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  1. 1. OVERVIEW OF THE VENTURE CAPITAL INVESTMENT PROCESS AND TERM SHEET PROVISIONS John J. McDonald Kelley Drye & Warren LLP 3 050 K Stree t, N.W . W ashin gton , D .C . 200 07 ( 202) 342 -8 805 T his article provides entrepreneurs with a user–friendly overview of the venture capital investment process and summarizes the investment terms typically included in term sheets for venture capital investments. While not a comprehensive review of all of the considerations involved in accepting venture capital financing, it should provide entrepreneurs with a good idea of what to expect from the process and a “leg up” concerning the investment terms that will be negotiated by the venture capitalist and the entrepreneur. _________________ Investment Process and Concerns of the Parties. The VC investment process involves a series of steps by the company and the VC, with the VC being satisfied with each step being required for the process to continue onward. The process can occur in as little as one to two months but typically takes three to six months. It is not uncommon for an attractive company to engage in this process simultaneously with more than one VC up to the time that the company “gives exclusivity” to one of the VCs. Although this article is focused on a start–up company’s first round of institutional equity financing (typically referred to as its “Series A” round), many of the considerations discussed in this article will be true for subsequent equity financing rounds, with the main difference being that the subsequent financings will involve a three–way negotiation process between the company, the existing investors and the proposed new investors, as the new investment will need to be integrated into the company’s existing capitalization structure and investment documents. The Timeline. The timeline for the VC investment process typically consists of the following events: Presentation of the company’s business plan to the VC, typically through a referring intermediary such as business person, attorney or accountant trusted by the VC, but sometimes through direct contact at a venture fair or similar event. Introductory meeting between the VC and company executives. Initial business due diligence by the VC. The VC will analyze the company’s market and projections and visit the company offices to meet its employees. Intensive business due diligence by the VC, consisting of discussions between the VC and customers and suppliers of the company and thorough analysis of the company’s technology by the VC’s experts.
  2. 2. The VC pitches the proposed investment to his or her partners or investment committee and obtains their approval to proceed to term sheet. The VC prepares and presents a term sheet for proposed investment to the company. The parties then negotiate the provisions of the term sheet, the term sheet is signed, the exclusivity period starts and the company ceases negotiations with any other VCs. Legal due diligence, consisting of analysis by the VC’s attorneys of the company’s organizational documents, customer and supplier contracts and other legal documents, including confirmation by the VC’s attorneys of validity of the company’s intellectual property filings. Using the agreed–upon provisions from the signed term sheet as the guide, the VC’s attorneys prepare and present to the company’s attorneys drafts of the definitive investment documents (i.e., stock purchase agreement, investor rights agreement, stockholders agreement and certificate of incorporation). Regardless of how detailed the term sheet is, issues will inevitably come up concerning matters that were not addressed in the term sheet or that arise as a result of the VC’s continuing due diligence process. Negotiation by the parties then follows, resulting in final investment documents. Closing of transaction – the investment documents are signed and the funds are wired by the VC to the company. Entrepreneurs’ Main Concerns with VC Financing. In considering and negotiating VC investments into their companies, some of the main concerns of entrepreneurs include: Dilution of their ownership stakes in the company from the VC investment, resulting in inadequate financial return to entrepreneurs upon a sale of the company or other liquidity event. Loss of management control over day–to–day operations of the company. Obtaining sufficient funding to be able to achieve business objectives, balanced against not wanting to sell “too much” of the company at the present (low) valuation. Security of the entrepreneurs’ employment with the company in the future and compensation if they are terminated without cause. Having a sufficiently large stock option pool available to be able to attract and incentivize future additions to the company’s management team. Repurchase of the entrepreneurs’ ownership stakes in the company upon employment termination (whether voluntary or involuntary). Anticipated future capital requirements resulting in further dilution of entrepreneurs’ ownership stakes in the company. Intangible aspects of the VC investment in the company, including “credentialing” effect of receiving funding from a well–known VC, access to industry contacts through referrals from the VC, and access to future rounds of capital from the VC and others. 2
