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.

Investors in venture financings almost always demand representation on the board of directors. In a VC-led Series A financing, there are typically three or five directors immediately after the financing. As a practical matter, smaller size boards are easier to manage (i.e. scheduling board meetings for larger boards is extremely difficult; meetings seem to go faster when there are less people in the room whose opinions needs to be heard).

If there is one lead investor, then there are typically three directors, consisting of one Series A investor designee, one common designee (typically the founder/CEO) and one independent person (approved by the investor and the common stockholders or the common designee). The independent seat will oftentimes be left vacant at closing, with the intention of filling the seat sometime after closing.

If there are two lead investors, there there are typically five directors, consisting of two Series A investor designees (one from each investor), one common designee, the CEO (which will be a seat elected by the common stockholders) and one independent person.

In later rounds of financing, investors in the later rounds will also inevitably demand a board seat, which results in larger boards dominated by investor representatives. Investors in later rounds will sometimes request that investors in previous rounds relinquish their board seat to limit the size of the board. These early investors are typically given board observation rights, which allow them to attend and participate in board meetings, but not have an official vote in board decisions.

For the entrepreneur’s point of view on the subject, please read the Venture Hacks articles “Create a board that reflects the ownership of the company” and “Make a new board seat for a new CEO,” along with Dick Costolo’s post on “Early Stage Board of Directors.”

In some financings, especially non-VC led Series A financings, the board composition can simply be a closing condition to a financing with no other mechanism to guarantee a certain board composition. In such case, the composition of the board in future elections typically defaults to one vote per share (preferred converted to common basis) and may be favorable to the common stockholders as they typically control a majority of the outstanding shares.

In most venture financings, however, the board composition is set forth in the certificate of incorporation (i.e. common may elect one board member, Series A may elect one board member and the common and preferred voting together may elect all other board members). A voting agreement among the common and preferred stockholders forces the stockholders to vote in favor of director nominees selected in a certain manner (i.e. all of the Series A stockholders agree to vote in favor of the nominee from VC Fund X for the Series A seat).

In my experience, it seems like founders are overly concerned about board composition compared to other provisions in a term sheet. At the end of the day, most founders typically don’t control the board after a VC-led financing, as the investors won’t allow a situation where the common stockholders have significant control or veto power. As a practical matter, investors will typically end up with a significant amount of control due to the protective provisions and the drag-along provision, aside from board composition.

The drag-along or bring-along provision forces a stockholder to vote in favor of a sale of company if a certain threshold of stockholders and/or the board of directors approve the transaction. Below is a typical term sheet provision.

“Drag–along” right: Subject to customary exceptions, if holders of [50]% of the Preferred approve a proposed sale of the Company to a third party (whether structured as a merger, reorganization, asset sale or otherwise), [__________] will agree to approve the proposed sale. This right will terminate upon a Qualified Public Offering.

The items typically negotiated in the drag-along provision include:

• Parties subject to the drag-along.  Generally, investors want common stockholders with significant holdings to sign up to the drag-along. This is especially important for companies that may be subject to the California long-arm statute, which would require the holders of a majority of common stock to approve the transaction.  Major investors also typicaly want the other investors to be subject to the drag-along to ensure that minority investors also approve the transaction.  If significant stockholders exercise dissenters rights, which would allow them to receive cash in the transaction, they could interfere with the tax-free nature of certain mergers.

• Threshold to trigger the drag-along.  The trigger is typically a certain percentage of stockholders (such as 50% or 2/3 of the Preferred, or a specific series of Preferred) and sometimes board approval.  The percentage to trigger and the group of stockholders that control the trigger are typically negotiated.

• Minimum price.  Due to liquidation preferences, some stockholders (especially common and junior preferred) may not receive any proceeds in a merger.  Forcing these stockholders to vote in favor of a merger in which they receive no consideration may be objectionable to them.  Therefore, some stockholders may try to negotiate minimum price thresholds for the drag-along to apply.  For example, a common stockholder may try to argue that the drag-along should only apply if the common stockholder receives at least a certain price per share (such as the Series A purchase price) or the valuation of the company is greater than a certain amount in the transaction.  Investors will likely resist these modifications to the drag-along because the purpose of the drag-along is to force a vote in the event of a sale of company transaction that might not be entirely supported by the stockholders subject to the drag-along.

• Limitation to cash/freely tradeable securities.  Many stockholders would object to having to vote in favor of (and waive dissenters rights in) a taxable merger transaction in which they receive illiquid securities.  Therefore, some stockholders argue that the drag-along should only apply if the merger consideration is cash or freely tradable securities.

• Limitation on representations, warranties and covenants made by the dragged party. Some stockholders may argue that the drag-along should not force them to give representations, warranties and covenants in the transaction that go beyond ownership and authority to sell the shares.  This is typically agreed to by investors.

