Venture capital transactions1 begin with the “term sheet” or “letter of intent” (the “Term Sheet”).2 Although a term sheet is typically expressed as a non-binding document, it is the foundation upon which all other (binding) transaction documents are prepared. Typically, a Term Sheet can be divided into three basic categories: (i) terms that impact valuation and economic division of profits and proceeds upon a “liquidity” event, (ii) terms that impact control over decision making and (iii) investor protection terms.
At the outset, it is important to bear in mind that venture capital investments require a multitude of transactions agreements, negotiation and corporate actions to protect both the investor (the “Investor”) and the company seeking the financing (the “Investment”). Each business will have unique issues, and the terms of the Investment (contained within the Term Sheet) should focus on those issues.3 These material issues should be addressed early in the transaction process, and the understanding of the parties should be reflected in the Term Sheet (and then solidified in the transaction documents themselves).
Term Sheet; No-Shop
Under the Term Sheet, obligations are made contingent upon the negotiation and execution of the final agreements, and the prior satisfactory completion by the Investor of due diligence.4 An Investor sometimes will require that the company agree to an exclusive negotiation period (a “No-Shop”). Since the Investor may have to expend significant time and effort in conducting due diligence and negotiating deal terms, the Investor will not want the company to use the Term Sheet to leverage better deal terms from other potential Investors. Companies, however, should exercise caution in agreeing to a No-Shop. If a company agrees to a No-Shop agreement too early in the transaction process, it may foreclose other better opportunities.5 From the company’s perspective, a “No-Shop” is problematic because Investors do not have an obligation to proceed with the Investment, but the company will have an obligation to
1 This memorandum focuses on the key concepts, provisions, and terms of a venture capital investment by outside (third party) investors and uses the first (the “Series A”) round of investment as the example. A Series A financing occurs after the initial “Angel” round of investment by the company’s founders at its inception. Although later rounds of investment (e.g., “Series B”, “Series C”, etc.) will share similar attributes and characteristics, the “Series A round” typically sets the landscape for future financings
2 See our memorandum, “M&A: Letters of Intent.” Whether the initial agreement is structured as a “term sheet” or a “letter of intent” is a technical difference with no substantive difference or effect. Rather, it is a matter of personal preference. For purposes of this memorandum, the phrase “Term Sheet” is used to describe the initial agreement of transaction terms between the parties.
3 For example, issues for information technology companies often arise in the areas of intellectual property and employment matters.
4 Otherwise, the Investor may find itself forced, pursuant to the Term Sheet, to make an investment that subsequent investigation of financial condition or events demonstrates was not in its best interests. This possible outcome must be avoided and accounted for before any definitive documents are executed. 5 Further, a No-Shop can be coercive if the company is having working capital problems (which prompted the Investment sought (capital infusion) to begin with).
refrain from seeking other available investors. This could leave the company in a poor position with few or no options at the end of the No-Shop period if a deal does not ultimately materialize.6
Preferred Stock and Conversion
The Term Sheet will indicate the type of securities that the Investor contemplates purchasing, whether common stock, preferred stock, warrants, debt securities, partnership interests, membership interests, another type of security, or some combination thereof. Investors are typically offered preferred stock which carry certain preferential economic and voting rights over the founders’ and existing common stock (the “Preferred Stock”).7
Preferred Stock is usually convertible into common stock whenever this is beneficial to the investor(s). It is also common to detail circumstances or events which would lead to automatic conversion of the Preferred Stock. For example, in the event of an initial public offering of the company (an “IPO”), it is typically the case that only one class of stock (common stock) is to be offered to the public and listed on an exchange. The decision as to when the investor will convert its shares and the number of common stock that it will receive in exchange for purposes of liquidating their Investment in an IPO is based on several factors, the most important being an assessment of whether or not the investor’s “liquidation preferences” and “participation rights” (described below) would yield higher returns if the Preferred Stock were to be converted into common stock at that time. The parameters of that decision will be outlined in the basic rights of each class of stock as set forth in a company’s Certificate of Incorporation as it may be amended or supplemented by any “Certificate of Designation” or otherwise (the “COI”).8
Pre-Money Valuation; Price Per Share
The price per share of the Preferred Stock is based upon a “pre-money valuation” of the company divided by the number of shares outstanding prior to the Investment. The number of shares outstanding
6 Whether a company agrees to a No-Shop will depend upon several factors, including, among other things, the company’s financial condition, the negotiating leverage of the parties and existing market conditions.