  3. 3. VC’s Main Concerns with Start–Up Company Investments. In negotiating VC investments into start–up companies, some of the main concerns of VCs include: Current and projected valuation of the company and its impact on the VC’s ability to obtain an adequate risk–adjusted return on the investment. Credibility of projections and other information supplied by company management. Current and future market for the company’s products or services, the strength of its competitors and the presence of effective barriers to entry (including verified IP protections). Stage of development of the company and resulting level of execution risk and likelihood of additional funding being necessary to get to cashflow break–even or another significant business milestone. Alignment between the proposed investment and the investment objectives and criteria of the VC firm, along with the historical experience of the VC firm (whether good or bad) in making investments in similar companies. Experience and ability of present management team and the company’s ability to recruit others to fill any missing skill/experience sets. The VC’s ability to manage risk through controls on management’s strategy and decision making process and protect its downside through liquidation preferences, additional board seats, anti–dilution adjustments and other measures if the company’s development doesn’t proceed as planned and additional funding is necessary. The VC’s ability to preserve its upside potential through preferred stock conversion rights and participation in future funding rounds through contractual pre–emptive rights. The VC’s ability to exit the investment, either through a sale of the company or a public offering of the company’s stock. Negotiating the Term Sheet. To facilitate negotiation of the terms and conditions of a VC investment, the parties typically prepare a term sheet listing the main terms of such investment, which can vary in scope from only covering investment amount, valuation and a few other terms, to going into significant detail concerning most of the terms and conditions of the investment. A “narrow” term sheet can help get the process started quickly, but will result in heavier negotiation of the definitive investment documents. A “comprehensive” term sheet will “front load” the negotiation process, making it more likely that the deal falls apart early on, but once the term sheet is signed, finalizing the definitive investment documents is a relatively quick and easy process. VCs typically have their own approach to term sheets and entrepreneurs are seldom able to negotiate significant deviations from that approach. As noted above, once the parties agree on the final term sheet, the definitive investment documents will be prepared, using the investment terms agreed upon in the term sheet. The remainder of this article summarizes the investment terms 3
  4. 4. that are sometimes included in the term sheet and are always addressed in the definitive investment documents. Since there are variations in VC investment terms – some of which are favorable to the VC and others of which are favorable to the company – and VCs will usually “tilt” the term sheet provisions to their advantage, entrepreneurs are well advised to develop a thorough understanding of the landscape before the negotiation process starts and engage counsel that is experienced in VC financings to assist with negotiation of the term sheet and definitive investment documents. Although term sheets are, technically speaking, not legal binding, bringing in counsel to assist with term sheet negotiations is usually money well spent, as VCs may be unwilling or unable to deviate from the term sheet provisions when preparing the definitive investment documents because they obtained approval from their investment committees based on the term sheet. As a result, requests from entrepreneurs to deviate from a signed term sheet are usually not well received, even if the entrepreneur later determines (with the advice of counsel) that he or she cannot allow the investment to be made on the basis of the provisions in the term sheet. Valuation and Amount of Investment. Valuation of the company determines what percentage of the company’s equity the VC receives for its money – the higher the valuation, the lower the percentage, and vice versa. The greater the percentage that the VC receives, the less will be left for the entrepreneurs. Typically referred to as the “pre– money valuation”, this is usually a hotly contested issue between the entrepreneurs (who want a high valuation to be placed on the company) and the VC (who wants the reverse). VCs usually formulate a proposed valuation for a company using their experience with similar companies and information learned about the company through the due diligence process, based on factors including the strength of the management team, market size and potential market penetration, and the sustainable advantage of the company’s product/service offerings. Specific methods for calculating valuation include comparable