Many acquirors will require a certain percentage stockholder vote in favor of a merger in order to minimize the risk of stockholders exercising dissenters rights.  If the thresholds for the drag-along are set at a level where various stockholder constituencies are protected against transactions that are not economically beneficial to them, the drag-along provision serves a good housekeeping function to make sure that minority shareholders vote in favor of the transaction.

Occasionally, some savvy investors will also require the drag-along provision to be included in the company’s option agreement so that any optionholder that exercises and holds common stock will be subject to a drag-along.

The right of first refusal and co-sale (“ROFR/Co-sale”) work together to prevent a founder or major common shareholder for selling shares without the company and the investors being allowed to purchase the shares or participate in the sale of the shares. Below is a typical term sheet provision.

In the event [__________] proposes to transfer any Company shares, the Company will have a right of first refusal to purchase the shares on the same terms as the proposed transfer. If the Company does not exercise its right of first refusal, holders of Preferred will have a right of first refusal (on a pro rata basis among holders of Preferred) with respect to the proposed transfer. [Rights to purchase any unsubscribed shares will be reallocated pro rata among the other eligible holders of Preferred.] To the extent the rights of first refusal are not exercised, the holders of Preferred will have the right to participate in the proposed transfer on a pro rata basis (as among the transferee and the holders of Preferred). The rights of first refusal and co-sale rights will be subject to customary exceptions and will terminate on an initial public offering.

The items typically negotiated in the ROFR/Co-sale include:

• Common holders subject to the ROFR/Co-sale. Generally, investors will want holders of large amounts of common stock to be parties to the ROFR/Co-sale. The company (and founders) will want to minimize the number of holders of common stock that need to be subject to the ROFR/Co-sale. The hassle associated with a large number of parties becomes evident in subsequent rounds of financing when the ROFR/Co-sale agreement needs to be amended.

• Exceptions to the ROFR/Co-sale. Founders will want various share transfers to be exempt from the ROFR/Co-sale such as transfers to family members or for estate planning purposes. In some cases, a founder may want to transfer up to a certain number of shares each year without being subject to the ROFR/Co-sale.

• Minimum investor shareholding to have ROFR/Co-sale rights. The company may want to limit the rights to investors that hold a minimum number of shares.

The ROFR/Co-sale forces a founder to provide written notice to the board and the investors of any potential transfers, which allows the company and the investors time to evaluate if they want to purchase (or participate in the “co-sale” of) the shares. I have never heard of a co-sale right actually being used, although I know that lots of companies remind former founders about their ROFR obligations.

The ROFR/Co-sale agreement rarely receives more than cursory comments in a typical venture financing.

A right of first offer allows an investor to purchase its pro rata percentage of issuance of new securities until an IPO. Below is a typical term sheet provision.

Each holder of Series A Preferred will have a right to purchase its pro rata share of any offering of new securities by the Company, subject to customary exceptions. The pro rata share will equal the ratio of (x) the number of Series A Preferred shares held by such holder (on an as-converted basis) to (y) the Company’s fully-diluted capitalization (on an as-converted and as-exercised basis). This right will terminate on an IPO.

The items typically negotiated in the right of first offer provision include:

• Major investor. Like information rights, the concept of “major investor” is often used to limit the investors that receive preemptive rights. The number of shares that an investor needs to hold to have these rights is typically set low enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives the rights and high enough to avoid giving rights to numerous small investors.

• Accredited investors. Sometimes, the right of first offer will be limited to accredited investors (to be covered in a future post). Federal and state securities laws limit offers and sales of securities to a limited number and certain types of investors.

• Percentage calculation. The pro rata calculation may be tweaked by aggressive investors so that the denominator in the formula is the aggregate number of preferred shares, which would result in existing investors having the opportunity to purchase 100% of the securities offering in the financing.

• Carveouts. The right of first offer typically not apply to certain issuances of securities. This list is generally the same as the types of issuances that do not trigger anti-dilution.

• Super pro rata rights. Investors sometimes ask to have a right to purchase more that their pro rata percentage ownership. This is not a common term in a typical venture financing. However, it may be requested in an early stage financing where the investor did not obtain a large percentage ownership because the company wanted to limit dilution, but investor expects to invest in additional rounds and wishes to increase their percentage ownership. Please read the commentary from AsktheVC and Venture Hacks for more thoughts on this provision.

• Over-allotment. If some investors with pro rata rights do not fully participate, then the participating investors may want the right to purchase the shares that the non-participating investors did not purchase. This potentially adds additional delay to completing the financing due to the need to comply with various notice periods for the initial offer and the over-allotment.