The term sheet, in time, segues into a formal agreement. The understandings between the parties (as set out in the term sheet or simply by oral agreement) may be primitive: "Here's some cash, give me some stock." Nonetheless, any deal involving the sale of securities is legally complex because the law views that category of transaction in a special way; lawmakers and regulators, based on historical evidence going as far back as the South Sea Bubble, entertain deep concerns that there exist unusual opportunities for fraud and overreaching when the commodity traded is a security. Accordingly, the simplest investment contract–"one share, one dollar"–is in reality far from simple, since the agreement of the parties is complemented by rules imposed by statute and administrative regulation.
In a structured venture financing, the contract between issuer and investor is, or should be, detailed, covering a number of issues which otherwise may be the subject of future disputes and misunderstandings. The instrument recording the issues on which the parties' minds meet can bear any number of titles; it usually is called the "Stock Purchase Agreement" or "Purchase Agreement." The following discussion, consistent with the theme of the text, is designed to illuminate not only the various deal points but also the principles underlying the negotiations and what hangs on winning or losing a given point.
If artfully drafted, the Purchase Agreement, like any contract, tells a coherent story. Most legalese is rightfully condemned as "Bastard English," incomprehensible to the lay person While there are, surely, some valid reasons for using what philosophers refer to as a "meta-language" in legal agreements–"terms of art" in legal jargon–much of the mystery in legal drafting is unnecessary, the product of sloppy, lazy writers, or worshippers of archaic, out-of-date conventions.
For example, a contract, like a story, should start with an introductory paragraph or two, which will set the stage and explain what the draftsman is trying to accomplish. Custom has it that the introduction should be segmented into a series of clauses, each introduced by the word "whereas," all of which makes the story jerky and difficult to follow. If the draftsman keeps in mind he is storytelling, he can readily perceive that the easiest and most understandable way to begin a preamble is with the label "preamble," followed by a consecutive narrative of the background of the transaction and a summary description. (The preamble is not, strictly speaking, a part of the agreement but the language is significant nonetheless, since, in case of a dispute, construction of the contested contract language will be influenced by statements in the preamble, to the extent material.) Calling a spade a spade, or in this case, a preamble a preamble, is not the only aid available to comprehension. A book has a table of contents for handy reference–the Purchase Agreement should as well.
The Purchase Agreement proper should open, again for purposes of clarity, with the basics: Who is buying what and at what price and when? The "who" are the investors and they are ordinarily designated in an attached appendix, a drafting device to allow changes up to the closing at a cost of retyping a single page. Even though subscribing en masse to a single document, the investors are, technically, each entering into a separate contract to buy stock. Usually, they are not responsible for any other investor welshing on the deal; their responsibility is, in legalese, "several" and not "joint."
The "what" is the security or bundle of securities being offered. If other than common stock–that is, preferred stock, warrants, convertible debt–often the most economical way to describe what is being offered is to attach the instrument itself and incorporate it by reference in an appendix, or a collection of appendixes labeled a "disclosure schedule." The danger in that practice, handy as it may be, is that a reader may overlook significant substantive terms by assuming that the appendix is "boilerplate"; that is, "a preferred stock is a preferred stock is a preferred stock." The fact is that many of the important points to be negotiated ("deal points" as they are called) are located in the document constituting the security, for example, the interest rate on the debentures and the conversion price. The moral of the story is to read and bargain out the appendixes; do not sign off on the Stock Purchase Agreement until the appendixes have been attached and carefully considered. Moreover, as discussed below, last-minute attachment of appendixes, as the parties are hurrying to close, is liable to provoke ill will as the issuer protests that counsel for the investors is nitpicking when counsel (often legitimately) points out that the appendixes introduce new substantive terms.
In this connection, if "units" are being sold–that is, a bundle of separate securities, debentures plus warrants, for example-it is only prudent to negotiate explicitly an agreed division of the purchase price and reflect that agreement in the Stock Purchase Agreement. This is usually a pro-investor provision; the investors want to mitigate "original issue discount." The idea of a mutually agreed allocation of the purchase price across the disparate commodities being sold is a subset of the general principle that parties to an agreement should specifically agree to take mutually consistent positions on matters of allocation (mutually agreeable filing positions on their tax returns, for example).