company valuation (i.e., start with the value of comparable public companies and values of companies sold in public M&A transactions and discount appropriately) and discounted cashflow analysis (i.e., project the company’s future cash flows and discount those cashflows back to the present using net present value calculations), but picking a number is usually more art than science, in practice. Ownership and valuation is typically calculated on a “fully–diluted” basis, meaning that all securities that can be converted into or exercised for shares of common stock (including convertible notes, preferred stock, options and warrants) are counted. A fixed amount of shares reserved for future issuance to employees, directors and consultants under the company’s stock option plan (often referred to as the “option pool”) is typically included in the calculation and thus dilutes the entrepreneurs’ stakes. The dollar amount of the investment is usually planned to get the company to its next stage of development (i.e., completion of prototype; beta testing; obtaining 4
  5. 5. “reference” paying customers; growing the customer base to cashflow break–even, etc.). Some companies are hesitant to accept more funding at the current (low) valuation than they absolutely need. Others get as much as they can, reasoning that doing so will free them from spending time fundraising and give them flexibility in timing their next round of financing. Sometimes, to enhance control over expenditure of funds by the company and limit their downside risk, a VC will want to split its investment into multiple “tranches”, each of which is conditioned upon the company achieving specified developmental milestones. Usually some of these milestones are subjective enough to eliminate any real obligation on the VC to complete the subsequent tranche investments if it becomes disenchanted with the company. As a result, multiple–tranche venture investments are usually resisted by companies, as they typically lock in the present (low) valuation of the company without contractually obligating the venture capital investor to actually make the subsequent tranche investments. Another way in which VCs try to limit their risk is to offer to lead a venture financing round of a specified size, as long as the company is able to find other VCs acceptable to the lead VC to participate in the financing and thereby “fill out” the round. A more company–favorable approach to this issue is for the company to establish a planned round size, conduct an “initial closing” involving the VC who is ready to invest, and agree to seek other VCs to fill out the round in one or more subsequent closings. VCs sometimes resist multiple closing financing rounds because the subsequent closing VCs will have reduced risk, since the company will have received and deployed the cash from the initial closing, but will invest at the same valuation as was used for the initial closing. Structure of the Investment (LLCs vs. Corporations and Use of Preferred Stock). Most VCs will not invest in any company other than a Delaware corporation that has elected to be taxed as a “C” corporation (rather than an “S” corporation). Delaware corporations are preferred because there are a substantial amount of judicial decisions interpreting Delaware corporate law provisions, which enhances predictability in the event of a dispute between the company and the VC. “C” corporation tax status is important to VCs because there are tax consequences to VC funds investing in pass–through entities such as LLCs or “S” corporations. As a result, to the extent that a start-up company is organized as, for example, a Maryland LLC, it will usually be a closing condition for the VC investment that the company have reorganized as a Delaware “C” corporation. Similarly, “S” corporations will be required to revoke their “S” elections and be taxed as “C” corporations. VC investments are almost always structured as a purchase by the VC from the company of shares of the company’s newly–created convertible preferred stock, the terms of which will be negotiated by the VC and the company. Preferred stock has priority over common stock if the company is sold or liquidated and also usually receives dividends before any dividends are paid on the common stock (liquidation 5
  6. 6. preferences and dividends are discussed in more detail below). Use of the term “convertible” means that the shares of preferred stock may be exchanged for shares of common stock (conversion is discussed in more detail below). The preferential rights of the preferred stock over common stock justifies a higher price for preferred stock, as compared to the common stock into which it can be converted. This differential is useful because it enables a company to sell shares of preferred stock to VCs at higher prices, while granting stock options and issuing shares of common stock to company management at lower prices. It is important to keep in mind, however, that the company’s method of valuing stock options and common stock issued to company employees must comply with applicable tax law provisions, with potentially significant adverse tax consequences to both the company and the