When a venture capital firm has completed its due diligence and reached an initial decision to invest in a portfolio company, the preparation and acceptance of a term sheet signals to the venture capitalist and the portfolio company that it is "all over but the shouting." The term sheet is handed over to investor counsel and company counsel, and it is expected that conforming documentation will be quickly forthcoming and that the deal will be closed promptly and for reasonable legal fees on both sides. In the case of a Series A Preferred Stock investment, the documentation takes on an enhanced importance, since it will normally establish the basis and general form of the documentation of later rounds of investment as well as for the current round. Venture capital documentation is fairly standard, i.e., a stock purchase agreement for the sale of a series of convertible preferred stock, preferred stock provisions in the corporate charter, and one or more additional agreements containing categories of investor rights such as rights to board representation, right of first refusal and co-sale rights, registration rights, and information rights. While this documentation may look similar from deal to deal, the overall approach to the drafting of these documents and the manner in which many of the details in the documents are handled, can vary widely, and will directly affect whether or not a friendly and successful closing can be achieved with a minimum of negotiation and for reasonable fees in line with the parties' expectations. This article includes some general comments on the most desirable approach to drafting venture capital documents and then focuses on some of the details that can enhance the usefulness of venture capital documentation to both investors and the portfolio company.
General Approach to Documentation
In drafting venture capital documentation, a middle-of-the-road approach is almost always the best way to proceed. Occasionally, venture capital documentation has become unduly onerous by the inclusion of oppressive representations, stringent indemnification provisions, and penalty provisions enabling the investors to take control of the Board upon the occurrence of certain "defaults" or "events of non-compliance." Those who draft these onerous documents fail to understand that the purpose of the representations in venture capital documents is not to create the basis for a claim if the company should get in trouble or fail (it's always too late by then), but rather to "smoke out" relevant information about the company before the decision to invest is irrevocable. The stock purchase agreement and its schedule of exceptions is a disclosure document, not a document that is expected to create the basis for post-closing liability on the part of the company or its founders. The reason for this is that once the investment in the company is made, the investors are significant owners of the company and will not be inclined to assert claims against their own entity. Additionally, rescission is not a realistic remedy, since the invested funds have usually been spent by the time things go wrong. Further, given the fiduciary duties involved (including duties to creditors as well as stockholders), it would seem highly unlikely that an investor group would wish to take control of the Board of Directors at a time when the company is in distress. It is more usual to see the venture capital firms' Board representatives heading for the exits as the company's financial condition deteriorates.
Difficult and oppressive documentation usually results in extended negotiations while company counsel attempts to reach agreement on more reasonable terms, which inevitably leads to the accrual of higher fees for both company counsel and investor counsel (both paid by the company with investor funds), and delays, both of which are anathema to company management and the investors. It also leads to distrust between management and the investors. The far preferable approach is for the investors and their counsel to recognize the true purpose of the documentation, which is to assist in causing the company to disclose all information that is relevant to the investment decision, to fix the terms of the transaction, and form the basis for the ongoing relationship between the investors and the company.
When fair, standard investment documentation is presented to the company and its counsel, the result is usually an abbreviated negotiation followed by a mutually cooperative effort to close the transaction speedily and for a reasonable fee.
There are numerous details and devices which can add to the usefulness and flexibility of venture capital documentation going forward, as more investors are brought in. The attractiveness of some of them depend on whether one is representing the company or the investors, but many are helpful to both in permitting transactions to move forward without unnecessary delay.
No Ongoing Covenants in Stock Purchase Agreement
The place for ongoing covenants such as information rights, voting agreements, etc. is in the Investor Rights Agreement or other similar agreements entered into in connection with the transaction, and not in the Stock Purchase Agreement itself. Once a transaction is completed, the Stock Purchase Agreement should be history. The ongoing Investor Rights Agreement and other agreements may then be restated in later rounds to incorporate the terms of later deals or to include new investors, without the necessity to revisit and amend the Stock Purchase Agreement for each earlier round, and for each of the earlier investors.