Describing the price is seldom a problem unless one of the investors is contributing property that requires valuation. The issuer sometimes insists the price be paid in "good funds" or "same-day funds," funds that are credited to its account the day of the closing so that "float"–that is, the loss of daily interest on the funds as they are being collected–is not the issuer's problem.
The "when"–the closing date–is usually straightforward: the date the cash is to be paid, the securities delivered, and the attendant paperwork completed. Some Purchase Agreements allow for multiple closings; indeed, this can be a significant element of the issuer's strategy on occasion. Thus, the problem, from the issuer's standpoint, in many start-up financings is delay; the investors will coo enthusiastic words in the founder's ear, exciting him to ecstasy, then sit on their hands while he edges closer and closer to the abyss. Occasionally, the tactic is deliberate; the terms may improve for the investors as the founder gets increasingly desperate. To counter investor lethargy, it is often advisable to admit the first investors as soon as they are willing to put up their money. Even if the proceeds have to be held in escrow, the fact of a closing often disciplines investors on the fence, the "train is leaving the station" effect.
If the transaction is being pushed at an accelerated pace, the Purchase Agreement may be signed and delivered and the closing take place simultaneously. More often, the closing is delayed while the securities are being sold, investors subscribing seriatim, or the investors sign as a group but conditions to closing (federal agency approval of a license transfer, for example) must be satisfied. It is sometimes necessary, after the agreement has been executed, to change the closing date, in which event it is handy if the subscribing investors have agreed in advance to be bound, as to this and other ministerial changes, by a single signatory–their special counselor–at any rate, by less than all of their number.
Multiple closings can also occur if the deal is of the "milestone" or "benchmark" variety, meaning that the investors parcel out the committed sums if and only if the founder is able to pass stated tests by specific dates. If the dates are missed, the founder is penalized by: (1) failing to be able to call down the later installment, (2) coughing up additional equity, or (3) a combination of the two. "Milestone" deals are characteristic of high-tech seed investments, when the viability of the entire project depends on certain technical hurdles being overcome. One milestone might be development of a prototype, the second a successful lab test, the third a successful beta test, such as proving out and debugging the device at a customer's location.
Some founders are nervous about milestone deals since they think the deck will be stacked against them in defining the milestones. However, viewed analytically, many venture financings are in fact, if not in name, of the "milestone" variety. Most start-ups are financed by multiple rounds: seed, first round, mezzanine, and so forth. The later rounds are, albeit not explicitly, based on milestones. If the existing investors do not think the company has made the necessary progress, they do not put up their money or do so at a reduced valuation. And, it is an article of faith in the business that no new investor will finance if the existing investors do not have enough faith to come forward as well. Therefore, in a very real sense, an explicit milestone deal favors the founder-at least he knows that if he does what he says he is going to do, he will get some more money at a specified price. In a conventional financing, the founder has only a reasonable expectation that more cash will come in if he "minds his P's and Q's." To be sure, nothing in the foregoing discussion should lead a founder to relax in negotiating a milestone financing. It is in the nature of the beast that ambiguities can creep into even the most rigorously defined scientific test.
A final note on closings. As indicated in the succeeding sections, the structure of the "representation and warranties" section is such that the majority of the language is in the agreement proper, but the substance is in documents which are attached, sometimes seriatim, to the main instrument-appendices or exhibits containing the problems which the issuer identifies as exceptions from the generic representations and warranties. Often the issuer will surface the all–important appendices on the eve of the closing, accompanied by urgings that the investors' counsel not "nitpick." To avoid this unwanted pressure, the investors are well advised to insist the closing date be the later of the scheduled date or some period, say forty-eight hours, after the appendices are exposed.
