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September 01, 2022

Cashing In: Getting Ready for Your Series-A Round

With the Summer 2022 Y Combinator Demo Day being held September 7 and 8, a new group of startup companies will have investors approaching them with term sheets for preferred stock financings. For many companies, the key points of the term sheet will be a breeze, as their main focus will be on the proposed amount to be invested and the valuation. But, what about the rest of the term sheet? Protective provisions, liquidation preference, voting rights, registration rights, rights of first refusal, etc. — these concepts may be foreign to some executives, while others that are more familiar with the concepts may be concerned that they’re agreeing to terms that are “off-market.” 

Not to fear: the National Venture Capital Association (NVCA), has produced a standard suite of legal documents that are utilized to draft the core legal documents in most venture capital financings. Below, we provide a brief summary of the key documents and workstreams you will encounter when conducting your initial preferred stock financing.

What Documents?

The below table includes each of the key legal documents that will be executed in connection with your financing, the basic function of each document and a few key considerations related to each document.

Document and Function
Key Considerations

Stock Purchase Agreement

This is the document where you agree to sell stock to the investors.

  • Disclosure Schedules — Drafting disclosure schedules will likely be one of the most onerous workstreams of the financing process, as the company representations and warranties, or company reps, in the stock purchase agreement (SPA), will either explicitly require disclosure of certain matters in the disclosure schedules (e.g., “Section 2.2(c) of the disclosure schedule sets forth the capitalization of the company immediately following the Initial Closing…”) or will require you to disclose any noncompliance with a company rep (e.g., “the company has not incurred any indebtedness over $50,000, except as disclosed in the disclosure schedules”). It is important to keep this in mind as you review the company reps.
  • Company Representations and Warranties — Read the company reps closely, as this draft of the SPA will likely be utilized for future financings, and it will be difficult to renegotiate company reps. A few of the more important company reps are below: 
    • Financial Statements — Ensure that you are only agreeing to provide financial statements that you are able to produce.
    • Material Adverse Event (MAE) Definition — Numerous reps will be MAE qualified, you should ensure that your MAE definition isn’t over-inclusive and should remove “prospects” if possible, as early-stage investors should understand that there are numerous different events that could have an MAE on your prospects. 
    • QSBS — Conduct a qualified small business stock (QSBS) analysis if your assets after the offering may be over $50 million. If you make the rep that the stock being issued in the financing will receive QSBS treatment incorrectly and without conducting any diligence, you could be on the hook further down the line if an investor has to pay taxes on stock it believed to be QSBS stock (holders do not have to pay taxes on certain capital gains on QSBS stock after such stock is held for five years).
    • CFIUS — If you collect sensitive personal data or create any potentially critical infrastructure or technology under the Defense Production Act, you may not be able to make the CFIUS rep, which would need to be disclosed and may bar non-U.S. investors from investing in the financing.
  • Additional Closing — If you do not believe that all investors in the financing will close on the same date, you should consider including language enabling you to conduct subsequent closings up to a set dollar amount pursuant to the SPA. Otherwise, you will need to amend the SPA and the other investment documents, and solicit board and stockholder approval for each subsequent closing. Some investments will also have milestones that require investors to make subsequent investments; you will want the SPA to make those milestones clear and not subject to investor outs. 

Certificate of Incorporation 

This governing document sets forth the terms for the preferred stock.

