Chapter 3 Venture Capital Financings of Technology Companies

Chapter 3

Venture Capital Financings ofTechnology CompaniesbyEdwin L. Miller, Jr., Peter N. Barnes-Brown and Jef-frey P. Steele*

Morse, Barnes-Brown & Pendleton, P.C., Waltham, Mas-sachusetts**

KeyCiteL: Cases and other legal materials listed in KeyCite Scopecan be researched through West Group’s KeyCite service onWestlawL. Use KeyCite to check citations for form, parallel ref-erences, prior and later history, and comprehensive citator in-formation, including citations to other decisions and secondarymaterials.

§ 3:1 Introduction§ 3:2 Approaching prospective VC investors§ 3:3 The term sheet§ 3:4 Legal due diligence and corporate clean-up§ 3:5 The initial venture �nancing—Basic terms§ 3:6 —Valuation—Pre-money valuation and the employee pool§ 3:7 —Board composition post-deal§ 3:8 —Founder and employee equity compensation and

vesting§ 3:9 —Section 83(b)§ 3:10 Form of security—The ubiquitous convertible preferred

stock§ 3:11 —Liquidation preference§ 3:12 —Dividends§ 3:13 —Antidilution provisions

*With special appreciation for the contributions of Lea B. Pendleton.**Morse, Barnes-Brown & Pendleton, P.C. is a business law �rm lo-

cated in the Boston area on Route 128 that represents a wide range ofinternet and other technology-based companies, and their investors,including venture and other investment funds.

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§ 3:14 —Mandatory conversion into common stock§ 3:15 —Covenants and separate voting rights of the preferred§ 3:16 —Redemption§ 3:17 —Ancillary agreements§ 3:18 Subsequent �nancing rounds§ 3:19 Conclusion§ 3:20 Sample legal due diligence request list§ 3:21 Sample term sheet for a �rst round venture capital

�nancing§ 3:22 Sample closing agenda for a convertible preferred stock

�nancing

§ 3:1 Introduction

The venture capital �nancing of a new technology companyis a signi�cant step in its corporate life. To put it simply, ‘‘itisn't just your company any more.’’

There are, of course, a number of positives to venturecapital �nancings. A very high proportion of successfultechnology companies achieved their success in no smallpart because of the availability of venture capital, which is,in the most commonly accepted de�nition, capital availablefor investment in early stage ventures which are, by thatvery reason, highly risky investments. While the conse-quences of the investment excesses of the late nineties mayhave temporarily cast venture capitalists (‘‘VCs’’) in a lessattractive light, venture capital funds, and the tax and legalinfrastructure that have fostered their growth, have been akey engine for growth in the economy of the United Statesthat has been the envy of many other countries and regions.

Not only do VCs provide necessary funding, but they oftenare helpful to their portfolio companies in a number of otherways. VCs typically have extensive experience with earlystage companies. Many have previously been successfulentrepreneurs themselves. They contribute this expertise tothe founding team and can provide access to a network ofmanagement talent, engineers and service providers. Theyare attuned to the current market parameters for equipmentlease and working capital debt �nancings, the local realestate market and vendor relationships.

VCs are active, not passive, investors. In exchange fortheir funding and other support, the VCs become activelyinvolved in the management of the business. As discussed in

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detail later, the investors typically take one or more seats onthe portfolio company’s Board of Directors and impose a va-riety of a�rmative and negative covenants on the company.

The real leverage that VCs exert over their portfoliocompanies, however, derives not from the legal documenta-tion but from the company’s need for their ongoing �nancingsupport, which as a practical matter must come at least inpart from the existing VCs. If the company has ful�lled theVCs’ performance expectations, then the need for additional�nancing is usually not problematic—the VCs will eitherprovide another round of �nancing themselves or help thecompany recruit new investors. If, however, the companyhas not lived up to the performance promises represented byits business plan, the VCs often deal with the companyseverely—they may provide additional funding, but at a pricethat results in signi�cant dilution to the existing stockhold-ers—a so-called ‘‘down round’’ �nancing. Furthermore, thereis no practical alternative for the company in this situa-tion—outside VCs rarely, if ever, invest in companies wherethe existing VCs are not continuing to support the company.In di�cult economic times, ‘‘down round’’ �nancings may oc-cur even though the company has met expectations, due togeneral market or business cycle disruptions.

One may ask how the emerging technology company canprotect itself from this scenario. The answer is at bestimperfect, and that is to be sure to raise enough funding inthe �rst round of VC �nancing to give the company a reason-able chance of achieving demonstrable progress in its busi-ness plan. The competing consideration is that companiesshould not raise more money than is needed in any round of�nancing because, if the company is performing well, thedilution to the founders is likely to decrease in successive�nancings at successively higher prices per share.