7 This memorandum assumes the company in question is a corporate entity incorporated in the State of Delaware as a “C” corporation. Further, warrants and other option securities that may be negotiated in the offer as a ”sweetener” to the deal are also not discussed here. This memorandum focuses upon the acute economic and legal features that a straight “Series A” Investment entails. That said, at times, a limited liability company entity may be the preferred investment vehicle because it: (1) is taxed as a partnership for federal income tax purposes; (2) provides limited liability to its members; and (3) unlike an “S” corporation, may have owners who are not individuals. Although often tax efficient, a limited liability company investment can be administratively challenging for venture capital investors structured as limited partnerships or other “flow-through” entities, because they must include the company’s K-1 information on their own K-1 filings. A careful analysis should be made early on as to what the optimal entity structure for the company would be after the Investment. Further, if debt securities are involved, the Term Sheet should state how the entity will account for the “invested debt” and its subordinate position with respect to debt from banks, financial institutions, trade creditors or other third parties. 8It is important to note, that many companies with the foresight of envisioning the necessity to seek future outside investors will draft its initial COI so as to allow for “blank check” issuances of Preferred Stock by the consent of the Board of Directors (the “BOD”) through their own independent authority. If no such blank check authority is set out in the company’s COI, then a stockholders’ approval would be necessary to allow for the Preferred Stock issuance and the creation of the separate class of securities. However, if the BOD is empowered to effect the issuance in this fashion, then a “Certificate of Designations” will be filed with the Secretary of State of Delaware and would become a part of the company’s COI. See Section 151(a) of the Delaware General Corporation Law.
or “fully-diluted” number is often a subject of negotiation. The term “fully-diluted” generally includes all outstanding common stock, preferred stock (on an as-converted basis), options, warrants and other convertible securities as if fully exercised or converted.9If it is to include unissued options, the parties must decide whether this includes the additional unissued options resulting from any increase in any available option pool as a result of the financing. Generally, if the larger the basis (the agreed upon number of outstanding shares), the less the Investors will have to pay per share of stock in connection with the Investment (and the greater the dilution to the existing stockholders).
The methodology typically used: per share price = pre-money valuation (divided by) total outstanding shares prior to Investment. The negotiation usually turns on the definition of “fully-diluted basis” in order to decide who will bear the cost of dilution. If the number of the securities in question are included in the fully-diluted number, the existing common stockholders will assume all of the diluting effect of those securities. If those securities are not included in the fully-diluted number, the existing common stockholders and the new Investors will assume on a pro rata basis the diluting effect of those securities. Investors argue for a larger fully-diluted basis (i.e.. one including the unissued options) so that the existing common stockholders will assume the diluting effect when those options are issued and exercised. The company, however. will seek a sharing of the diluting effect of the unissued options equally between the existing common stockholders and the new Investor(s).
