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Brad Feld and Jason Mendelson, co-founders of the VC firm Foundry Group, wrote in their bestselling book “Venture Deals” that the two things VCs should care about most when making an investment are economics and control.
Economics refers to the return investors will get in a liquidity event, and control refers to the mechanisms an investor has to either affirmatively exercise control over the business or veto certain decisions the company makes.
Where is the breakdown of economics and control found? For equity investments, it’s in the equity financing documents.
Therefore, it pays for an investor to understand what they’re agreeing to when they sign these documents. In this guide, we’ll look at the documentation an investor may receive when putting money into a startup.
The term sheet is a non-binding document that states the terms under which the fund manager (also known as the general partner or "GP") agrees to invest in the company. In the term sheet, you’ll find provisions like the size of the investment, the company’s pre-money valuation, and key economic and control terms. The term sheet serves as the foundation for the drafting of the remaining documents (sometimes called the round's “definitive agreements”). It’s common over the course of negotiating these definitive agreements to hear parties referring back to the intentions captured in the term sheet.
A term sheet may also include clauses around confidentiality and exclusivity, which are legally binding, to prevent the founder from shopping the term sheet around to get competing offers after they’ve already signed.
If the term sheet lays out the guidelines of a deal, the stock purchase agreement solidifies and expands on them. An SPA sets forth the specific terms related to the sale of stock to investors. It contains the purchase price, the amount of stock being sold, representations and warranties for both the company and the investor, indemnification provisions, closing conditions, and other key terms. SPAs (and the other definitive documents) can range from rather straightforward and industry standard to highly negotiated and customized, depending on the specific needs of the company or investor.
We mentioned that the SPA contained “representations and warranties” of the company. This is another way of saying that the company is providing certain statements of current fact and promises for the future regarding the legal and financial status of the company and its shares.
To modify these representations and warranties, a company will usually draft a disclosure schedule in connection with the SPA. This document provides explanations or exceptions to the representations and warranties. For example, the SPA may include a representation that the company is not currently subject to any litigation. If that is not true (i.e., if the company is being sued for whatever reason), the company would include information about the lawsuit in the disclosure schedule.
The disclosure schedule effectively puts investors on notice of any variation from the company’s blanket statement representations and warranties in the SPA. In this sense, the disclosure schedule essentially shifts the risk of these variations from the company to the investors.
The Voting Agreement is a document that sets forward requirements as to how certain shareholders must vote with their shares in certain instances. A voting agreement sometimes contains a “drag along right,” by which minority shareholders are essentially made to vote in the same way as the majority on a particular issue (i.e., a liquidity event). One of the main goals for the company behind executing a Voting Agreement is simplified management of shareholder voting in the future.
An IRA breaks down certain rights and privileges afforded to some investors. This may include information rights (such as access to a company’s financial information, which is important for LP updates), registration rights (requiring a company to register an investor’s stock with the SEC, thereby giving the investor the right to resell their shares), rights of first refusal (allowing the investor to accept or refuse the purchase of company shares before third parties can invest), and redemption rights (requiring a company to cash in an investor’s shares if certain conditions are met).
An IRA may also grant investors say in the establishment, composition, and rights of a company’s board of directors. IRAs often only grant rights to major shareholders based on a defined ownership threshold (say, investors who own at least 10% of the company).
Broadly, a Right of First Refusal (ROFR) provides the company the first opportunity to purchase the shares of any investor who wishes to sell them. The company can choose to exercise or waive its ROFR. If the company waives its ROFR, the shareholder can sell to other parties. A Co-Sale right provides certain investors the right to sell alongside selling shareholders. The ROFR and Co-Sale Agreement provide the company and shareholders protection in the event of:
Early-stage investors typically receive preferred stock in a company. The privileges and rights that come with that preferred stock are defined in the company’s certificate of incorporation. In the certificate of incorporation, the investor can see a description of the rights provided by their preferred stock, including liquidation preferences, dilution protections, voting rights, dividend rights, and rights regarding the conversion of their stock into common stock.
Investors will negotiate provisions to include in the certificate of incorporation to acquire more favorable terms, such as veto rights or right of first refusal. These changes must be voted and agreed upon by a majority of current shareholders. Most companies also include a “blank check stock” provision. This allows the board to create additional preferred stock (in the event of a fundraise) without shareholder approval.
GPs on AngelList receive assistance from our legal team in handling all paperwork associated with closing an investment in a portfolio company.
For a complete list of downloadable venture capital financing documents, visit the National Venture Capital Association (NVCA) website.
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