Venture Financing Process 101 — Drafting Series A Transaction Documents
An overview of the typical venture financing transaction documents and how HyperDraft can expedite the drafting process.
This article is one of a series by HyperDraft on the process of a venture financing deal. Deals are busy and often the basics are glazed over in practice. Our team has been there practicing in the trenches and understands the need for quick refreshers. This series aims to quickly fill in the blanks with a brief overview of common topics.
As discussed in prior articles, in a Series A (B, C, D, etc.) financing, investors invest in a company by purchasing preferred stock which holds special rights and privileges. The first step in any venture financing deal is to finalize a term sheet. Once the term sheet is finalized, then the lawyers begin drafting the necessary documents for the transaction. The process of drafting the initial set of transaction documents can take 10 to 15 hours. Although this process takes a considerable amount of time, lawyers rarely draft these documents from scratch. Generally, lawyers begin with a preferred form that has been widely adopted in the market or previously vetted and approved by their law firm or client.
Many law firms now use the model set of financing documents published by the National Venture Capital Association (“NVCA”). The NVCA is a working group of lawyers who are experts in venture capital financings and have developed a model set of documents that are intended to serve as a starting point for venture financing documents. The widespread adoption of the forms allows the negotiation of venture financing documents to be centered on bigger picture legal and business issues instead of legalese and wordsmithing.
Main Transaction Documents
The main transaction documents are the long form agreements that contain the deal terms and govern the rights, privileges, and obligations of the deal. These documents govern the actual purchase and transfer of preferred stock, the rights of the preferred stockholders, the governance procedure of the company, and the structure of the board of directors among other items.
There are five (5) main transaction documents in a venture financing (sometimes fewer if some agreements are combined). Each agreement is detailed below:
- Stock Purchase Agreement (“SPA”)
The SPA provides for the actual sale of the preferred stock to the investors. Its main components are:
(i) the purchase price of the stock,
(ii) the number of shares of stock being sold/issued to each investor,
(iii) the representations and warranties of the company and investors, and
(iv) any covenants, continuing obligations or closing conditions.
A SPA usually includes disclosure schedules (sometimes called a schedule of exceptions). Disclosure schedules are an attachment to the SPA where the company lists the exceptions to the statements made in the representations and warranties within the SPA. Investors pay close attention to the disclosure schedules because it lists carve-outs to the representations and warranties that the company is making. Disclosures provide some security to the company since investors cannot later claim that they were not aware of material facts and attempt to back out of the deal or bring a lawsuit against the founders after closing.
- Amended and Restated Charter or Certificate of Incorporation (“Charter”)
A company’s Charter is a state filed document and is the main governing document for a company. The Charter contains (among other things):
(i) the authorized number of shares for each series and class of stock of the company,
(ii) the rights and privileges of the preferred stock, and
(iii) voting thresholds to waive such rights and privileges.
When a new class of stock is created, or the number of authorized shares is increased, the company’s Charter will need to be amended to reflect the change and files with the company’s state of incorporation. The Charter will describe the rights, preferences and privileges associated with the preferred stock such as protection provisions and anti-dilution provisions.
- Voting Agreement (“VOT”)
The VOT is an agreement between the company, the investors, and large common stockholders (referred to as “Key Holders”) and governs how the parties will vote on certain items. This agreement mainly provides:
(i) the composition of the company’s board of directors following the closing of the transaction, and
(ii) any drag-along rights.
The board is the main governing body of the company and the VOT will detail how many directors there are and who is able to elect those directors. Often holders of a series of preferred stock will get the right to elect a director to the board. Drag-along provisions give majority stockholders who wish to sell their shares in a merger or sale the right to force the remaining stockholders to sell their shares on the same terms. Drag-along provisions are generally investor-friendly, but also decrease the administrative burden during a merger to get all stockholders to agree to sell.
- Right of First Refusal and Co-Sale Agreement (“ROFR”)
The ROFR sets forth certain procedures and restrictions for Key Holders who want to transfer their shares. The two main rights this agreement provides are:
(i) the right of first refusal, and
(ii) the right of co-sale.
The right of first refusal requires a Key Holder who wishes to transfer their shares to first offer them to the company to purchase. If the company passes on purchasing the shares, then the preferred stockholders will get the opportunity to purchase them. The right of co-sale allows the preferred stockholders to step into the shoes of the Key Holder and sell their shares in lieu of some or all of the Key Holder’s shares.
