By: Ali Rahimtula and Matt Eckert
I am delighted to collaborate with Matt Eckert, partner at the law firm Foley Hoag, on this post. I have worked with him on many investments over the years and if you are looking for an excellent corporate lawyer to help you on your next deal, you can’t do much better than Matt.
A common question we get asked by entrepreneurs we work with is what are the key deal documents that are created in a venture funding round and what – from a commercial perspective – is important for a founder or CEO to pay attention to.
Let’s get started.
- Term Sheet
While not legally binding per se, the term sheet should map to all the different documents we discuss below. The goal of the term sheet is to get clear understanding among the parties (entrepreneur and investor) of the key economic, governance, and other terms they have agreed to in principle.
Our philosophy is that any important terms should be addressed in the term sheet and not punted to the definitive documentation stage. It is better, in our view, to have any difficult conversations or negotiations upfront. If the term sheet is properly negotiated, the drafting of the various legal agreements should be a relatively painless process.
Key terms will of course include valuation, amount raised, governance, board composition, establishment of an additional options pool (and if pre or post-money), and so on. We also strongly suggest that the term sheet should include a cap table. Entrepreneurs find it helpful to see the impact of the round on their pro forma ownership. Additionally, including a preliminary cap table in a term sheet can help uncover any errors or oversights early in the process.
- Purchase Agreement
The purchase agreement overlies the entire transaction. It is the agreement under which the issuer is selling to investors. Below are some of the more important sections to pay attention to in the purchase agreement.
- Purchase and Sale of Preferred Stock: This section will include the price per share.
- Sale of Additional Shares: This will specify whether you need to close on entire round at once or during some period of time after an initial closing at some minimum amount after which you can finalize the round. So, for example, you might have a maximum round size of $15 million and a minimum initial close of $12 million. You might have 60 days to sell the remaining $3 million to close out the round. This construct is becoming more common now and allows you to raise smaller investment amounts from value-add investors or angels. There may also be certain investors not comfortable leading the round but that you nevertheless would like to include.
- Schedule of Purchasers: Contains an exhibit including the various purchaser names (and contact info), number of shares to be purchased, cash payment amounts for those shares, and closing dates.
- Representations and Warranties: These are factual statements the company is making about itself that investors are relying upon to make their investment. They include capitalization, law suits / litigation, intellectual property, material agreements, and so forth. The consequences of being materially wrong (including important errors of omission) are at best an angry investor and at worst an investor that wants their money back.
- Certificate of Incorporation (a.k.a. Charter)
The charter authorizes the terms of the stock being sold under the purchase agreement. The charter says what the features of those shares are.
- Liquidation: This describes what happens when the company is sold, i.e. what the order and amount of payment (the “waterfall”) is to the various classes of shares. Pay particular attention to the section “Payments of Holders of Preferred Stock.” This section will explain the relationship between the preferred classes and their liquidation preference. It is important to understand these terms because it can impact the payment you will receive as a common shareholder (which may get paid after the preferred shares). In particular, multiples of liquidation preference or participation of preferred shares can adversely impact the payment founders receive in the case where the company is not a runaway success.
- Special voting rights, including rights to elect board members as a class and veto rights.
- Conversion rights (including automatic conversion provisions, such as in a qualified IPO).
- Other important rights including dividends, redemption rights, anti-dilution protections.
- Investors Rights Agreement
Usually covers four main topics.
- Registration rights: if company goes public, circumstances under which that happens; and rights of investors once that happens.
- Information rights: periodic information company has to provide its investors (financial statements, annual budgets, cap table, and other general info).
- Participation rights or rights of first offer (ROFO): this includes pro rata rights. Investors and entrepreneurs care a lot about this. This is the right of an investor to maintain their fully diluted percentage ownership even through successive funding rounds.
- Investor director approvals: subset of things the company can not do without some special board approval (of investor directors) like changing compensation, hiring and firing executive officers, related party transactions, incurring indebtedness.
- Voting Agreement
Fundamentally, the voting agreement is the document under which shareholders pre-agree how they will vote their shares under specified circumstances. The voting agreement is usually concerned with two governance-related topics.
- Board composition: the voting agreement will indicate who has the right to choose board directors (e.g., the lead investor may designate one person for election – usually the venture partner driving the deal) and obligates the shareholders to vote their shares in support of these choices.
- Drag along rights: these terms are often a source of confusion for entrepreneurs but are important to understand because they control the timing by which the company will be sold. It obligates shareholders to vote in favor of a transaction that has the support of a specified subset of stakeholders.
- In some cases, the approval to trigger the drag-along may require the consent of the Board, a majority or supermajority of investors, and a majority or supermajority of key holders/founders. This type of drag-along is mainly focused on ensuring minority stockholders have less ability to interfere with a transaction that is otherwise generally supported by the company and its stockholders.
- In other cases, the approval might involve a subset that affect the governance balance of the company in exit scenarios, such as the Board and a majority or supermajority of investors, or the Board, investors and common stockholders who are still employed by the company. These types of drag-alongs favor stakeholders who remain actively involved in the company, either as investors or in management.
- Right of First Refusal and Co-Sale Agreement
The right of first refusal and co-sale agreement is an agreement that enables the company to have more control over who its shareholders are by requiring key common stockholders to offer shares to the company before selling them to a third party. It also provides investors with an opportunity to purchase shares the company declines to buy and participate in any sale to a third party if investors also declined to buy. Although the agreement is styled as rights of first refusal, it is better thought of by entrepreneurs and other significant common stockholders as fulfilling two principle aims of investors: restricting the ability of founders and other holders of “sweat equity” to transfer shares, and ensuring that if they will be, that the investors have access to liquidity as well. The agreement does not entail that founders and employees can never have access to liquidity before investors – only that when this does occur, it is with the agreement of the company and investors (which is often given, particularly in the context of later stage financing). Of all of the financing agreements, this is the one that generally involves the least negotiation, perhaps because the typical entrepreneur (and certainly the type investors like most) is not a motivated seller when it comes to his or her equity.
This post has focused on principle documents in a financing. Other documents are prominent in the context of an exit, and also contain important obligations an entrepreneur should understand, including the letter of intent (“LOI”), which, like a term sheet, often contains a summary of the most important terms that will appear in the definitive acquisition agreement. In addition to the headline purchase price, post-closing price adjustments can be complex and can materially impact the ultimate purchase price. We will address M&A deal documents in a future post.
The formal legal documents in a standard venture financing are not especially complex. However, if it is your first funding round as an entrepreneur, they can be a little daunting. We hope this post gives you a high-level familiarity with the various documents and the confidence to negotiate favorable financial and governance terms that work for you.
Copyright 2018 Ali Rahimtula. All rights reserved.