recipients of the stock option and common stock grants resulting from violation of such provisions. Dividends. VCs invest in start–up companies for capital appreciation potential, not to receive periodic dividends, and start–up companies rarely (if ever) actually issue any dividends. However, the preferred stock issued to VCs in venture financings will typically provide for “accruing” dividends as a way of compensating the VC for tying up its funds in the investment for extended periods of time. Accrual of preferred stock dividends works like interest accruing on debt – a stated percentage of the purchase price of the preferred stock (e.g., 8%) will accrue every year until paid. Although dividends will accrue every year, they are usually only paid “when, as and if” declared by the company’s board of directors. More importantly, as discussed in more detail below, accrued dividends on preferred stock are used in computing the amount of “liquidation preference” paid to the holders of the preferred stock upon a sale or liquidation of the company, as well as the redemption amount paid to the preferred stock holders upon redemption of their preferred stock by the company. VC investment documents usually specify that no dividends can be paid on common stock unless the accrued and unpaid dividends on the preferred stock have been paid first. Where a company has multiple series of preferred stock outstanding (i.e., Series A, Series B, etc.), each series of preferred stock will either be “senior” to (i.e., gets paid before), “junior” to (i.e., gets paid after), or “pari passu” with (i.e., gets paid at the same time as) the other series of preferred stock for purposes of payment of dividends. Liquidation Preference. When a venture–backed company is sold or liquidated, the preferred stockholders will receive a specified amount (the “liquidation preference” amount) before any sale or liquidation proceeds are distributed to the common stockholders. The liquidation preference amount is usually equal to the original purchase price of the preferred stock plus any accrued but unpaid dividends on the preferred stock. Since the preferred stock is usually only held by the VC investors and the common stock is usually only held by company management, this means that, upon a sale of the company, the VC investors will get their money back, plus 6
  7. 7. accrued dividends, before company management receive any sale proceeds and, if the company is sold for less than the VC investment amount plus accrued dividends, company management will receive nothing in connection with the sale. Although not very common, sometimes VCs are able to negotiate liquidation preferences that are a stated multiple of the original purchase price plus accrued dividends (i.e., “2X” or “3X”), which make it less likely that management receives anything for its common stock upon a sale of the company or liquidation. A “participating preferred” or “double dip” preferred stock provision enables the preferred stock holder to receive not only the liquidation preference amount discussed above, but also to share (on an as–converted basis) with the common stockholders in any remaining amount be distributed to the common stockholders after the deduction of the liquidation preference amount from the sale proceeds. By adding the (VC) preferred stockholders to the pool of (management) common stockholders, participation provisions reduce the amount of sale proceeds realized by management and other common stockholders upon a sale of the company. For this reason, sometimes the preferred stock participation aspect will be “capped”, with the cap typically formulated as the preferred stockholders participating with the common stockholders only until the preferred stockholders have received liquidation preference plus participation payments equal to some multiple (two is typical) of their original investment. Alternatively, sometimes the preferred stockholders can choose to either receive their liquidation preference amount or participate with the common stockholders upon a sale of the company or liquidation, but not receive both types of payments. Most venture–backed companies obtain venture financing in a number of separate financings occurring one after the other, which are usually denominated as “Series A”, “Series B”, “Series C” and so on, referring to the type of preferred stock sold by the company in each such financing. As is the case for preferred stock dividends, when a company has multiple series of preferred stock outstanding, there will be an established ranking of such preferred stock whereby, for purposes of payment of the liquidation preference amount, each series of preferred stock will either be “senior” to, “junior” to, or “pari passu” with the other series of preferred stock. Preferred stock seniority is typically one of the most significant issues in negotiating a Series B or other later–stage VC investment. Conversion Rights. As noted above, the preferred stock purchased by the VCs is usually convertible into shares of common stock. From the perspective of the VCs, the advantage to convertible preferred stock, as compared to common stock, is that it has the “upside” benefit of being convertible into common stock if the company does well and the common stock increases dramatically in value, but also has “downside protection” through the liquidation preference (discussed above) and restrictive covenants (discussed below). Convertible preferred stock is typically convertible into common stock at any time, at the option of the holder, although VCs will typically only convert into common upon an exit transaction (and then only if doing so will give them greater proceeds 7