- Investor Rights Agreement (“IRA”)
The IRA sets forth certain contractual rights that the investors will have once the transaction closes. The main rights that investors receive under the IRA are:
(i) the right to demand registration of the company’s stock,
(ii) rights to the financial and general condition of the company;
(iii) board meeting observer rights,
(iv) the right of first offer, and
(v) and approval rights over certain company actions.
Observer rights are sometimes given to a specific investor, but are often contained in a side letter or management rights letter rather than the main agreement. The right of first offer requires the company to first offer any new securities it wants to issue to the investors before it can offer them to anyone else. Often these rights are limited to investors who put in a large investment and are referred to as “Major Investors.”
Ancillary Documents
Ancillary transaction documents (“Ancillaries”) do not contain the main deal terms, but rather are required to move the deal along and ensure good corporate hygiene. Ancillaries include consents approving the transaction, certificates from the officers and the state, a legal opinion by company counsel, a management rights letter, and an indemnification agreement.
Below are the Ancillaries that are typically required in a venture financing:
- Officer’s Certificate
A certificate signed by an officer of the company and delivered at closing which contains a certification by the officer that he / she reviewed the representations and warranties and disclosure schedules within the SPA and that both are accurate as of the closing date.
- Secretary’s Certificate
A certificate signed by the secretary or similar officer of the company and delivered at the closing of a transaction which contains:
(i) certified copies of the organizational documents (i.e. bylaws, charter, or certificate of incorporation, etc.), and
(ii) certified copies of resolutions from the company’s board and stockholders approving the transaction.
- Good Standing Certificate
A certificate ordered from the company’s state of incorporation which indicates that the company is in good standing in the state (i.e. has paid all state taxes owed, that the company is a real company, etc.).
- Management Rights Letters
As discussed in our series on venture financing term sheets, this type of letter provides the specific contractual rights held by certain investors.
- Indemnification Agreements
A contract between the company and individual directors of the company, usually new directors, which provides for the indemnification of the director on behalf of the company for actions taken in the course of their duties as a director.
- Legal Opinion
Opinion letter from the law firm representing the company stating (among other things) that:
(i) the company is validly existing,
(ii) the company has the authority to enter into the transaction,
(iii) the company’s shares are properly issued and fully paid, and
(iv) the capitalization table is indeed what the company represents it to be.
- Stock Certificates
Certificates which confirm that a person or entity owns shares of the company. Not all companies actually issue physical stock certificates. If they do, however, these certificates must comply with state law and be issued in accordance with the company’s organizational documents.
- Board Consent and Stockholder Consent
Corporate resolutions whereby the company’s board of directors and stockholders approve the financing and any other related matters that require approval.
- Amendment of Stock Option Plan (if applicable)
An amendment to the company’s existing stock option plan, if applicable, to increase the number of shares in the option pool.
HyperDraft can save 90% of time spent on drafting
HyperDraft is a zero-fuss, no-code solution for generating financing and other customized form documents quickly. We understand that lawyers choose templates because they have spent a considerable amount of time reviewing and editing them so that they trust them. HyperDraft helps lawyers draft trusted forms faster.
Our team of lawyers and engineers will code templates into our document generators (called “Quests”) so that HyperDraft users do not have to do any heavy lifting. Quests are choose-your-own-adventure style document generators that allow lawyers to generate their preferred templates by answering a number of questions and can reduce as much as 90% of the time spent drafting certain documents. Quests save lawyers’ time and allow them to maximize value for clients.
HyperDraft’s growing library of pre-built modules and document generators has industry standard forms for venture financing deals and other practice areas. The Quests within our pre-built tools help attorneys quickly generate trusted industry standard documents for any occasion.
HyperDraft provides full service document generation. As forms evolve, our legal engineers and attorneys will recode, update and customize Quests to ensure that up-to-date documents can be quickly generated.
Tying it All Together
Lawyers often use established forms, such as those published by the NVCA, as templates to begin drafting venture financing documents. There are many documents that need to be drafted in a venture financing. HyperDraft can save lawyers considerable time (up to 90%) in generating documents for venture financing transactions and provide effortless customization.
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