  • Liquidation Preference 
    • Payment Seniority — The initial series of preferred stock will be senior to common stock in the event of a liquidation event. The seniority of each subsequent series of preferred stock will be negotiated in each financing on a one-off basis. 
      • Non-participating — The typical liquidation preference is non-participating, so, in the event of a liquidation event, investors will receive the greater of their initial investment, plus any accrued and unpaid dividends, or such amount as would have been payable if all of the investors’ shares of preferred stock would have converted to common stock. The term sheet may also include a multiplier on the initial investment amount, so that in the event of a liquidation event, you must pay the investors the greater of their initial investment times such multiplier or the value of the preferred stock on an as-converted to common stock basis, whichever is greater.
      • Participating — Although rare, investors may require a “participating” liquidation preference, which requires that in the event of a liquidation event, the investors must be paid back their initial investment, plus any accrued and unpaid dividends, plus such amount of the remaining proceeds as would have been payable if all of the investors’ shares of preferred stock would have converted to common stock (e.g., investors invest $4 million in a company and receive 50% ownership at the highest liquidation preference, and the company is sold shortly after the financing for $20 million. The investors get their initial $4 million returned, plus 50% of the remaining $16 million, for a total of $12 million, while if the liquidation preference was non-participating, the investors would just receive $10 million (50% of the $20 million)).
  • Protective Provisions — The NVCA form contemplates protective provisions that provide investors in the series with consent rights, voting separately as a class, over certain company actions that would have an adverse effect on such investors.
    • Typical consent rights are related to creating senior series of preferred stock, conducting any liquidation event, incurring debt, issuing dividends or conducting redemptions, among other company actions. 
  • Board Rights — The lead investor will likely request to have a director on the board, and such right to nominate a director will be included in the certificate of incorporation (and the stockholders will be committed to vote for such nominee pursuant to the terms of the voting agreement referenced below). Some investors may want more than one board seat and may ask to remove certain directors and/or add additional independent investors to the board.
  • Authorized Shares — Your lawyers will likely be all over this, but you will need to ensure that you have enough authorized shares of common stock to cover outstanding equity grants, the remaining shares of common stock in your equity plan post-financing and the conversion of all outstanding preferred stock into common stock (such total including any convertible notes that are converting into preferred stock in the financing).

Investors’ Rights Agreement

This grants investors various rights while subjecting you and the investors to certain covenants. 

  • Registration Rights — Investors will receive both demand and piggyback registration rights with respect to the shares of common stock underlying their shares of preferred stock. The demand rights will enable investors to force the registration of such shares pursuant to a registration statement upon the earlier of a set time period and 180 days post-IPO. The “set time period” enables investors to force you to go public if you have not already done so by the end of the period. Such period is typically set between three to five years, with five years being most typical. Piggyback registration rights enable investors to include their shares on a registration statement that you file.
    • Underwriter Cutback — Both piggyback and demand registration rights are subject to the satisfaction of certain conditions, but it is important that an underwriter cutback is included, which enables the managing underwriter of your IPO or subsequent registered equity offering to not register investor shares if it would jeopardize the success of the offering. This underwriter cutback effectively enables the underwriter to exclude such secondary shares from any registered primary offering you conduct.
  • Market Stand-Off — It is standard to include a market stand-off provision that locks-up investors for 180 days post-IPO, which can save you from having to solicit lock-up agreements from all of your preferred investors prior to consummating your IPO (although it is possible that the lead IPO underwriter will still require each investor to sign the IPO lock-up regardless of whether such investors are subject to a market stand-off).
  • Covenants to Make Certain Operational Updates 
    • NDAs — A covenant will often be included requiring you to enter into confidentiality agreements with employees that have access to confidential information.
    • Insurance — A covenant will often be included requiring you to obtain D&O insurance and key-person insurance within a set number of days from the closing of the offering.
    • Policies —The NVCA form contemplates a covenant requiring you to implement a code of conduct and anti-harassment policy within 60 days after the financing. You may want to implement these policies prior to the financing to avoid having to seek approval of such policies from the post-financing board.
    • Cybersecurity — You may be required to implement certain cybersecurity controls, safeguards and training. To avoid including this covenant, you will need to have a rationale prepared (already have sufficient controls, don’t handle personal information, etc.).
  • Information Rights — The investors will be granted rights to quarterly, annual and potentially monthly financials. You will also likely need to provide an anticipated annual budget. Depending on your stage in development, you may want to push back on the requirement to produce audited financial statements from a nationally recognized accounting firm given the additional time and cost related to producing audited versus unaudited annual financial statements.
  • Inspection and Observer Rights — “Major Investors” (typically a few lead investors) will typically have the right to inspect your books and records. Additionally, if the lead investor is not granted the right to elect a director it may be granted board observer rights. It is important to ensure that such rights are limited, to the extent necessary, to prohibit sharing sensitive information with strategic corporate investors that may be competitors.
  • Preemptive Rights — It is standard for certain Major Investors to receive a waivable right of first offer over future financings, which requires you to provide notice of the subsequent financing and provide such investors with an opportunity to purchase their pro rata portion of such newly issued securities.

Voting Agreement

This commits stockholders to vote in a certain manner.

  • Director Nominee — The voting agreement commits substantially all stockholders to vote in favor of a slate of nominees to serve on the board (including the investor director nominee(s)), and to continue to vote for such nominees. This commitment should terminate, as should the voting agreement, post-IPO or sale of the company.
  • Drag-Along Right — The voting agreement often commits all investors to approve a sale of the company if set groups approve the sale of the company; typically, this includes the board, the preferred stockholders and perhaps the founders. In addition to the standard set of drag-along conditions, the investors may include a condition that the drag-along is not effective unless the proceeds per share in the sale are a multiple of the price per share paid in the financing.

