Archives for December 2007

Almost all Series A Stock Purchase Agreements are drafted so that they contemplate a signing of the agreement, then a closing after certain conditions are met.  These closing conditions may include:

• Representations and warranties are correct and covenants have been complied with;
• Securities laws have been complied with;
• The Certificate of Incorporation has been filed with the Secretary of State of Delaware;
• Ancillary agreements (such as the Investor Rights Agreement, Right of First Refusal and Co-Sale Agreement, Voting Agreement, Indemnification Agreements and Management Rights Letter) have been executed and delivered;
• Various closing certificates (such as an officer’s certificate, secretary’s certificate, and good standing certificates) have been delivered;
• A legal opinion has been delivered;
• Necessary consents and waivers have been obtained;
• The Board consists of specified persons; and
• A minimum number of shares is being sold in the closing.

As a practical matter, most venture financings are signed and closed simultaneously. Once company counsel and investors’ counsel have finalized the financing documents, company counsel collects stockholder consents and files the Certificate of Incorporation.  In financings involving multiple investors, wire transfers (and checks) may be sent to a trust account at company counsel prior to or on the closing date.  Signature pages for the various documents are also collected by company counsel and investors’ counsel.  The funds and signature pages are held in escrow pending the closing.  Once company counsel receives confirmation of filing of the Certificate of Incorporation, the financing is deemed closed (assuming that funds are held in escrow with company counsel).  Company counsel will then wire transfer the funds to the company (and deliver any checks), which occasionally may occur the day after the official closing due to wire transfer deadlines.

If funds have not been held in escrow, then the investors may initiate wire transfers directly to the company after filing of the Certificate of Incorporation and the financing is deemed closed when the company has received the funds.  As a practical matter, stock certificates are typically not delivered to the investors until sometime after the closing, although some investors demand to see a copy of the stock certificate before initiating the wire transfer.

Venture funds do not want their term sheets disclosed to other potential investors in order to avoid the deal terms being shopped. Below is a typical term sheet provision.

[Confidentiality: Until the initial closing of the financing contemplated by this Memorandum of Terms, the existence and terms of this Memorandum of Terms shall not be disclosed to any third party without the consent of the Company and the lead investor(s), except as may be (i) reasonably required to consummate the transactions contemplated hereby or (ii) required by law.]

Please keep in mind that venture funds typically do not sign non-disclosure agreements. Therefore, the confidentiality provision in a term sheet is not binding until it is signed by both sides. However, I suppose that venture funds need to trust companies not to disclose unsigned term sheets in the same way that companies trust venture funds to not disclose business plans.

Venture funds often include a binding no shop, or exclusivity, provision in a term sheet. Below is a typical term sheet provision.

[Exclusive negotiations: From the date of the execution of this Memorandum of Terms until the earlier of (i) [__________], (ii) notice of termination of negotiations by the lead investor(s) and (iii) the initial closing of the financing contemplated by this Memorandum of Terms, neither the Company nor any of its directors, officers, employees or agents will solicit, or participate in negotiations or discussions with respect to, any other investment in, or acquisition of, the Company without the prior consent of the lead investor(s). [The lead investor(s) consent to the Company soliciting, and participating in negotiations and discussions with, [__________].]

Whether a no shop is included in the term sheet and the time period of the no shop are subject to negotiation. Venture funds may insist on a no-shop of 45 to 60 days in order to complete due diligence and legal documentation for the financing. The rationale for the no shop is that the fund does not want to expend the time and resources on additional due diligence and legal fees if the company will continue “shopping” the deal.  If companies are unsuccessful at removing the no shop from the term sheet, they may try to limit the time period to 30 days or less. In my experience, most venture financings seem to take more than three weeks from term sheet signing to closing.

Companies may want to negotiate carve outs from the term sheet to allow for discussions with existing investors, banks, and specific other co-investors.

Company counsel legal fees in venture financings have increased since the 1990s. Legal fees in Series A venture financings routinely exceed $50K, and fees easily exceed $100K in complicated and later stage financings. In my experience, many companies also need to complete some corporate cleanup in connection with venture financings, especially with regard to capitalization matters, which leads to increased costs. Generally, working with competent counsel will be less expensive than fixing problems later or dealing with deferred housekeeping at the time of a venture financing.