Traditionally, after the deal has been described, the Purchase Agreement plunges into the issuer's representations and warranties, one of the longest sections in the Agreement. This is the section with which lawyers inexperienced in venture financings feel most comfortable, and the overwriting in this section becomes almost competitive. Thus, investors' counsel from one of the major New York firms, accustomed to billion-dollar merger and acquisition transactions, will write in representations dealing with multiemployer collective-bargaining agreements for a company with two employees. The way to approach the representations and warranties section, accordingly, is to understand the underlying dynamics.
By way of introduction, representations and warranties are not designed to serve the same purpose in venture finance as in giant merger and acquisition (commonly abbreviated as M&A) transactions between solvent investors and issuers. If the startup issuer misstates its balance sheet to prospective investors, the inclination of the damaged investors to seek restitution must be restrained because the guilty party, almost by definition, will be out of money. As an aid in making aggrieved investors whole from the pockets of the issuer, the representations and warranties in an early-round financing are usually a bust. Moreover, it is arguable that explicit representations and warranties are superfluous, since the investor enjoys common-law remedies for the tort of deceit and statutory protection under Rule 10b-5 of the '34 Act. Why, then, bother with elaborate representations and warranties?
First of all, the section is designed, although not explicitly, as a device to draw into a lawsuit, given a misrepresentation, the perennial "deep pockets" in the financing: the law firm, the accountants, and the investment bankers (if any) serving as placement agents. Although the representations as to the financial statements are made by the issuer and the issuer alone, the existence of the representation makes it plain, if the question were ever in doubt, that the investors were relying on the accuracy of the statements, and that all the ancillary parties engaged in preparing the Purchase Agreement are, or should be, aware of such reliance. Since reliance to one's detriment has historically been an element of a plaintiff's case in the tort of deceit(although not universally required in the modern cases), memorialization in writing of the investors' reliance may obviate problems of proof. The issue of scienter–a claim by the issuer that it did not know of the critical omission–is also avoided by explicit "warranties." Further, those representations that have to do with the legal facts surrounding the issuer's existence–its due organization, the number of shares outstanding–form the reference point for an opinion of issuer's counsel validating those propositions which counsel are in a position to verify; again, a deep pocket if a damaging error is made. (A point of particular interest in a high-tech startup fill often be counsel's opinion concerning the validity of the patents, copyrights, or trade secrets protecting the issuer's technology.) Moreover, participation in the process of preparing the written representations–drafting the language in the case of counsel–may be enough to draw counsel into the zone of responsibility as a matter of law; the lawyers become "participants" in the entire transaction. Similarly, the founder can sometimes be induced to endorse certain of the representations personally, putting his pocketbook (for what that's worth) behind the statements made. If the founder balks, claiming he cannot be held to know certain facts absolutely, a representation can be softened to a so-called knowledge rep–that is, "to the best of my information and belief"–thereby catching the founder who is demonstrably lying. If the founder cannot pay in cash, the worst case is that investors can pick up some or all of his equity.
The representations also serve to motivate all hands-founder, investment bankers, lawyers, and accountants–to reexamine the facts. This is an incontestably salubrious use of the section: to energize these parties to do their investigations carefully so as to minimize subsequent disputes. In fact, if the investors want to make (as they usually should) their own investigations–an "acquisition audit" as it is sometimes called–they may be deterred by a fear that the issuer will attempt to defend a charge of misrepresentation by claiming the investor is stopped by its own inquiries. Unconditional written representations, perhaps accompanied by a statement that the investors may rely on the same even in light of their own audit, serve to diminish that concern.
The representations serve an important ancillary function: as closing conditions. Assuming that the Stock Purchase Agreement is not closed simultaneously with its execution, the investors will be able to withhold their investment if they discover imperfections in the period between execution and closing. In fact, one of the traditional representations is to the effect that there will be no materially adverse change in the issuer's business between signing and closing, which gives the investors an "out" even though the issuer has told the truth throughout.
Finally, the warranty flavor of the representations and warranty section indicates the function of these provisions as a risk-allocation device. Thus, it assumes a contingency the warranting party did not know about and could not have known about. The resultant loss is the responsibility of the warranting party even though the representation was not, at least consciously, untrue.
