Venture capital (“VC”) financing transactions are usually based on a typical set of offering materials. The wording used in the transaction documents themselves also tends to be highly standardized. Using uniform language, formats, and mechanisms that are familiar to most industry players (and the lawyers that represent them), streamlines the negotiation process and reduces the transaction costs for all parties involved. In the US market, many venture capital transactions are closely based on the model documents drafted by the National Venture Capital Association (NVCA). This section will review the primary offering materials used in VC financing transactions and their key provisions.
In the startup’s first round of VC financing (usually referred to as its “Series A”), it is customary for the lead investor to propose the initial drafts for all primary transaction documents. In the startup’s following investments transaction, the finalized transaction documents of the previous investment will often be the starting point of negotiations with the incoming lead investor.
The Term Sheet is typically the first transaction document to be negotiated and executed by the startup and the investor. It is a non-binding document that summarizes the parties’ understanding of the investment transactions’ core economic and legal terms. The final wording of all other transaction documents is expected to closely follow the Term Sheet high-level understandings. While legally non-binding, Term Sheets are neither delivered nor signed lightly. Pulling out of a transaction after a Term Sheet was signed is an extreme measure that would only be used under unusual circumstances (for instance, severe and irreparable “red flags” discovered during the investor’s due diligence).
One crucial Term Sheet clause that is legally binding, however, is the No-Shop/Confidentiality clause. The startup would usually undertake that for a set period following the execution of the Term Sheet, it would not solicit competing offers from other investors. The startup would also normally undertake not to disclose the contents of the Term Sheet to outsiders without the investor’s consent. The length of the no-shop period corresponds with the parties’ expectations of the time it should take for the transaction to close.
Stock Purchase Agreement
Standard VC financing transactions are based on the issuance of the startup’s preferred stock to an investor for an agreed-upon amount of cash consideration. The Share Purchase Agreement (“SPA”) describes the terms and mechanics of such a purchase.
The SPA is typically comprised of three main parts. The first part describes the core economic terms of the transaction. It sets forth the investment amount and the number of shares to be issued, the time and place for closing, and the actions to be taken by each party at the closing date.
The second part contains representations and warranties by the startup and the investor. The startup provides a broad set of representations and warranties covering different aspects of the investment and the startup’s ongoing activity. The startup would represent, for instance, that the issuance of shares was duly authorized, that it holds sufficient legal title to its intellectual property and other assets, and that it complies with the laws and regulations that apply to its operations. The investor’s representations and warranties are more limited and mainly focus on the investor being duly authorized to purchase the shares and compliant with the securities regulations that apply to the transaction as structured.
The third part describes the conditions of each party’s obligations under the SPA. In essence, for the transaction’s closing to occur, each party must execute and deliver all transaction documents to its counterparty, and the parties’ mutual representations and warranties must remain true and correct as of the closing date.
Certificate of Incorporation
The Certificate of Incorporation (“COI”) describes the rights attached to each class of the startup’s capital stock. It sets forth the rights shared by all classes (voting rights, for instance) as well as the special rights and preferences of each class of preferred stock. Standard COIs of venture-backed startups would provide preferred shareholders with two primary sets of rights and preferences: liquidation preference and conversion rights.
Liquidation preference provisions determine the distribution of proceeds between the startups’ shareholders in exit scenarios (for instance, upon the startup’s sale to a third party, or its dissolution). Their function is to guarantee that a certain amount of proceeds will be disbursed to each class of preferred shareholders before any remaining proceeds may be disbursed to lower-ranking classes.
Conversion rights define the terms under which each preferred stock may be converted into common stock. They describe the scenarios under which such conversion may be triggered, who may initiate such conversion, the preferred-to-common conversion rate, and the mechanisms for adjusting the conversion rate in response to certain events.
Another significant COI provision specifies the composition of the startup’s board. A typical board of a venture-backed startup would be comprised of directors appointed by the entrepreneurs, directors appointed by the investors, and sometimes also independent, industry-expert directors appointed by the majority vote of other directors or the shareholders.
Lastly, the Certificate of Incorporation may also include a set of “protective provisions.” These are, in essence, investor veto rights that prevent the startup from taking specific corporate actions without first obtaining certain investors’ consent. These may include, for instance, selling the startup or its business, declaring dividends, adjusting the board size or composition, or amending the COI.
Investor Rights Agreement
While the SPA sets forth the terms relating to the purchase of preferred stock, and the COI describes the nature of the stock to be purchased, the Investor Rights Agreement contains various provisions that govern the relationships between the startup and its shareholders and among the shareholders themselves. The most significant provisions of the IRA relate to investors’ registration rights, information rights, and preemptive rights.
Registration rights determine the terms for registration of the investors’ shares for public trading should the startup hold an IPO. These may include “demand” registration rights, which require the startup to use its best efforts to hold an IPO once certain conditions are satisfied, as well as “piggyback” registration rights, which entitle the investors to join future public registrations initiated by the startup.
Information rights require the startup to provide certain investors with financial statements and other information, and allow such investors to visit and inspect the startup’s properties from time to time. Occasionally, they would also allow some investors to appoint an observer to the board of directors, who would be entitled to receive all materials delivered to the startups’ directors and attend board meetings in a non-voting capacity.
Preemptive rights, sometimes also referred to as “rights of first offer,” allow certain investors to purchase their pro rata share out of future issuances of equity by the startup. These rights typically apply only to equity issued for financing purposes (and not, for instance, equity issued under employee stock ownership plans).
Right of First Refusal and Co-Sale Agreement
The Right of First Refusal and Co-Sale Agreement sets certain limitations on transfers of startup stock by the startup’s “key holders” (usually, the startup’s entrepreneurs or senior management). As its title indicates, these typically include a right of first refusal (or “ROFR”) and a co-sale right.
A right of first refusal requires key holders that wish to transfer their stock to offer the startup itself to buy back such stock first. If the startup would not buy back all of the proposed stock, some investors may have the right to purchase, on the same terms, any portion not bought back by the startup. Co-sale right, conversely, entitles certain investors – typically, the same ones that hold a right of first refusal – to participate in transfers of stock by key holders and sell, together with the key holders, a proportional amount of their own stock as well.
The Voting Agreement covers investor rights that may require the startup’s shareholders to vote in a certain way. The voting agreement allows the investors to secure such consent in advance, and provides them with remedies and enforcement tools in case some shareholders would not use their voting power as agreed.
Drag-along rights are a notable example. These rights require all shareholders to vote in favor of the sale of the startup or its business, provided that such a sale is supported by specified corporate organs (typically, the board and a special majority of the shareholders). Failure by a shareholder to do so may entitle other shareholders to specific enforcement. Occasionally, shareholders would also be required to provide some corporate organ (for instance, the president or the chairman of the board) with an irrevocable proxy that would allow voting their shares in their stead in accordance with the voting agreement’s provisions.