SOSV Share Purchase Agreement (“SPA”) Terms & Conditions
An SPA is an agreement which records the terms under which shares of stock (common or preferred) are issued to SOSV by an accelerator participant company. Whilst some of the companies that are selected to participate in our accelerator programs may have raised financing previously and may be somewhat (or completely) familiar with standard investment terms and conditions there are also many who are not. Below is a (hopefully!) simple explanation of the material legal terms and conditions of the SOSV accelerator contracts that we issue and sign with all companies who participate in our accelerator programs.
TERM/CONDITION: “Employee Stock Ownership Plan” (“ESOP”)
RATIONALE: We are of the view that ESOPs are a fundamental requirement in startups and we always require that a form of ESOP be made available in the startups in which we invest.
An ESOP is a pool of stock from which options can be issued. Options are basically a right to purchase shares in the company at a future date. They can be given out to directors, advisors, employees, officers, service providers, and just about anybody.
An ESOP enables a cash-strapped startup (and aren’t they all!?!?), which may not yet be in a position to offer market-rate salaries, to attract high-caliber employees, by affording the opportunity to those candidates to earn equity in a potentially successful startup combined with an initially modest salary.
An ESOP can give employees the incentive to commit to the startup in order to achieve ultimate value through their ESOP holdings. Employees will see the value of their contribution over time as their stock value increases.
RATIONALE: Vesting is an important provision especially in early-stage companies. Vesting provisions should be discussed and agreed to between founders even before the incorporation of the company. SOSV encourages all startups to agree a Founders Agreement incorporating vesting provisions and financial controls prior to participating in all of our accelerator programs.
Founders are generally allocated shares of Common Stock. However, in order to ensure the founders stick around over time, vesting permits the startup to retain the right to repurchase (at a nominal value), some or all of these founder shares in the event that a founder decides to quit the company.
The vesting of founders’ shares should be seen as “founder-friendly” and should be implemented in the form of vesting schedule in order to protect each founder & the company. Vesting provisions will ensure that all founders are focused on achieving ultimate success for the startup.
A standard vesting agreement would have equity vesting over 4 or 5 years, with the first 25% of shares vesting after one year and the remainder vesting in monthly or quarterly increments. Standard vesting provisions would allow an additional year of accelerated vesting in the event of a sale, merger, consolidation, etc., provided that such founder is still with the company at the time of sale, and would have contributed to the value being added that attracted the interest of a purchasing party.
The options granted from the ESOP are generally subject to similar vesting provisions (except in that case the options are just cancelled instead of the issued stock being re-purchased).
The importance of vesting provisions are demonstrated in the event of a sale of the company, which had a founder who quit prematurely. With the protection of vesting provisions the quitting founder would only be entitled to benefit from the sale proceeds to the extent of the value that they added during their time in the Company i.e. to the amount of the fully vested shares in his/her name prior to departure. By way of example, if there are two founders with 40% ownership of the company each, and they’re vesting is over four years, and one founder quits after one year, they’d only have vested 10% of that 40% (one quarter of their shares). So the other 30% of the company would be repurchased by the company (and perhaps re-issued to a replacement co-founder).
SOSV is committed to our accelerator companies long-term, and we want to see benefit accruing to founders who demonstrate their long term commitment to the startup. Vesting facilitates this and all investors seek these assurances.
Below are some interesting links on the value of vesting provisions in startups:
RATIONALE: A question we get asked on a regular basis is: where should I incorporate? An interesting question with lots of possible different answers and solutions. There are a number of considerations with regards to incorporation.
– Fundraising — where are your Investors, — Trading — where is your product being manufactured & sold, — Grant availability — is there non-dilutive funding available for locating in certain areas,
– Residence — where do you live, where are you entitled to live.
Each of these will have an impact on where you incorporate. US Investors do not generally invest into entities that are incorporated outside of the US (A Delaware C-Corp would be the standard investment entity used in the US). This is due to onerous tax filing and information requirements on US citizens for off-shore investment activity.
Also US Investors do not generally like to invest into a Limited Liability Corporation (LLC). This link explains the LLC –vs– C corp argument well:
In simple terms an LLC = Sole Trader/Partnership: Income is taxed at personal income tax rates and you can be liable for tax on income that has not been distributed to you.
C-Corporation = Capital Asset, buy and hold, dispose in the future at a profit (hopefully), taxed at Capital Gain Tax rates, (15%+)
My thought would be why make yourself “less investable” by having a structure that your target investors probably don’t like from the get go? If you exclude yourself automatically when an investor does not even consider your existing structure then you have eliminated the opportunity without it ever even having a chance, which is to you and your companies detriment.
Investors can be finicky and any sort of obstruction or tax inconvenience can turn a hot investor very cold very quickly.
An LLC structure is fine for an early stage startup or a lifestyle business but a venture capital firm probably won’t invest in it, why?
– VCs like different classes of stock — they will predominantly want preferred stock — LLCs don’t have stock, they have membership units. — VCs like employee stock options, these are easy in a C-Corp structure, not in an LLC. LLCs can give “profit interests” but not incentivize employees via stock options. Also the tax implications of an LLC profit interest are extensive, which is a disadvantage. — An LLC is more difficult to IPO, why would a VC want to hinder this, (although we are seeing less and less of this exit strategy). — Some VC firms have specific provisions in their investment documents which prevent them from investing into an LLC. — An LLC can generate a tax liability (at income tax rates), even though you have received no income. Nobody likes to pay taxes, let alone taxes on income that you have not actually received!
– For a VC firm with foreign LPs (Limited Partners — the people, companies, and nations who invest in VC funds) there can be US tax implications in holding LLC shares and they might be required to file a US tax return on flow-through income; even though they might not even have received it. VC firms are not in the habit of causing needless problems for their LPs.
RATIONALE: We live to build value in our portfolio companies and to ensure that the companies grow and develop over time following graduation from our accelerator programs (we include/require an ESOP formation as part of our SPA to add future value to the companies, as detailed above).
The reason for the anti-dilution clause in the SPA is to ensure that subsequent financings are sufficiently material such that they add value to and are in the best interests of the company (including the founders, staff, and investors).
This clause ensures that until a Qualified financing occurs that the SOSV stock is protected from dilution by a minor round which would not add significant value to the Company. SOSV intends to continue to add value to your Company on an on-going basis.
TERM/CONDITION: “Pro Rata Right”
RATIONALE: We believe in the companies that we invest in and we want to maintain and build on that relationship of trust for the coming years. We invest at such an early stage in the companies that we would view ourselves as a form of partner, and are developing our graduates into a community in order to leverage all of the experience and talent throughout our 300+ company portfolio for the benefit of all of that portfolio.
Under the terms of the pro rata rights as detailed in the SPA, SOSV is entitled to acquire further equity in a future financing round, generally to maintain SOSV’s pro rata (pre-financing) equity stake. This will be on the terms of the first financing investment round (negotiated at that time).
The entitlement to SOSV under the pro rata rights demonstrates that SOSV is interested not just in an ultimate percentage return but in maintaining its percentage ownership in a company in which SOSV has been involved with and committed to since its beginning.
Pro-rata rights aim to ensure an ongoing, open, and productive relationship between SOSV and the startup, and we have a history of maintaining our pro rata share (if not more!) in our companies.
The benefit to the company here is that it is easier to raise future financing rounds with an existing investor who is committed to following on. Any new investor will want a capitalisation table that is working for the benefit of the company so that rather than investors who are “one round and done” you have investors who are happy to follow on at higher valuations in future funding rounds. Other investors look favorably on committed investors.
Originally published at sosv.com on July 17, 2015.