  8. 8. that they would receive as preferred stockholders). The initial conversion ratio is usually 1:1 and is subject to adjustment in connection with subsequent dilutive stock issuances, as discussed below. Conversion may also happen automatically in response to certain events, such as when the company goes public at a valuation that provides a sufficient return to the VCs (e.g., a “Qualifying IPO”, which is an initial public offering in which common stock is sold for a per–share price of more than a stated multiple of the per–share preferred stock price). Where there are multiple investors holding shares of a given series of preferred stock (e.g., Series A Preferred Stock), sometimes a provision is included making the consent of the holders of majority of stock in the series sufficient to force conversion of all the preferred stock in the series into common stock. Anti–Dilution Protection. Preferred stock terms usually include “anti–dilution” provisions, which are designed to protect the existing investors from the dilutive effect of future issuances by the company of securities at a lower valuation than the valuation at which the existing investors’ investment was done. Such investments are considered to be “dilutive” because the later investors receive stock representing a greater percentage of the company for less money, on a per–share basis, than was paid by the current investors. Anti–dilution provisions apply to issuances of stock as well as issuances of promissory notes, options and warrants that are convertible into or exercisable for shares of stock. Anti–dilution protection is implemented by adjusting the ratio at which the current investors’ shares of preferred stock are convertible into shares of common stock (which, as discussed above, is usually initially set at 1:1), so that the preferred stock becomes convertible into more shares of common stock if the company does a subsequent dilutive issuance, effectively counteracting the effect of that dilutive issuance. Anti–dilution adjustment provisions can be either “full ratchet” or “weighted average”. “Full ratchet” anti–dilution provisions adjust the preferred stock conversion ratio in response to the dilutive issuance without taking into account the amount of stock sold in the dilutive issuance (i.e., the adjustment is the same whether the company sells 100 shares or 10,000,000 shares in the dilutive issuance). “Weighted average” anti–dilution provisions, which adjust the preferred stock conversion ratio in a manner that is sensitive to the number of shares being sold in the dilutive issuance, are usually viewed as being more fair, since they more accurately counteract the actual dilution resulting from the dilutive issuance. Weighted average anti–dilution provisions can be either “narrow–based” or “broad–based”, with narrow–based provisions resulting a greater anti–dilution adjustment for a given dilutive issuance (which benefits the VC preferred stockholders), as compared to broad–based provisions. Broad–based, weighted average anti–dilution adjustment provisions are most typical (and most company–favorable), narrow–based weighted average anti–dilution adjustment provisions are less typical and full–ratchet anti–dilution adjustment provisions are least typical (and most VC–favorable). 8
  9. 9. Anti–dilution provisions usually have “carve–outs”, resulting in no adjustment to the preferred stock conversion ratio, for issuances of stock options and restricted stock pursuant to the company’s stock option plan, issuance of warrants to lenders and landlords, and issuances of stock by the company in connection with corporate acquisitions and other strategic transactions. Sometimes there are numerical caps on the amount of shares that may be issued under the carve–outs. The term sheet will typically state that there will be “customary” carve–outs from the anti– dilution adjustment and the actual list gets negotiated when the definitive investment documents are prepared. Voting Rights. Preferred stock issued in VC financings typically entitles its holder to vote (on an as–converted basis) with the holders of common stock in matters submitted to the vote of the company’s stockholders. In addition, preferred stockholders usually receive certain special voting rights. The special preferred stock voting rights usually include the right to elect one or more of the members of the company’s board of directors. Although VC board representation is customary, the precise composition of the board is usually a negotiated deal term, with a five person board, consisting of the CEO, another company executive or other company-friendly person, two VC representatives and one independent