Stock Purchase Agreement; Subscription Agreements
The “Stock Purchase Agreement” or “Subscription Agreement” (collectively, the “SPA”) serves as the lead document setting out the key terms of the agreement between the parties regarding the sale of the Preferred Stock and consummating the Investment. The SPA (and any ancillary subscription agreements) are binding and typically will set out the basic terms of other agreements to be executed in conjunction with the Investment (as discussed in further detail below).10
The SPA is commonly entered into between the company, the founders and the investor(s). The SPA will include more comprehensive provisions normally geared towards protecting the investor(s) interest (such as warranties as to the condition, financial affairs and accounts of the business), and may also include requirements to restructure the company’s management and operations either prior to or after the Investment.11
Preferred Stock Terms and Conversion
The Preferred Stock typically issued to investors will carry certain preferential economic and other rights over the founders’ (and existing) common stock. Preferred Stock is usually convertible into common stock whenever it is beneficial to the investor(s). It is also common to detail circumstances or events which would lead to automatic conversion of the Preferred Stock. For example, in the
9 One heavily negotiated issue is whether “outstanding options” includes only issued options, or should include (reserved) unissued options as well.
10 It is not uncommon for a series of simple subscription letters to accompany the SPA and each confirming Investment amount committed per investor, the number and class of shares being issued in consideration for the Investment and the expected date on which the Investment round will be completed.
11 In addition, the SPA will also include provisions requiring the investors to make certain representations regarding their status as “accredited investors” in their individual subscription agreements, or in questionnaires that will be provided to them, in order to qualify the Preferred Stock issuance as a private placement within the provisions set forth in Rule 501 and Rule 506 of Regulation D of the Securities Act of 1933, as amended.
event of an IPO of the company where it is typical that only one class of shares (the common stock) are listed on an exchange. The decision as to when the Investor will convert its Preferred Stock and the number of common stock that it will receive upon conversion is based on several factors, the most important often being an assessment of whether or not the Investor’s liquidation preferences and participation rights (described below) would yield higher returns if the Preferred Stock were converted into common stock at that time.
The Term Sheet should also specify the circumstances under which the Investor must convert all shares of the Preferred Stock into shares of the company’s common stock. It is not uncommon for Preferred Stock financings to include provisions for “automatic” conversion of all the Preferred Stock into common stock upon the vote or written consent of holders of a defined minimum number of shares. This feature aids in avoiding the risk of holdouts when the conversion, or a transaction contingent upon the conversion, is in the best interests of the company and the stockholders. It is also typical to provide for automatic conversion in connection with an IPO that meets specified criteria as to size and valuation. Underwriters for an IPO will want the company’s capitalization structure to be simplified to the extent possible to facilitate their marketing efforts. Automatic conversion by stockholder vote provides a convenient means to simplify the company’s capitalization structure, without having to undertake to amend the COI or to get the unanimous agreement of the preferred holders to convert their shares. Automatic conversion may, for example, reduce the risk that a minority of stockholders, or the holders of a particular series of stock, will effectively have the ability to block important transactions that may be contingent upon a more simplified capital structure (i.e., a highly-dilutive financing or an IPO that does not meet separate automatic conversion thresholds).
Liquidation Preference and Participation
A liquidation preference is a right of the investor to receive proceeds from a “liquidity event” (“Liquidity Event”) in priority to (that is, before) other classes of stockholders are permitted to receive their share of proceeds. Thus, investor(s) will receive payment as a result of a Liquidity Event before any of the founders or other holders of common stock. Accordingly, the definition of a Liquidity Event can vary depending upon negotiation, but typically includes the sale of a majority of the company’s stock (or a sale of a controlling interest of the company), a sale of a substantial portion of the company’s assets or the winding up of the company.12
12 A new Investor in a later-stage financing should exercise care in negotiating the automatic conversion provisions, particularly if the new Investor is entitled to a larger preference or has priority relative to other existing series of shares. The new Investor should be cognizant of the risk that the other Investors may be able to effectively eliminate any preferences or priority by effecting an automatic conversion through a class vote of all of the preferred voting as a whole. To protect its liquidation preference, the new Investor may want to request a higher vote threshold or a separate series vote. Since the conversion of all preferred stock into common stock may be a practical condition precedent to a public offering of the company’s common stock, the company will want lower thresholds. In contrast, the Investors will not want to be forced to convert to common stock unless they are assured of a sufficient return on their Investment and will want to ensure that there is sufficient liquidity to allow them to sell their shares. To ensure that the Investors receive an appropriate return on their Investment before an automatic conversion, the per share minimum offering price ensures that the Investor achieves a significant return
Further, a liquidation preference typically grants the preferred stockholder a minimum return equal to a multiple of the capital invested, in addition to any declared or unpaid dividends payable to the holder of the Preferred Stock.13 Both investors and the company must carefully analyze and agree upon the methodology of calculating a Liquidity Event outcome.