The "Major Investor" Concept
Venture capital documentation typically provides for the investors to have rights of first refusal, sometimes referred to as "contractual preemptive rights" with respect to future offerings of equity. Additionally, the documentation calls for the delivery to investors of ongoing financial information concerning the company, often including monthly, quarterly and annual reports, as well as additional information, such as the auditor's annual management letter and copies of certain governmental filings. These rights can become a burden to the company if there are a significant number of small investors in the investor group, and too wide dissemination of detailed financial information may be damaging to the company if it falls into the wrong hands. One useful solution (from the company's standpoint) is to limit the right of first refusal and/or certain informational rights to "Major Investors, i.e., investors owning at least a minimum number of shares of preferred stock. If only a handful of "Major Investors" who are close to the company are entitled to participate in the follow-on offering, their desire to participate in the offering can be determined informally without delaying the completion of the follow-on offering, whereas, if a large number of stockholders is involved, the procedure for advising the stockholders of their right to participate in the offering becomes a "rights offering" and may require the development of formal offering documents. This results in additional cost and delay in completing the offering, both of which are irritating to the company's management and the new investors.
One solution with respect to the right of first refusal that minimizes delay in completing a follow-on offering is to provide that the Company may offer the securities to the earlier investors after the completion of the offering to the new investors.
Another important point is that the right of first refusal to participate in future equity offerings should be limited only to earlier investors who are "accredited investors," as defined in Regulation D promulgated by the SEC. This eliminates the burdensome necessity to provide all of the earlier investors with the specified information which may have to be included in an offering of securities to a group of purchasers that does not include only "accredited investors." While almost all venture capital financings are limited to accredited investors, transfers to nonaccredited investors may occur, and to minimize the cost and delay of gearing the offering to them, they should be excluded from the right of first refusal by the terms of the provision itself. This may be deemed to be unfair to the nonaccredited investors, but the savings in time and cost justifies it.
Use of "Blank Check" Preferred Stock
On it face, the authorization in the corporate charter of so-called "blank check" preferred stock, which empowers the company's Board of Directors to fix the terms of one or more new series of preferred stock, appears to be attractive, since no stockholder approval is required for the authorization of the new series. The principal problem with this approach is that as each new series is designated, the terms for that series alone are added to the corporate charter, resulting in a series of designation documents instead of one integrated document setting forth the rights and privileges, etc. of each series. Each designation must work with the others, and with multiple series, with different liquidation preferences, this can be difficult and confusing. Additionally, it is necessary that each series take into account the different rights, preferences and privileges that may be accorded to future series. For example, the statement of the liquidation preference of a series should begin with: "Subject to the liquidation rights and preferences of any class of series of Preferred Stock designated in the future to be senior to, or on a parity with, the Series A Stock with respect to liquidation preferences." This is true of rights of redemption as well.
The better approach is to amend the charter to integrate the preferred stock provisions relating to each series into a single unified section of the charter. This permits the relative rights, privileges and preferences of each series to be set forth together with those of the other series. While the approval of the stockholders is needed to amend the charter, in most cases, the requisite majority can be assembled from management and a few significant investors, and, under Delaware law, the amendment can be approved by a written consent signed by them, with notice to the other stockholders. If any class or series has veto rights with respect to the new series, it would have them regardless of which approach is taken, so that is not a determinative consideration. Thus, although 'blank check" preferred stock appears to be an attractive alternative, the amendment of the charter to provide a single integrated section dealing with the rights, privileges and preferences of the preferred stock may well be the better approach.
There are many critics who are of the view that registration rights agreements are a general waste of time, given the likelihood that shares issued in a venture capital transaction will normally be held for more than the two year period set forth in Rule 144, and the fact that the underwriter in an IPO or later public offering will most likely dictate who may or may not participate in a public offering, The other side of the argument is that registration rights may be of value to a stockholder after an IPO, particularly an affiliate who remains subject to the volume restrictions of Rule 144, or the holder of a large block of stock that can only be disposed of with the help of a broker-dealer. A middle ground in an early round is not to provide for full-blown registration rights, but to require that the investors be included on an equal basis if registration rights are granted later to others, or to require that standard registration rights be granted later upon request of a certain percentage in interest of the investors.