director, being a somewhat typical configuration for a Series A round. VC investors typically require the company to obtain their consent before taking certain capitalization–related actions, such as amending the certificate of incorporation, redeeming or paying dividends on any company stock, or creating any new series of preferred stock that is senior to, or pari passu (equal rank) with, the existing series of preferred stock. Because any such restriction on the company creating a new series of preferred stock effectively gives the VC investors a veto right on any future equity financings of the company, such restrictions are sometimes resisted by entrepreneurs, some of whom are able to get the VCs to limit the consent right to issuances of senior preferred stock, thereby allowing the company to issue junior or (more importantly) pari passu preferred stock. This is an important distinction, as new VC investors are typically unwilling to make their money junior to that of existing investors but may be willing to invest on pari passu basis with the existing investors. Sometimes, VCs will impose restrictions on the company’s ability to take certain operational actions without their consent such as incurring debt (other than trade payables), hiring or firing members of senior management, changing the company’s business or entering into related party contracts, which can be implemented through requiring the approval of the VC (in its capacity as a stockholder in the company) or by requiring approval of the VC’s appointees on the company’s board of directors. While including some restrictive covenants is customary, an overly burdensome covenant package can act as an impediment to operation of the business and should be resisted by the company. 9
  10. 10. Pre–Emptive Rights. VC investors usually receive a contractual right to participate in future equity financings of the company through “pre–emptive” rights, in which they get to maintain their percentage interest in the company by purchasing their pro rata portion of any company stock (or notes, options, warrants or other securities convertible into or exercisable for stock) that is sold in any equity financing done by the company subsequent to the VC’s investment. The term sheet will typically state that there will be “customary” carve–outs from the pre–emptive rights provisions and the actual list gets negotiated when the definitive investment documents are prepared. The list of company securities issuances that are “carved–out” from pre–emptive rights typically includes issuances of restricted stock and stock options pursuant to the company’s stock option plan, issuance of warrants to lenders and landlords, and issuances of stock in connection with corporate acquisitions and other strategic transactions (which often mirror the list of carve–outs from the anti– dilution provisions discussed above). Pay–to–Play. When making an investment in a start–up company, many (if not most) VCs plan on making not only the initial Series A investment, but also making “follow on” investments in later financing rounds. Where more than one VC is participating in a financing round, sometimes the lead VC will want to include provisions in the investment documents to help ensure that the other VCs will continue to support the company in future investment rounds, which are referred to as “pay to play” provisions. Pay–to–play provisions typically punish any existing preferred stock investor that fails to fully exercise its pre–emptive rights to purchase its pro rata portion of the securities sold in a new financing transaction by adversely changing the terms of the non–participating investor’s investment in the company. The adverse change can be forced conversion of all of the non–participating investor’s preferred stock into common stock or elimination of anti–dilution protection from the non– participating investor’s preferred stock, among other things. Because pay–to–play provisions encourage existing investors to participate in future financing rounds, they could be considered to be pro–company. However, since some strategic investors and smaller VCs have institutional prohibitions on investing in pay–to–play companies, companies that agree to include pay–to–play provisions should keep in mind that doing so will reduce the pool of possible investors for subsequent financing rounds. Redemption Rights. VC investors sometimes require a redemption feature on the preferred stock, which requires the company to buy back the preferred stock from the VCs on or after a specified time period after the closing of the VC financing (usually 5 to 7 years). The redemption price is usually the “liquidation preference” amount (i.e., original purchase price plus accrued and unpaid dividends) discussed above, but is sometimes equal to the greater of the liquidation preference amount or the fair market value of the preferred stock as of the time of redemption (which is usually 10