In addition, the holders of Preferred Stock will typically wish to be entitled to “participate” in the proceeds of a Liquidity Event pro rata to its shareholding in the company (on an “as converted basis”). This right only arises after the preferred stockholder has received its “liquidation preference.” This would thus mean that the preferred shareholder would first receive its capital invested before other shareholders receives any funds (as provided for by its liquidation preference), and would then share (or “participate” in) the remaining proceeds of the Liquidity Event with all other shareholders pro rata in addition to its “liquidation preference.”14
Another key feature of a Series A Investment is the anti-dilution provision. This should not be confused with a “pre-emption” discussed below.
An anti-dilution provision effectively operates to protect an investor’s ownership interest if the value of the company diminishes after the date of the investment. Therefore, on a subsequent (future) issue of new shares, if the shares are issued at a price-per-share that is lower than the price which the investor
paid during its Series A financing round (commonly known as a “down round”), the anti-dilution provision would effect itself automatically. The right is built into the mechanism known as a “conversion price” (the “Conversion Price”), which is the reference point of a price per share at which Preferred Stock would convert into common stock of the company.
on Investment before the company can go public. The price may lie in the range of three to five times the original issue price, depending upon existing market conditions.
13 Although investors often seek to negotiate higher return multiples, often the standard market practice changes as the market environment changes. Often, however, the liquidation preference is a limited payment equal to the capital invested by the investor, together with any declared or unpaid dividends due on the Preferred Stock.
14 By way of example, assume an investor has made an investment of $1 million in consideration for 100,000 shares of Preferred Stock, for a resulting ownership of 50% of the company’s equity capital structure (i.e., the company’s entire share capital comprises of 200,000 shares of capital stock). The terms of the Investment include a “liquidation preference” equal to the full value of the $1 million Investment. The company does not perform as expected, and one year later, 100% of the company’s common stock is sold to a private equity investor at a total valuation of $1.5 million. Given that the investor has a “liquidation preference” in respect of the full value of its Investment, the investor will receive $1 million from the buyout, with the remaining $500,000 distributed to all other common stockholders pro rata. If such a “liquidation preference” had not been included in the terms of the Preferred Stock, the investor would have received only $750,000, representing its 50% share of the total purchase price. Furthermore, using this example, in the event the investor also has participation rights, the investor would first receive its $1 million, and would then be able to “participate,” on a pro rata basis, with the remaining shareholders in the $500,000. The investor would therefore receive $1.25 million, which is its $1 million investment, plus its pro rata share (50%) of the remaining $500,000, which is an amount equal to $250,000.
There are two approaches to determining the relevant Conversion Price; the first is the more simple approach of using a “full ratchet” conversion formula, where the share price originally paid (e.g., $10.00 per share) is automatically reduced to the price-per-share of the new Series B round (e.g., $5.00 per share). The second, and more complicated approach, is using a “weighted average” conversion formula, which takes into account the weighted average value of previous issues of shares as well as the current issue. The more common approach is the “weighted average” calculation.15 Weighted-average formulas account for the number of shares issued in the new financing and the number of shares already outstanding (in addition to the respective prices at which the shares were issued) in adjusting the conversion price. Because full ratchet provisions do not calibrate for differences in the size of a new issuance relative to previously outstanding shares, a full-ratchet formula tends to result in more dramatic changes than weighted-average formulas.