Registration rights agreements have become so standardized that there is really no harm in including them in the documentation package, whatever their utility. The one change to the standard agreements served up by investor counsel that may be helpful to the company's founders is to include the founders' shares of common stock in the definition of "registrable shares" for purposes of piggyback registrations, and, if possible, for registrations on Form S-3. The trade-off for this concession on the part of the investors is to provide in the "underwriter's cutback" that the founders shares will be excluded from the offering by the underwriter before the investors' shares. The argument against including the founders in the coverage of the registration agreement, even if only for piggyback rights, is that founders who remain with the company will have the clout to have a portion of their shares registered at the time of an offering, and founders who leave the company before it goes public should not be given the benefit of registration rights.
Stock purchase agreements in venture capital transactions often call for one or more additional closings within a stated period, say, 90 days, after an initial closing, which permit the company to line up additional purchasers of the shares being sold on identical terms to those upon which the initial purchasers by their shares. Investor counsel are often inclined to call for the additional closing to include the same closing documents that were delivered at the initial closing, including a new opinion of counsel, certificates of public offices, officers' certificates as to corporate action taken to approve the transaction, officer's "bringdown" certificates, and so forth. The result of these requirements is the necessity for both investor counsel and company counsel to prepare and implement a full-blown second closing at the expense of the company. In general, this is viewed as overkill by both the principal investors and management, who do not want to see the investors' funds applied for this purpose. The alternative practice is for the company to obtain the subscription documents from the new investors, and a "bringdown" certificate from a company officer, and to close the sale of the additional shares based upon the initial closing documents and opinion. This is usually acceptable to the additional investors. The second closing is also a means for including those earlier investors who have exercised their rights of first refusal referred to above.
Right to Amend, Grant Waivers, and Approve Fundamental Changes
Most agreements relating to venture capital transactions contain provisions permitting amendment of the agreements and the corporate charter with the consent of the company and a specified percentage (in interest) of the investors - usually two-thirds). The purpose is to allow changes in the documentation to be effected even if a minority of the investors object. These provisions should be viewed carefully by the larger investors to determine that they either do or do not have a veto under the percentage selected, and to change these provisions accordingly if they insist on a veto.
It is important that the amendment provisions also empower the specified majority to grant waivers in addition to approving amendments. This would permit the requisite majority to waive the implementation of certain provisions of the documentation in appropriate circumstances, such as a waiver of an antidilution adjustment in a "down round," which is sometimes required by the new investors.
In many cases the provision in the charter requiring automatic conversion of the preferred stock to common stock in the case of an IPO will additionally require automatic conversion upon the affirmative vote of a specified majority in interest of the preferred stockholders. This is also often the case with mandatory redemption provisions, which may require that a scheduled redemption be approved by a specified majority to take effect. These provisions are preferable from the company's standpoint, but they may also be desirable from the standpoint of certain investors, depending upon the distribution of stock ownership. The alternatives are to require redemption of all shares as of a date certain, or to permit individual stockholders to require redemption of their shares after a certain date, both of which are less attractive from the company's standpoint. In dealing with mandatory redemption provisions, it should be kept in mind that mandatory redemption in compliance with these provisions almost never happens, so this is not an area of the documentation that the parties and their attorneys should dwell upon. The provision is intended to provide investors with an exit strategy and a certain amount of leverage when the company has not done well.
Reincorporating in Delaware
If a portfolio company is incorporated in another state, the investors have the opportunity to request that it be reincorporated as a Delaware corporation. Among the benefits of reincorporation (aside from the usual ones, such as well established business law, and familiarity to investors), are the ability to get a fresh start with the corporate documents (charter, corporate minutes, stock issuances, etc.) to replace inadequate or incomplete incorporation documentation (this requires cleaning up the initial incorporation documentation to enable the reincorporation to be accomplished, but results in a clean set of new corporate documentation). Any necessary stock split can also be effected in the course of the reincorporation (normally accomplished through a merger into a newly organized Delaware corporation). Further, in states such as Massachusetts, where the cost of a one-time filing fee for the authorization of a large number of shares normally required in connection with a venture capital transaction is high, the cost of the reincorporation is often offset by the savings realized from the avoidance of that fee. Going forward, the company will benefit from the ability of the stockholders of a Delaware corporation to take action approving future financings and other significant corporate actions by written consent of majority stockholders (with notice to non-voting stockholders), instead of by unanimous consent (as required by some states' laws) or the necessity to call and hold a stockholders meeting.