  11. 11. based mostly on the then–current value of the common stock into which the preferred stock is convertible). VCs usually argue that they need redemption rights due to the finite life of each investment partnership managed by their firms (which are generally six to ten years). More candid VCs will admit that they are disinclined to invest in “lifestyle companies”, in which management makes a steady living but no exit for the investors is forthcoming, and redemption provisions are a way of moving a company to an exit event. The remedies for the failure by a company to redeem its preferred stock when requested to do so by the VC investors sometimes include additional “penalty rate” dividends accruing on the preferred stock, the VCs receiving the right to appoint a majority of the company’s board of directors, and the VCs becoming entitled to force a liquidation of the company or to “drag–along” the other company stockholders in a sale of the company (drag–along rights are discussed in more detail below). Where there are multiple VC investors holding shares of a given series of preferred stock (i.e., Series A Preferred Stock), sometimes the investors require a provision stating that the consent of the holders of majority of the stock in the series is sufficient to force redemption of all of the preferred stock in the series. Right of First Refusal and Co–Sale Rights. VC investors usually seek to ensure that company stock does not go outside of “friendly hands” by requiring the entrepreneurs and other significant stockholders to agree to first offer their company stock to the company and the VC investors, prior to transferring any such stock to a third party. In addition, as a disincentive for entrepreneurs and other significant stockholders to sell their stock to third parties, VC investors typically require that the entrepreneurs and other significant stockholders allow them to participate in any such transfer by requiring the buyer to also buy a pro rata portion of the VC investors’ company stock (if the third party purchaser doesn’t want to buy all of the stock, the entrepreneurs or other significant stockholder usually must reduce the amount of stock that it sells in the sale). There is a usually a carve–out from right of first refusal and co–sale provisions for estate planning–related transfers to family members of the stockholder and trusts established for their benefit. Sometimes entrepreneurs are able to negotiate a carve–out from right of first refusal and co–sale provisions for transfers of company stock among the existing employee stockholders. Drag–Along Rights. To help ensure that their exit from the investment goes smoothly, VC investors sometimes subject minority stockholders (i.e., entrepreneurs, other management stockholders and any angel or other pre–VC funding equity investors) to a “drag–along” provision, in which the minority stockholders agree that, if the VCs and other investors collectively holding a majority of the company’s stock (on an as–converted basis) decide to sell the company, the minority stockholders will also agree to sell their stock and take other actions in support of the sale transaction 11
  12. 12. For the drag–along obligation to apply, usually the price and other terms for the sale of the minority investors’ stock has to be the same as those for the majority investors (i.e., no “control premium” is paid to the majority investors). Entrepreneurs are sometimes able to negotiate the holders of a specified “supermajority” (rather than just 50.1%) of the company’s stock being required to initiate a drag–along sale, with the threshold being set high enough to effectively give a group of minority investors (such as the management stockholders and some other minority investors), acting together, the ability to block a drag–along sale. Registration Rights. Another VC exit protection is registration rights, which require the company to register the common stock received upon conversion of the VC’s preferred stock with the SEC for sale in a public offering. This can be done either as part of an SEC–registered offering already planned by the company (called “piggyback” rights) or in a separate SEC registered offering initiated at the VCs’ request (called “demand” rights), in each case at the company’s expense. Although demand registration provisions typically relate to SEC registrations that are effected after a company does its initial public offering, sometimes demand registration provisions include an outside date by which the company must register the VC’s stock with the SEC (usually 5 to 7 years after the investment closing), which effectively require the company to go public by such date or obtain a waiver from the VCs. As is the case for the redemption rights discussed above, VCs typically request these provisions as a means of helping to ensure that they will be able to exit their investment in a timely manner. However, unlike the redemption provisions, a company’s ability to go public is driven to a significant degree by the state of the public securities markets, which are not controlled by the company or the VC investors and may not be hospitable to an IPO at a particular time. In addition to the inclusion of “forced IPO” demand rights, as discussed above, the number of demand registration rights that the VCs will receive generally is sometimes negotiated by the parties, with two being a relatively typical number. In addition, sometimes VCs will request a “most favored nation” provision, restricting the company’s ability to grant registration rights to others on more advantageous terms. Vesting of Entrepreneurs’ Stock. VCs sometimes require, as part of the VC financing transaction, that entrepreneurs subject their company stock to repurchase by the company upon termination of the entrepreneur’s employment with the company. Over time after the VC financing, if the entrepreneur stays employed by the company, an increasing percentage of his or her company stock becomes “vested”. Stock that has not become vested as of the date on which an entrepreneur leaves the company is considered “unvested.” 12