Investors almost invariably wish to ensure that their investment proceeds are being employed for the agreed upon purpose. Also, they will also want to make sure that the company does not take any critical decision without the investor’s approval. These decisions are commonly referred to as “reserved matters” and include any decision to (i) reduce or otherwise alter the rights attached to
the investor’s shares, (ii) involve material capital or operational expenditure or (iii) change the nature of the business. These are just three examples of what is usually a list of what is generally referred to as “control rights”.
Control rights typically operate at the board level, where the lead investor in a Series A round would be given a board seat (and “Investor Board Member”). A common approach is that no extraordinary actions may be approved by the board of directors without the presence and affirmative approval of the Investor Board Member. Control rights can also operate on the shareholder level in respect of certain key decisions, including those which, as a requirement of applicable law, require the affirmative vote of the shareholders (e.g., a merger or the sale of all or substantially all of the company’s assets). In these instances, it is common for the extraordinary event to require a shareholder resolution effecting the affirmative vote of a certain percentage of the holders of the Preferred Stock.
Share Transfer Provisions
There are also usually five (5) key provisions that grant the shareholders of the company (including its investors) certain protections in connection with the transfer of the company’s shares or the
15 Furthering our example above, if an investor in a Series A funding round subscribed for 50% of the total shares at a price of $10.00 per share with a total investment of $1 million, that investor would receive 100,000 shares. If, during a later Series B funding round, the company’s valuation has diminished, and new shares are offered to Series B investors at price of $5.00 per share, the Series A investor’s anti-dilution right would effect itself and the Series A investor would be deemed to have originally invested at a price per share that is lower than $10.00. A lower conversion price translates into more shares, given that the value of the investor’s original subscription ($1 million) is divided by a lower price-per-share (for example a price of $5.00 per share). The negotiation is then whether the Conversion Price should be effected on a “full ratchet” or “weighted average basis.
issue of new shares. These are typically found in the shareholders’ agreement and may be built in the company’s COI itself.
A pre-emption right is offered to existing shareholders in respect of any future issues of shares (or other “equity securities”) by the company, giving the existing shareholders the first option to purchase the newly issued shares. A pre-emption right offers the shareholders a right to maintain (or increase) their ownership percentage by subscribing for new shares on a pro rata basis. A failure by the existing shareholders to subscribe for the shares usually allows the company to offer these shares (or any remaining portion that remains unsubscribed by the existing shareholders) to third parties.
A standard approach to a new financing round is to either obtain waivers from all non-participating shareholders in respect of their pre-emption rights, or otherwise offer the new shares to the existing shareholders first, and then (after the expiration of the period during which existing shareholders may exercise their pre-emption rights) offer the new shares to the new investors.
Rights of First Refusal
A right of first refusal is offered to existing shareholders in respect of any transfer of shares by a shareholder in the startup to a third party. The right gives the existing shareholders of the startup a right to purchase the shares being sold before a third party can acquire the shares. In a venture capital transaction, a right of first refusal may also be granted to the startup in priority to the existing shareholders.
Shareholders’ Agreement; Registration Rights Agreement
The shareholders’ agreement (the “Shareholders Agreement”) is another key binding agreement and will reflect the terms agreed to in the Term Sheet. It will set out the rights of the investors and the founders and will contain provisions that govern the management and operation of the company.
In addition, the Shareholders Agreement will either contain within it (or reference as a separate agreement) certain registration rights bestowed upon the investor(s) in connection with their Investment. It is important for Investors to have a means to eventually liquidate their Investment. Securities sold in private financings typically are subject to restrictions on resale under Federal securities laws. Although there are certain exemptions from these resale restrictions, these exemptions subject the investors to holding periods and other potentially applicable conditions that may limit the ability of Investors to resell their shares. The Term Sheet should indicate whether the Investor is to receive registration rights for public offerings of the shares purchased.