Sometimes the agreement becomes confused between the company's representations and its covenants. Conceptually, the two are quite different. The company "represents" facts-that is, existing statuses. When it "covenants" something, the obligation is promissory; the company is promising to do (or not do) an act in the future. In both cases, the company is liable for breach, but the damages are technically different. A misrepresentation entails tort damages while failure to perform a covenant opens up contract damages. It is not unusual to find promissory statements mistakenly included in the representations and warranties section; viz., "The company's insurance policies are as listed on Exhibit A" (a representation), and/or "the company will maintain those policies in force" (an affirmative covenant). This is a problem principally for the draftsmen of the complaint when and if the agreement is involved in litigation.
The covenants divide into two categories (affirmative and negative) and onto two levels (ministerial and very serious). The ministerial covenants, usually affirmative, have to do with promises the company can keep with relative ease: sending out reports and the like. Breach of the same usually involves only corrective action. (Occasionally, a covenant concerning a control issue will find its way into the Stock Purchase Agreement; that is, "the company will elect X, Y, and Z, nominees of the investors, to the board of directors." This is usually a rookie mistake. The agreement between the company and the investors is not the place for that type of promise because the company does not elect people to the board, the stockholders do; such provisions belong in the Stockholders Agreement.)
Certain negative covenants are also within the clear power of the company to observe, and are, in that sense, ministerial. Thus, typically the company promises it will not engage in certain major activities absent investor consent–for example, payment of dividends, fees to insiders, large borrowings, new issues of stock, mergers, changing management salaries, firing a given officer, redeeming shares; such negative covenants buttress and enlarge the statutory requirements that certain significant proposals-that is, mergers–be put to a shareholder vote. The issues can be important and worthy of spirited debate, but the point is that the promisor–the company–can still exercise control over its destiny. It is unlikely the company will violate them if only because the objecting shareholders can restrain any breach.
The covenants that the company cannot control, the more ominous covenants, are those of the loan agreement type, for example, the company will maintain a given net worth and/or specific asset-to-liability coverage. These promises, which can be stated affirmatively or negatively, are dangerous because they are beyond anyone's control; moreover, they usually entail specific remedies. The investors need not start litigation since a well-drafted agreement provides them with practical compensation (in addition to and not in lieu of their other remedies); that is, control of the company "flips" in their favor and/or the founder gives up stock, the equity equivalents of acceleration clauses in a debt instrument.
A popular form of managing risk entails a form of contingent payment, depending on the postclosing performance of the entity. The principal issues involved are negotiation of the earn-out formula and protection of the investors against a cooking of the issuer's postclosing books, whether deliberate or inadvertent, which will cause the formula to work against the interest of the investors. An earn-out formula may simply refer to the earnings of the issuer "according to generally accepted accounting principles" after the closing; but the matter should not be, and usually is not, disposed of that simply. Draftsmen have to deal with what Gilson calls "nonhomogenous expectations," if, for example, there exists a substantial amount of goodwill on the balance sheet of the issuer, the question is whether the amortization of goodwill should impact the formula. Other items to be covered in such negotiations include the depreciation schedules to be employed; treatment of extraordinary charges; the appropriate method for valuing inventory; whether or not to capitalize or expense items such as research and development; and changes in historical practices such as the treatment of pension costs. The formula should also reduce, to the extent possible, the rewards of gaming–for example, management's attempt to manipulate the indexes during the earn-out period.
Securities law issues include the question whether the receipt of contingent stock involves a new investment decision and, therefore, the need for separate registration (or an exemption) and the appropriate holding period under Rule 144 for nonaffiliates vis-á-vis the contingent stock.
From the investors' point of view, one advantage of "earn-outs" is obvious: if the issuer has breached a surviving representation or warranty, the investor may set off against its earn-out obligation (or any deferred payment) versus chasing the issuer or its shareholders for the money.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
McCarter & English, LLP
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