Venture Financing Process 101 — Drafting Stock Purchase Agreements

An overview of the key terms of a stock purchase agreement — the heart and soul of a preferred equity venture financing transaction.

via memegenerator.net

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.

What is the SPA and why is it necessary?

As we discussed in prior articles, a stock purchase agreement (“SPA”) is one of the main documents in a venture financing transaction. A SPA provides for the actual sale of a company’s preferred stock to investors and provides certain representations and warranties of the parties. Prior to drafting and negotiating the SPA, the parties to the transaction typically negotiate and finalize a term sheet which addresses the key terms of the transaction, which is then incorporated into the SPA.

The SPA provides:

(A) The purchase price,

(B) The number of shares of stock being sold/issued to each investor,

(C) The representations and warranties of the company and investors, and

(D) Closing conditions.

Who drafts the SPA?

Customarily, the company’s attorneys will prepare the first draft of the SPA. The initial turn of the SPA involves building off of a form SPA, if it’s the company’s first financing, or the last round’s SPA, if there was a previous round of financing. The company’s counsel’s main task is to incorporate the terms from the term sheet into the document. The party that prepares the first draft of the SPA sets the tone for the negotiation of the transaction documents. If the initial draft of the documents is overly aggressive or favorable to the company, it could put off the investors or lead to a more intensive negotiation. Neither are good for the parties who need to work together to build the business.

Each party needs to provide legal and / or business justification for their desired changes in each turn of the documents. Unless the company is a red hot and attractive startup, the negotiating power is often skewed in favor of the investors. The investors hold the purse strings and the company is often strapped for cash giving investors more leverage.

What are key provisions of the SPA?

The SPA is divided into several parts (for an example of the SPA, check out the NVCA form). As discussed in our prior article which covered an overview of the venture financing documents, firms may use their own variation of the NVCA forms in the transaction.

The key provisions of the SPA are typically the following:

1. Preamble and Recitals

The preamble is the first paragraph of the SPA. The preamble serves as the introductory paragraph for the SPA and ordinarily:

(A) Names the agreement,

(B) Introduces the parties to the agreement, and

(C) Sets for the effective date of the contract.

It also clarifies, by creating defined terms, which party is the “Seller” (commonly defined in the SPA as the “Company”) and which party is the “Purchaser.”

The recitals are a series of statements immediately after the preamble. These begin with the word “WHEREAS” and, unlike the majority of the remaining terms in the agreement, the Recitals are not generally meant to be binding on the parties. The recitals tell the story of the intentions of the parties and provide context to anyone later attempting to interpret the SPA.

2. Details of Transactions

Section 1 of SPAs will customarily provide the specific terms of the sale of stock including:

(A) The purchase price,

(B) The closing procedure (including subsequent closings), and

(C) A use of proceeds provision.

Subsequent closings will often be permitted after the initial closing with the major investors. This allows the transaction to close in a timely fashion even though some of the smaller investors need more time before they can wire the funds.

3. Definitions

Section 1 will also provide an alphabetical list of definitions of important terms used within the agreement. These definitions are important and can drastically change the effect of the provisions in which they are used. Drafters need to pay especially close attention to drafting the definitions. Two of the most important definitions are “Material Adverse Effect” and “Knowledge.” These two definitions play a large role in determining the scope of the company’s reps and warranties.

4. Company’s Representations and Warranties

Section 2 contains representations and warranties from the company about itself. Representations and warranties are statements of fact relating to the business, its assets, liabilities, properties, conditions, results, operations, and prospects. Inaccurate representations and warranties may lead the party making the statements to incur liability.

The fundamental premise behind representations and warranties is that there are certain pieces of information about the parties that are only known by the specific parties themselves. From the purchaser’s perspective, the representations and warranties provided by the company are a valuable source of information about the company that can support the purchaser’s due diligence process. From the company’s perspective, the representations and warranties provided by the company increases the risk of legal liability and as a result, the company and its counsel have to be very cognizant of the representations and warranties made by the company.

There are many different types of representations and warranties, however, generally they can be grouped into a few categories. These categories are often used in an M&A context, not venture financings, but categorizing them is helpful to conceptualize these reps and warranties.

• Fundamental — Representations and warranties regarding the fundamental facts required for a transaction, including:

(A) Capitalization,

(B) Due organization,

(C) Authority,

(D) No conflicts,

(F) Valid and binding obligations,

(G) No litigation, and

(H) No insolvency.

• General — Representations and warranties regarding general facts about the company, including:

(A) Financial statements,

(B) Corporate structure,

(C) Material contracts, and

(D) Books and records.

• Special — Representations and warranties regarding matters that the purchaser requires further assurance on which often are company or industry specific, for example:

(A) Environmental claims,

(B) Employee benefits, or

(C) Securities laws.

• Tax — Representations and warranties regarding tax matters, including:

(A) Tax returns,

(B) Payment of all taxes due, and

(C) Tax audits, investigations or pending/ongoing legal proceedings.

5. Purchaser’s Representations and Warranties

The SPA customarily contains reciprocal representations and warranties from the purchaser to the company. Typically, the purchaser’s representations and warranties are significantly more limited in scope.

The representations and warranties made by the purchaser typically include:

• Authority and enforceability,
• Investment intent;
• Accredited investor status,
• Exculpation among investors,
• Acknowledgement of the restricted nature of the securities and facts about the offering, and
• Foreign investor status.

6. Closing Conditions

Closing conditions are the conditions that must be satisfied or waived by the parties prior to the consummation of the transaction. These conditions generally require that each party’s representations and warranties are accurate when made as well as at the time of closing and that any required government, regulatory, or third party consents that are required for the transaction have been obtained prior to closing. Also, these conditions will list the deliverables and ancillary documentation that will need to be delivered prior to closing in order for the parties to be ready to close the transaction.

7. Miscellaneous Provisions

SPAs also contain miscellaneous provision governing a variety of subjects including:

• Expenses,
• Governing law,
• Notice,
• Dispute resolution,
• Severability,
• Counterparts,
• Assignment, and
• Amendment.

Tying It All Together

The SPA provides for the actual sale of the preferred stock to the investors, allowing the company to put cash in its coffers. The actual rights and preferences of the stock are contained in the Charter and the rights of the investors are contained in the other financing documents. The reps and warranties in the SPA are the main way a company can incur liability in the transaction, making those the most negotiated point of the document. Overall, the SPA tends to be less complex than the other financing documents, but plays a critical role in the transaction.

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