If the Investor does receive registration rights, then the Term Sheet should indicate: (1) when, during what period, and how frequently the Investor may demand registration of its shares; (2) whether the investor receives “piggyback”, “Form S-3”, or “demand registration rights”; and (3) who pays the
expenses of each such registration.16 Although it is somewhat unusual for registration rights to be exercised, the availability of registration rights can serve as leverage in effecting the timing of an IPO or other liquidity event, and the extent to which Investors’ shares are included in any registered offering. In general, companies will want to limit the scope of any registration rights due to the time, expense and liability associated with registrations. Note that founders and management sometimes seek registration rights, particularly if registration rights are extended to all shares of capital stock held by the Investors and not just those originating from the Preferred Stock. It is typical for Investors to agree to a standard market “stand-off” agreement, sometimes referred to as a “lock-up”, in which the Investors agree not to sell company securities for a certain period of time after a public offering. Underwriters for a company’s IPO normally will require that all company stockholders be subject to market “lock-up” agreements as a condition to the offering. This feature ensures an orderly market for the company’s stock following the offering. Because potential disagreements at the time of the offering may delay or threaten the offering, it is ideal for the company to obtain these lock-up agreements at the time of each securities issuance, rather than waiting until the IPO is being pursued.
Tag Along Rights
A tag along (or “co-sale”) right is also typically offered to the holders of Preferred Stock upon the transfer of shares in the company to a third party. The right gives the investor (as a minority shareholder (if that is the case) and holder of Preferred Stock) the right to join in the sale of shares of capital stock to a third party.17
Drag Along Rights
A drag along right is usually offered to a majority of the shareholders (or such number of shareholders that can exercise control over the company’s management). It is usually triggered upon the sale of the company, which is typically described as a sale of 50% or more of the company’s assets or shares of capital stock. The drag along right gives the controlling shareholders the power to force the sale of the minority shareholders’ shares alongside their own. Investors and founders should discuss the appropriate triggers for a drag along right and should ensure that only significant (material) transfers trigger a drag along right.
Change of Control Restrictions
A “change of control” restriction is a restriction that prohibits any change in the identity of the person (or company) that owns and/or controls an existing shareholder of the company. This prevents existing shareholders from circumventing applicable rights of first refusal and ensures that
16 Expenses in this regard are an important provision to consider. The registration of stock with the Securities and Exchange Commission can be an expensive and time-consuming undertaking which will require onboarding a number of professionals (accounting, legal and market professionals).
17 Investors and founder shareholders should be very careful when drafting the tag along right, as the key players should seek to limit the tag along right to circumstances where a majority of the company’s shares are being sold, or otherwise in circumstances when the founders seek to dispose of a significant percentage of their shareholdings. Otherwise, any transfer of shares by a minority shareholder could trigger an unanticipated flood of accepting (also known as “tagging”) shareholders.
the identity of the person (or company) that controls an existing shareholder does not change, for example, to become a competitor to the company’s business. A change of control can be drafted to include a sale of the company’s assets (or certain assets) or the change in control of an influential or majority shareholder.
Other Ancillary Documents
In addition to the agreements, mechanisms and concepts discussed above, there are a myriad of other agreements, issues and topics that must be addressed and solidified which are distinctive to each deal, including: (i) the manner in which stock option pools for employees (and importantly, “key employees”) should be treated; (ii) Directors and Officers Insurance; (iii) voting rights of the Preferred Stock and (iv) “pay-t-play” provisions.
Venture capital investments require a great deal of foresight and contemplation. Each transaction Is unique to the company involved (its business, its prospects and market conditions surrounding the business). Further, each transaction will require nuance(s) and a tailoring of the terms to meet the expectations of the company and the investor(s) after solid and thoughtful reflection. Importantly, both investors and companies seeking to pursue such a transaction should engage professional legal counsel who are experienced in such transactions so that any investment can achieve the expected value of the Investment by both parties.
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Venture capital transactions are a complex and layered endeavor that includes many nuances and complexities that lay beyond the scope of this memorandum. No legal or business action should be based upon the above summary. Questions concerning the topics or issues addressed in this memorandum should be directed to:
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