Please keep in mind that the company also needs to pay legal fees for investor counsel. This is because venture funds receive a management fee of 2% to 2.5% for managing the money, which pays for day to day operating expenses of the fund, such as salaries, office space and other costs. Venture funds do not want legal fees to be paid from management fees and instead want them paid from the fund itself, via the portfolio company. Sometimes investor counsel legal fees are deducted from the wire transfer that the company receives upon the closing of the financing. Occasionally, venture funds will try to have the company pay legal fees even if the financing does not close.

Legal fees for investor counsel may be capped in routine financings, although some venture funds will not cap legal expenses and will expect payment of “reasonable” expenses. These caps may be as low as $20K or range as high as $100K or more in complicated financings. If investors need to conduct specialized IP or regulatory due diligence, fee caps or expectations may be higher, as the investors may engage separate patent or regulatory counsel to conduct due diligence.

Fees for company counsel are typically 2X investor counsel fees because company counsel (at least on the west coast) typically drafts financing documents, coordinates due diligence and delivers a legal opinion, which requires more work than investor’s counsel. In my experience, it is difficult to adequately represent an investor in a venture financing without incurring less than $25K to $35K in legal fees, simply due to the time necessary to review documents and conduct due diligence.

If investors are not represented by counsel, such as in some angel financings, then company counsel legal fees can be significantly lower. This is partially due to the lack of back and forth negotiations among the attorneys and also due to the fact that these companies may be fairly early stage with few due diligence issues. In my experience, I believe that it would be difficult to complete a simple angel Series A financing for less than $20K to $25K on the company side.

Please also see the post by Jason Mendelson on Ask the VC answering the question: “How Much Should I Pay Lawyers to Complete My Financing?”  Dick Costolo has a humorous (and fairly insightful) post about legal fees entitled “Legal Fees: Start Swearing Now.”

In any event, actual mileage may vary.

Venture funds often request a management rights letter when investing in a company. The management rights typically include the ability to attend advise and consult with management of the company, attend board meetings and inspect the company’s books and records.

Venture funds request these rights in order to obtain an exemption from regulations under the Employee Retirement Income Security Act of 1974. Absent an exemption, if a pension plan subject to ERISA is a limited partner in a venture fund, then all of the venture fund’s assets are subject to regulations that require the venture fund assets to be held in trust, prohibit certain transactions and place fiduciary duties on fund managers.

However, a “venture capital operating company” is not deemed to hold ERISA plan assets. To qualify as a VCOC, a venture fund must have at least 50% of its assets invested in venture capital investments. In order to qualify as a venture capital investment, the venture fund must receive certain management rights that give the fund the right to participate substantially in, or substantially influence the conduct of, the management of the portfolio company. In addition to obtaining management rights, the fund is also required to actually exercise its management rights with respect to one or more of its portfolio companies every year.

Some investors request that they have the right to have an observer at board meetings. The observer attends board meetings and may participate in board discussions, but does not have the ability to vote on matters. Some investors request that they have a board observer in addition to a board seat. An observer right is typically contained in a side letter in connection with a venture financing or one of the investment documents.

Board observers are sometimes excluded from portions of meetings in order to preserve attorney client privilege. This occurs when the board is discussing litigation or potential litigation. Communications between an attorney and a client are considered confidential and generally cannot be forced to be disclosed in litigation. For purposes of the privilege, board members are considered part of the “client,” but board observers are not. Depending on the culture of the company/board, observers may also be excluded from executive sessions of the board, where the board may discuss sensitive personnel matters or strategic matters.

One reason to limit board observer rights is to limit the number of people in a room during a board meeting, as larger meetings are more difficult to manage. Depending on the culture of the company/board, observers may participate in discussions like any board member or may be expected to remain silent (especially in the case of junior representatives of investors). As a practical matter, most companies/boards will allow an investor to bring another person to board meetings from time to time without a formal observer right.