ROFR & Co-Sale Agreement

This provides investors with a right of first refusal on certain sales of stock by common stockholders.

  • Limiting Who Is a Key Holder — The ROFR and co-sale agreement grants the company the primary right, and the investors a secondary right, to purchase any shares of common stock that certain key common stockholders propose to sell. The agreement also grants the investors the right to co-sell their shares if any key stockholders propose to sell their shares. There will likely be an “additional key stockholder” provision that automatically makes certain individuals that acquire stock in the future key stockholders based on their common stock holdings (such holdings typically including stock options and other rights to purchase shares). It may benefit you to include a higher ownership threshold for determining who is an additional key stockholder, so early employees don’t become key stockholders as they accumulate options.
  • Termination — This agreement will almost always terminate upon an IPO, but you should ensure that is the case, as the restrictions pursuant to this agreement are relatively immaterial while you are private because of the illiquidity of your common stock, but post-IPO, your key stockholders will want to be able to freely trade their shares.

What Else?

Other Legal Documents

In addition to the above, you may also be required to provide the lead investor with a management rights letter, which provides the lead investor with further information rights and a board observer if the lead investor doesn’t have a nominee serving on the board. You will also likely enter into a standard indemnification agreement with the lead investor’s director nominee. At the outset, you should also review your outstanding convertible notes or other investor documentation, if any, for any notice requirements or waivers you must solicit prior to the consummation of the financing.

Investor Data Room

Prior to the execution of the term sheet, you will field questions from investors that are contemplating (and hopefully competing!) to be the lead investor in the financing. These questions are often related to your operations, previous results, projections, customer agreements and diligence concerns. To address these inquiries, most companies set up a data room and give each investor access to a specific folder that contains the requested materials.

Capitalization Table

You will be required to produce a capitalization table while the term sheet is being negotiated, along with a pro forma capitalization table at the agreed-upon pre-money valuation to determine the price per share in the round. The initial capitalization table will need to include all issued and outstanding shares of common stock, all outstanding equity grants, all shares that are reserved for issuance pursuant to your equity plan, and your outstanding convertible notes and details related to how such notes convert. After a valuation is agreed upon, you will need to update the capitalization table to pro forma for (a) the conversion of the convertible notes into the round and (b) the increase of the equity plan pool. This fully diluted total (Pre-Money Total) will then be divided by the agreed-upon pre-money valuation to determine a price per share. After that price is determined, the number of shares to be sold in the round is determined by dividing that price by the proposed investment amount. Summing the number of shares in the Pre-Money Total with the number of shares sold in the round and multiplying by the price per share in the round will produce your post-money valuation.

The VC firm’s counsel will conduct a due diligence review of your capitalization table to ensure that all securities that are reflected in the capitalization table are supported by the appropriate documentation (stock certificates, option grants, convertible notes, etc.) and to confirm that all issued shares, equity grants and notes are reflected in the capitalization table. It may be worth conducting your own due diligence review of your capitalization table prior to the financing to ensure that the proper supporting documentation exists and that your capitalization table is accurate. Your counsel will typically need to provide a legal opinion on your capitalization, and you will want to get their diligence done early in the deal process so no surprises derail the deal.

Form D and State Securities Filings

You have 15 calendar days after the first investor irrevocably contractually commits to invest in the financing (typically the day that the stock purchase agreement is executed) to file a Form D with the SEC, which is a notice of an exempt offering of securities. If you have not yet conducted any SEC filings, you will need to file a Form ID with the SEC to obtain EDGAR codes prior to filing your Form D, which usually takes two to three business days. Additionally, after filing the Form D, you should have your counsel make the requisite state securities filings to comply with the relevant fee and notice requirements in jurisdictions where accredited investors purchased shares in the financing.

Then What?

After the financing is complete and the requisite filings have been conducted, you will continue to operate as-is, likely with a new board set-up and potentially with a few operational updates in process to comply with the terms of the financing documentation (and with some additional cash in the bank!). Additionally, after taking professional investor capital, companies typically upgrade their governance and corporate formalities to ensure they can meet their go-forward investor obligations and lead the company through its next chapter of growth.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

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