Investing in an early stage business or startup for a seed or Series A round can have significant advantages, as these equity deals can lead to substantial returns if the business is successful. On the other hand, such deals carry significant risk if they go badly. Because of the high risk and serious potential liabilities that can be involved in VC funding, investors should carefully consider all related documentation. As you consider becoming involved with venture capital financing, make sure to discuss the investment and related contracts with an investment lawyer from the Priori network.
About Venture Capital Financing Law
While the investment instruments (e.g., convertible notes, equity) used in VC funding arrangements are similar to loans and equity investments in other sectors, venture capital financing involves an entirely distinct set of business expectations, legal terms, and relationships. Unlike loans and equity investments in established businesses, for which the expected return consists of interest (loans) or predictable year-over-year growth (equity), venture capital financing looks to establish equity positions in relatively new businesses that are poised to grow dramatically. Returns depend on extremely high (and often rapid) growth in the underlying business. This dynamic means that most investors interested in VC funding work very closely with the company—legally and practically.
Most VC funding contracts require the venture capitalist to nurture the company and help it grow. This is in the investor’s best interest, as it helps determine the potential return they will receive on their investment. Legally, investors must be careful to adhere to securities laws that will apply, but their greatest concerns are with the contracts themselves and the negotiation process for venture capital financing, as these aspects of the VC funding process will dictate the terms of an investor's relationship with the startup for years to come until the investor can make a profitable exit, such as via acquisition or IPO.
Due Diligence & Venture Capital Law
Before you consider investing in a startup, your investment lawyer should complete a thorough due diligence check to find any potential liabilities and ensure that everything within the company is as it appears. A vital part of this process is the legal opinion on the company provided by an outside investment lawyer. This opinion provides an independent assessment of records and procedures relating to the company’s formation, ensures that corporate governance and capitalization are in order, and checks that the company has the legal authority and approval to enter into a VC funding transaction. This issue can be contentious--startups tend to worry about the cost of such an opinion--but it is nonetheless vital.
Venture Capital Financing Contracts (Investment Contracts)
The investment contract is a complex legal instrument consisting of several key documents. As an investor, it is important to negotiate the terms with the help of an experienced investment lawyer so that the terms are in your favor.
Typical financing rounds include the following documentation:
- Term Sheets. A term sheet outlines the terms under which you agree to invest, including considerations regarding financing structure, corporate governance, and liquidation.
- Investor Rights Agreement. An investor rights agreement details the rights of shareholders of the company, especially with respect to minority investor rights. Generally, the agreement sets out reporting and financial disclosure requirements, observer rights, and when you have the right to inspect the company or indicate concerns.
- Stock Purchase Agreement. A stock purchase agreement details the terms and conditions upon which you are purchasing the company’s shares.
- Amended and Restated Certificate of Incorporation. The amended and restated certificate of incorporation is filed immediately before the VC funding deal closes. This formalizes any changes to business structure and corporate governance the parties agreed to under the Stock Purchase Agreement, Investor Rights Agreement, and any other venture capital transaction documents.
Key Terms & Provisions
The following provisions appear frequently in venture capital financing documents:
- Anti-Dilution Protection. This provision offers protection to existing investors during subsequent venture capital financing rounds. The exact nature of the protections vary, but generally these provisions provide existing investors some ability to participate in future financing rounds in order to prevent a certain amount of dilution.
- Right of First Refusal. This provision provides an option to purchase existing shares held by current shareholders and/or new shares before they are sold to third parties. In the VC funding context, the company often has a right of first refusal on the sale of stock by existing stockholders, and certain stockholders often hold a right of first refusal subordinate to the company’s in case existing holders sell stock. Existing stockholders may also hold a right of first refusal on new issuances. A ROFR is a type of pre-emptive right.
- Right of Redemption. This gives you the right to demand that the company repurchase shares at a specified price (or at a price determined by a specified formula) if specific triggering events occur.
- Restrictive Covenants. Often seen in early stage documents or special situations investments, restrictive covenants limit the actions the company may take without first receiving permission from a specified person or group of persons (for example, the venture capital investor or the investor’s representative on the board of directors). Examples of restrictive covenants include spending caps, sales of important company assets, share issuances, debt issuances, and dividends. Restrictive covenants allow venture capital investors to protect themselves.
- Tag Along Rights. Tag along rights provide protections for minority investors by specifying their right to participate if a majority shareholder is selling shares to a third party. This participation right is generally on a pro rata basis.