  13. 13. Usually termination of an entrepreneur’s employment by the company without “cause” or by the entrepreneur for “good reason” will result in accelerated vesting of all of the entrepreneur’s unvested stock. Some stock vesting agreements provide that unvested stock may be repurchased by the company at the price originally paid by the entrepreneur (which is usually a de minimus amount) and vested stock may be repurchased by the company at the fair market value of such stock. Other stock vesting agreements only subject unvested stock to repurchase by the company (at original purchase price) and vested stock is not subject to repurchase. Entrepreneur stock vesting arrangements are often fiercely resisted by entrepreneurs, who argue that their company stock is their property, which was accepted in lieu of salary and other employment benefits, and which therefore should not be subject to forfeiture or other loss if they leave the company. VC investors that require these types of arrangements usually argue that a large part of the value in the company stock is being created with their money and entrepreneurs shouldn’t benefit from increases in the value of the company that occur after they leave the company. * * * * * This article does not constitute legal advice from the author or the law firm of Kelley Drye & Warren LLP. If you have any questions about the matters discussed in this article, please don’t hesitate to contact John McDonald at (202) 342-8805 or 13
  14. 14. John McDonald Biography John McDonald is a member of the Private Equity Group at Kelley Drye & Warren LLP, resident in the firm’s Washington, D.C. office. John’s practice focuses on counseling clients on a full range of corporate transactional and general commercial matters, with particular emphasis on representing early-stage growth companies, venture capital firms, strategic investors and angel investors in venture capital and other debt and equity financing transactions. John also has extensive experience representing private equity investment firms and their portfolio companies in leveraged buyouts, mergers and acquisitions, divestitures, recapitalizations, equity and debt financings, joint ventures, executive employment matters and equity incentive issues. John is active in the local venture capital community. He presently serves as Co-Chairman of the Selection Committee for the Business Alliance of George Mason University “Grubstake” venture investor breakfast series and served as a presenting company advisor for the 2003, 2004 and 2005 MAVA Capital Connection venture fairs. John received his law degree, cum laude, from the Georgetown University Law Center in 1998. While at Georgetown Law, John served as lead articles editor of The Tax Lawyer and was an intern at the Division of Enforcement of the New York Stock Exchange and at the Division of Investment Management of the Securities and Exchange Commission. He received his bachelor of science degree, magna cum laude, from the State University of New York at Stony Brook in 1994, where he double majored in economics and business management and was elected to the Phi Beta Kappa national honor society. Representative Venture Capital Financing Transactions Company Receiving Series of Investors Represented Party Investment Investment Telarix, Inc. Series C-1 Edison Venture Fund; Redshift Ventures Telarix, Inc. Vidsys, Inc. Series B IDG Ventures; Motorola, Inc.; JVAX Investment Vidsys, Inc. Group Regent Education, Inc. Series A Edison Venture Fund Edison Ventures ASIP, Inc. Series C Nokia Venture Partners; Redpoint Ventures; Intel Nokia Venture Capital; Fina Ventures Partners Broadmargin, Inc. Series A ABS Capital Partners; Concert Capital Broadmargin, Inc. Orbcomm, LLC Series A SES Global; Ridgewood Capital Partners; Northwood SES Global Ventures Glycomimetics, Inc. Series A New Enterprise Associates; Alliance Technology Glycomimetics, Ventures Inc. enPocket, Inc. Series A Nokia Venture Partners Nokia Venture Partners Qovia, Inc. Series A Nokia Venture Partners; Anthem Capital; Maryland Nokia Venture Department of Business and Economic Development Partners TecSec, Inc. Series B Boeing Corporation TecSec, Inc. Aspen Aerogels, Inc. Series A Rockport Capital Partners Rockport Capital Partners Seclarity, Inc. Series A Blumberg Capital Partners; Valley Ventures Blumberg Capital Partners Sonic Series D HSBC; Murjan Holdings Sonic Telecommunications, Telecommunicatio Inc. ns, Inc. Broadwave, Inc. Series A Telesoft Partners Broadwave, Inc. 14