A Primer on VC Deal Docs
Miscommunication on deal terms is a terrible way for a founder and investor to get started with their partnership and so I am a huge fan of efforts that help both sides to get 100% aligned on terms.
A number of VC firms have done a good job of this; the Plain English Term Sheet by Passion Capital is a great example, as is the Term Sheet Grader on Pillar.VC. However, once you get through the term sheet stage, you may be left wondering where these hard-won terms reside in what can feel like an overwhelmingly dense set of legal documents.
To help with this, I’ve created a short primer that describes (in order of importance) the legal docs used in an equity financing and relates them back to the term sheet. This will either be extremely helpful or extremely dry reading! Enjoy and thanks to Dave Kimelberg at Kimelberg PLLC for his help.
Navigating Equity Financing Documents
The SPA refers to the following sections of the term sheet: Securities Offered, Valuation, Amount Raised, Price Per Share, Conditions to Closing
What you need to know: This is the central agreement that details the terms and conditions related to the financing. A lot of detail is included in the SPA, but the more important sections are the Purchase and Sale section & the Representations and Warranties.
- Purchase and Sale: defines the security that is being issued (ex. Series Seed Preferred Stock) and details all of the other associated economic terms such as the price per share and the number of shares being sold. It also deals with the conversion of any debt as part of the transaction and the price per share for convertible debt holders.
- Representations and Warranties: this section includes a long list of the claims that the company makes about itself. These claims include things like confirming that the company’s capitalization is as represented at the time of closing (including shares reserved for the option pool), and confirming that the company has taken the necessary steps to authorize the financing. It also includes confirmations that the company does not have outstanding litigation against it and that it owns all of the IP necessary to conduct its business. This section also references disclosure schedules, which highlight any exceptions to the representations and warranties that are being made by the company. This is the real meat of the SPA and companies generally spend a lot of time working on any disclosures that they may need to make.
- The SPA also contains representations and warranties from the investors. These essentially confirm that the investor is accredited and knows what they are doing by participating in the financing.
- Finally, the SPA includes a section on closing conditions. This includes all of the actions that the company needs to take before the transaction can close and the money can be wired. These include things like appointing the specified board directors, filing the amended charter, etc. The end of the SPA includes a schedule of investors and the amount each is investing.
Refers to the following sections of the term sheet: Liquidation Preference, Voting Rights, Protective Provisions, Conversion, Anti-Dilution, Redemption Rights
What you need to know. This section details that the company needs to amend and restate its certificate of incorporation in order to authorize the issuance of the new class of stock that is being sold as part of the equity financing. The charter includes a statement of the designations and the powers, privileges, and rights, qualifications, limitations, or restrictions of each class of capital stock of the company. Here, key provisions for the new stockholders are laid out including (but not limited to) the liquidation preference, voting rights, protective provisions, and conversion mechanics. Anti-dilution provisions are also included in the charter and any exceptions to anti-dilution. If a redemption clause was agreed in the term sheet, it will also live here.
Refers to following sections of the term sheet: Information Rights, Participation Rights, Founder & Employee Matters/ Vesting, Future Rights, Registration Rights
What you need to know. The Investor Rights Agreement covers four main topics:
- Information Rights: focuses on the flow of information between the company and the investors. It details the type of information (access to financials, budgets) and the cadence with which the investor can expect to receive information from the company.
- Participation Rights: lays out the stockholders’ right to participate in future financings of the company. For example, an investor who owns 5% of the company after the closing of the transaction and who can exercise pro rata participation rights, has the option to take up to 5% of future financing rounds in order to maintain their initial ownership stake.
- Registration rights are also located in the investor rights agreement.
- Additional Covenants: this section includes promises made by the company. Examples include: commitments to a specified vesting schedule for founder and employee shares and options, an agreement to purchase Directors and Officers (D&O) insurance on behalf of board directors, an agreement to purchase key man insurance for the CEO and other key employees.
Refers to the following sections of the term sheet: Board of Directors, Drag-Along Rights, Voting Rights
What you need to know. The Voting Agreement deals with two main subjects. The first subject is the board composition, where the agreement defines: the size of the board at the time the transaction closes, how directors are appointed, and how the transition of directors is handled. The second subject is the drag-along provision. This essentially states that if the board and a requisite majority of the stockholders approve the sale of the company, the rest of the stockholders will go along with the transaction. The specifics of the required majority are also included in this section.
Refers to following sections of the term sheet: Right of First Refusal/ Co-Sale
What you need to know. The premise underlying this agreement is that the Key Holders (most often defined as the Founders and anyone who owns 1% or more of the common stock) agree that if in the future they decide to sell their shares, they will offer to sell them to the company first and to preferred stockholders second, before offering the shares to anyone else. This agreement lays out the mechanics around this type of transfer.
If you are a founder getting familiar with typical venture deal terms, other helpful resources include Fred Wilson’s AVC Archive (particularly MBA Mondays), Brad Feld’s Venture Deals and CooleyGo.com
This material is for general informational purposes only and is not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or product. This information should not be used as the sole basis for investment decisions. All content is presented as of the date published or indicated only and may be superseded by subsequent market events or for other reasons. Past performance is no guarantee of future results. Investing involves risk including the loss of principal and fluctuation of value.