- Drag Along Rights. In the event a certain percentage of shareholders elects to sell their shares, drag along rights allow that majority to require all remaining shareholders subject to the drag along to sell their shares as well (on the same terms as the majority shareholders).
- Subsequent Round Protections. These protections are designed to ensure that early investors maintain certain enumerated rights during subsequent rounds of funding.
- Board Seats. Board seats are generally heavily negotiated. Becoming a board member allows you to have ongoing input on the actions of the company, as well as some oversight of the actions of the executive team.
- Merger, Acquisition & Other Major Corporate Events. These provisions typically set forth specific rules for how mergers, acquisitions and other major corporate transactions must be approved and, if they are approved, dictate specific economic outcomes for shares.
- Key Person Clause. A key person clause, sometimes known as a key man clause, helps investors protect their investment by ensuring that a particular individual or group of individuals, such as a key employee necessary for the company's operations or a founder, will not leave the company. These clauses are common in venture capital financing documents to help ensure that co-founders and other key personnel stay with the company as a way to protect their investments. In practice, these clauses often work by requiring the key employee or employees to spend a particular amount of time working with the company. If the key employee or employees fail to do so, investors are not required to make any further investment payments to the company.
- Registration Rights. Registration rights provide investors with assurance that their preferred shares, which later convert into common stock, are able to be sold on the general market. These rights are important because only the company, not investors, can register the company's securities. There are two main categories of registration rights--demand rights and piggyback rights. Demand rights permit investors to require the company to register their shares with the SEC so that they can be sold on the general market. Though this may seem trivial, it is expensive and time-consuming for companies to register shares with the SEC. Therefore, there are typically limits on the demand registration rights, such as requiring investors to wait a certain amount of time to exercise these rights. Piggyback rights permit investors to require the company to allow investors to participate in a public offering by the company. However, these rights do not permit investors to require a company to register its shares; they only require a company to include investors' shares in a public offering initiated by the company. Sometimes, piggyback rights are subject to limitations. For example, the company may limit the amount of shares investors may register for sale if there will be negative implications on a related public sale.
- Lockup Period. A lockup period requires an investor to wait a certain amount of time before selling or trading their shares after a financing transaction. Typically, a lockup period lasts between 90 and 180 days, and it prevents those who are holding company stock before a financing from selling their shares for that period of time after the financing. These provisions also help prevent scaring off potential buyers of company securities; if many insiders sell off their shares immediately after a financing, potential buyers may worry about insiders' faith in the company.
The National Venture Capital Association (NCVA) issues model forms that aim to reflect best practices for a series of common venture capital agreements, including: Certificate of Incorporation, Investor Rights Agremeent, Right of First Refusal and Co-Sale, Management Rights Letter, Stock Purchase Agreement, Term Sheet, and voting agreement. These NCVA forms can serve as a useful starting point, and your lawyer can customize them to fit your unique situation.
Valuation is always a contentious issue in VC funding negotiations. You will often find negotiations on this issue to be difficult, especially in early rounds. Sometimes independent third party valuations can be useful. In other cases, investors opt to use a convertible note which can serve to delay the discussion until the company is more mature.
Creating Funding for Venture Capital Financing
Most venture capitalists invest not as a single individual but as a group. Many of the same laws apply to such funds as would apply to hedge funds. You must be careful to comply with the Investment Company Act and other SEC regulations. This means that you cannot publicly solicit any potential co-investors, along with other limitations. Because such joint investment ventures can be quite complex, consult your investment lawyer to make sure that you do not accidentally violate securities laws and that all your paperwork is in place.
Depending on your venture capital law needs, the cost of hiring a investment lawyer to help you draft and review VC funding documents and conduct due diligence can vary widely. Hourly rates for lawyers with experience handling venture capital law and securities typically range from $200 to $450 per hour. In order to get a better sense of cost for your particular venture capital law question, put in a request to schedule a complimentary consultation and ask for a free price quote from one of our lawyers.
How can convertible notes benefit investors?
Convertible notes let startups raise capital while delaying the actual valuation of the company until a later date. These financing vehicles are structured as loans but convert to equity at a later round of funding. This can benefit investors because they usually get special assurances or warranties in exchange for taking on the risk of an unspecified valuation. You are also spared the tense and often fruitless valuation negotiations that are otherwise necessary to sign a deal.