally or in writing about a specific risk. Unless the information is fully and fairly disclosed in the disclosure letter, it will not count as disclosure. Do not rely on general disclosure.

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