In an age where private equity firms and venture capital investors are becoming more cautious in the investments they make, we’ve seen a growing trend of investors requiring their portfolio companies to agree to some form of Investor Rights Agreement (or “check and bucket” agreement) as a condition to investing. These agreements almost always have standard terms that apply to most venture deals, such as standard representations and warranties and various affirmative and negative covenants. But different firms have started adding very specific terms that are tailored to their risk profile, such as non-compete or non-solicitation obligations, clawback provisions in the event of subsequent stock sales at a loss, change-of-control restrictions, secondary equity resale marketability standards or other unique investor rights provisions.

What is an Investor Rights Agreement?

An “Investor Rights Agreement” (“IRA”) is a legally binding contract between an early-stage company and an investor that governs the terms of their relationship. The IRA will often include representations and warranties made by the founder, as well as some “covenants” that must be met, such as minimum revenue or profitability targets. If the terms are breached by either party, the other party is entitled to damages. Investor Rights Agreements are not laws in any country, but they are binding contracts between parties that are often used in conjunction with convertible note financing rounds. The IRA will usually include representations and warranties made by the founder and the company, as well as certain covenants such as minimum revenue or profitability targets. If the terms are breached by either party, the other party is entitled to damages.

Why Are There So Many Disputes Regarding Fosfa Clauses?

Fosfa refers to the “force or final ‘ask’ for relief” in a dispute. Disputes over the meaning and applicability of various provisions in Investor Rights Agreements are a recurring problem in Silicon Valley. The main causes of these disputes are: (1) the complex and highly specialized nature of investment agreements themselves, (2) the fact that both parties are sophisticated parties who are highly incentivized to fight the battle to the bitter end, and (3) the fact that disputes are often not resolved at the negotiation table, but instead in court. The most common disputes we see are over the meaning of “liquidation event” on the one hand, and “change of control” on the other. Most disputes are resolved by the parties reaching an agreement to settle the issues, but sometimes these disputes end up in court.

What is a Fosfa Clause?

A “Fosfa Clause” is a term used to describe a specific type of liquidation event. The term comes from the fact that a “force-out” clause is the final “ask” for relief in a dispute. In an investment agreement, a force-out clause is a provision that requires the investors to purchase the founder’s equity stake in the company at a certain price if there is a certain type of liquidation event, such as a merger or acquisition. When founders sign an investment agreement, they usually also sign a “Fosfa Letter” that spells out the terms of the Fosfa Clause in the event a dispute over the terms arises.

Why Do Investor Rights Clauses Cause so Many Problems?

Because the two parties to a dispute over the liquidation event triggering provision in an investment agreement are highly incentivized to fight the battle to the bitter end, the disputes often end up in court. This means that disputes over the triggering events are increasingly being fought out in litigation. The problem is that even though both parties have a strong interest in resolving the dispute and coming to an agreement, it is the very nature of litigation that parties are often unable to reach an out-of-court settlement.

Arbitration Is The Solution to Fosfa Problems

Most of the disputes we see over the triggering event provisions in investment agreements are best resolved through arbitration since: (1) arbitrators are able to look at the facts of the case, and are not bound by the strict rules of evidence used in civil litigation, (2) arbitrators are generally well-versed in the standard definitions of triggering events in VC investment agreements, (3) arbitration is a private process where the dispute is resolved behind closed doors, and (4) the parties can agree to keep the proceedings confidential. The parties can also agree to have the dispute resolved through mediation or through a “hybrid” approach that includes both mediation and arbitration. The key is for the parties to agree on the dispute resolution mechanism at the beginning of the relationship, so that it is clear from the outset how the parties will resolve a dispute in the event that one arises.

Only One Way Out of FOSFA-Related Conflicts: Arbitration

Most disputes can be resolved through the arbitration process, but there are a few exceptions. Disputes over the enforceability of the arbitration clause itself will have to be resolved through the courts, as will disputes over the enforceability of the investment agreement itself. Given the fact that most disputes are best resolved through arbitration, it is important that the parties clearly agree on the dispute resolution mechanism at the outset of the relationship. The parties should agree on the arbitration forum and the arbitrator, as well as the procedure for selecting the arbitrator. It is also important that investors include a “walk-away” provision in their standard investment agreements. This will allow the founder to walk away from the investment if the investor is unwilling to agree to arbitration as the dispute resolution mechanism.

Conclusion

The key takeaway from this article is that investor rights clauses cause problems mostly because of the nature of litigation and the fact that the two parties have a strong interest in fighting the battle to the bitter end. Given the nature of these disputes, the best solution is to agree on arbitration as the dispute resolution mechanism at the outset of the relationship. This way, the parties can agree to have disputes resolved behind closed doors by an independent third party who is well-versed in the standard definitions of triggering events in VC investment agreements. Only one way out of disputes over Fosfa clauses: arbitration https://fortiorlaw.com/news/fosfa-arbitration/.