This post is the sixteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior fifteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion rights and features of preferred stock, voting rights and investor protection provisions, anti-dilution provisions, anti-dilution carve-outs and “pay to play” provisions, redemption rights, registration rights, management and information rights, preemptive rights, drag-along rights, representations and warranties, and rights of first refusal and co-sale. In this post, we will discuss closing conditions and expenses.
Conditions to closing in an agreement are events that must take place or tasks that must be completed before the transaction the agreement provides for can be consummated. A stock purchase agreement sets forth an agreement for one party to purchase stock from the other, but the purchase may not actually happen on the date the parties sign the agreement. It might happen on a future “closing” date, after specified conditions are satisfied. This is appropriate, for example, when the transaction requires governmental approvals that take some time to obtain. The NVCA model term sheet (here) provides that the stock purchase agreement among the company, the founders, and the venture capital investor will contain “standard” closing conditions, including satisfactory completion of due diligence, qualification of the preferred stock under state “blue sky” securities laws, filing of an amended certificate of incorporation for the company establishing the new preferred stock to be issued, and an opinion of the company’s counsel. All of these conditions must be satisfied before the venture capital investor is actually obligated to purchase the company’s preferred stock (unless the parties waive any of them). Following is a brief discussion of each of these conditions.
The venture capital investor will perform an investigation of the company’s financial and legal affairs and history, known as “due diligence.” Naturally, if the investor discovers anything during this investigation that causes it to rethink its decision to invest in the company, it will want an “out” to avoid having to complete its purchase. Thus, the stock purchase agreement conditions the investor’s obligation to close on the “satisfactory completion” of the due diligence investigation. Founders will want to respond quickly and thoroughly to the investor’s due diligence requests in order to avoid unpleasant surprises late into this expensive and painstaking process that could prevent a closing. The due diligence condition in the stock purchase agreement is usually not a major factor, as the investors will often complete their investigation prior to execution of the definitive documents.
Blue Sky Qualification
State securities laws that govern the offer and sale of securities are known as “blue sky” laws. With some variation, each state requires that offers and sales of securities in that state must be registered or qualified, and the persons conducting the offering or sale of securities must be registered as broker-dealers, unless an exemption is available. Counsel to the company will determine which states are involved in the transaction and, therefore, which states’ blue sky laws apply. Most states have exemptions from the lengthy and expensive registration and review process for limited offerings of securities to certain types of purchasers, which often cover venture capital transactions. In the event qualification is required, however, it must be complete and the relevant state agency’s approval obtained before the investor is obligated to close the stock purchase.
Amended Certificate of Incorporation
The characteristics of all classes of a corporation’s stock must be set forth in its certificate of incorporation (which in some states might be called a charter or articles of incorporation). Since the venture capital investment involves the creation of a new class of preferred stock, an amendment to the company’s certificate of incorporation establishing the rights and preferences of that class must be filed before the investor is obligated to purchase any shares of that stock.
It is common in venture capital transactions for the company’s counsel to deliver an opinion letter to the investor covering such legal matters as the company’s valid formation, power to conduct business, and valid issuance of stock. The investor relies on the legal conclusions in the opinion in entering into the investment. The company’s lawyers will need to review the company’s corporate documents and minute books and get various certifications from the company’s officers and directors in order to prepare this opinion. Founders sometimes find out at this stage, to their chagrin, that they have not properly observed corporate formalities in past, and need to go back and ratify their past actions. The inclusion of an opinion letter as a closing condition adds to the expense of the transaction for the company and, if possible, founders should try to negotiate the removal of this condition.
Some other typical conditions to each party’s obligations to close include the following:
- The other party’s representations and warranties (see this post for a discussion of representations and warranties in a venture capital transaction) are true and correct as of the closing and the other party has performed all of its pre-closing obligations.
- As of the closing, the board of directions is a certain size and comprises certain members.
- The other party has executed and delivered various related agreements and documents.
- A minimum number of shares has been sold at the initial closing (when there is more than one closing).
The conditions to closing in a venture capital transaction are largely standard and in many cases amount to no more than a checklist to guide the lawyers in exchanging signed documents at the closing. Be on the lookout, however, for anything atypical, especially when the approval or consent of third parties is required, as that can be time-consuming or even prevent a closing from taking place.
A venture capital term sheet typically sets forth who will draft the stock purchase agreement and other transaction documents — counsel to the venture capital investor or counsel to the company. The term sheet also states who will pay the expenses of the deal. It is usual for the company to pay the legal and administrative costs of the transaction, including the fees of the investor’s attorneys. (Given that, it is generally less expensive for the company to designate its own counsel to prepare the transaction documents, as it will have more control over the time spent by its own counsel.) Founders may wish to try to limit the investor’s legal fees to a specified cap. Expenses are often paid at the closing of the transaction from the proceeds of the investment. The expenses section is often listed as one of the binding sections of the term sheet, which in practicality means that if the deal doesn’t close, the company would still have to pay for the investor’s legal fees. If that is the case, founders should at least ask for a clause that provides that the company is not required to pay expenses if the deal doesn’t get done because the investor withdraws its commitment without cause.
In the next post, we’ll discuss board matters.
© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.