With respect to the terms of the initial �nancing itself,companies should attempt to solicit interest from a numberof VCs in order to test the general availability of capital andthe terms being o�ered. They should also be extremelyprotective of their existing cash resources. All leverage islost if the company becomes desperate for funds. Conversely,there is no better leverage than to subtly let prospectiveinvestors know that they are not the only ones interested ininvesting in the company. On the other hand, this cat andmouse game can be played too vigorously by the prospective

§ 3:1Venture Capital Financings of Technology Companies


portfolio company, as VCs do not take kindly their deal be-ing ‘‘shopped’’ to other investors.

An alternative is for the company to obtain ‘‘seed’’ �nanc-ing from so-called ‘‘angel’’ investors. These are wealthy indi-vidual investors, frequently successful entrepreneursthemselves (sometimes semi-retired or between active posi-tions), who invest in early stage companies. There are alsoestablished networks of this category of investor. Terms fromangels typically are more favorable to the company than theterms o�ered by VCs, and some angel investors intend tobecome actively involved in their portfolio companies,sometimes even at the operations level. VCs, on the otherhand, add the imprimatur of their endorsement of thecompany and its technology in its dealings with strategicinvestors, corporate partners and service providers, and typi-cally put more e�ort into shepherding their investments, butat the level of the Board of Directors. Participation insubsequent �nancing rounds by angels who invest in an earlyround should not be presumed. Often the larger capital needsaddressed by follow-on rounds are beyond the means of manyangel investors, while established VC �rms have muchdeeper pockets and will often reserve funds for their portfoliocompanies’ subsequent rounds.

§ 3:2 Approaching prospective VC investors

Before even considering the �rst approach to a VC, thefounders need to have prepared a good business plan thataddresses all of the important issues that will be of concernto a prospective VC investor.

It is beyond the scope of this Chapter to explore the attri-butes of business plans that attract funding, but forentrepreneurs that have not ‘‘done it before,’’ good sources ofadvice on business plans include experienced legal counseland accounting �rms, and a variety of consultants thatspecialize in the development of business plans and strategicplanning. Many VCs will say, though, that it is often amistake for a business to hire an outsider to write its busi-ness plan (as opposed to consulting on re�ning and improv-ing the company’s best e�orts), because a business planneeds to be in the voice of the entrepreneur to adequatelyconvey the message about the business opportunity and themarket context in which the company must succeed. There

§ 3:1 Internet Law and Practice

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are also several excellent books on the subject and softwareproducts that can assist at least to the extent of providing astructure and methodology for preparing a business plan.

While the entrepreneur should always develop a full busi-ness plan, the initial document sent to a VC will generallybe a much shorter ‘‘executive summary.’’ The executive sum-mary should be as brief as possible, but must summarize allmaterial information from the full business plan in order toprovide prospective investors with enough information tomake an initial evaluation.

The �rst step in planning the approach to VCs is toidentify appropriate potential investors. To do so the entre-preneur needs to screen the now quite large universe of VCsfor the following factors:

E the �rm’s reputation and track record, including theexperiences of other successful (and unsucessful)entrepreneurs

E local o�ces, although there may be other factors withenough strength to justify looking at �rms in otherregions

E an investing focus in the company’s vertical spaceE an investing focus in portfolio companies at the

company’s stage of developmentE an interest in deal sizes consistent with the company’s

capital needs

Although not a screening factor, the entrepreneur shouldalso know whether the VC prefers to be, or insists on being,the lead investor or will allow another investor to lead.

The outcome of the screening will be a preliminary list ofpotential investors. This list should then be vetted by thecompany, its counsel and its other advisors to determine thepreferred �rms for the initial approach, based on factorsincluding the screening factors, but also on the likelihood ofsuccess at getting a meeting. The preliminary list should bepared down to between 5 and 10 VCs to be targetted initially,and if any of the founders or the company’s professionaladvisors have contacts with the �rm, those contacts shouldbe identi�ed.

When the business plan has been completed, the most ef-fective way to get a meeting with a VC is by an introduction(accompanied by delivery of the business plan) by someone



known to and respected by him or her, particularly includingsuccessful entrepreneurs funded by the VC in the past andlawyers, bankers, accountants, or other professionals whohave been a source of attractive opportunities previously.Once an expression of interest has been elicited, a meetingfollows, typically with a single partner of the VC �rm. If thepartner’s key concerns are addressed satisfactorily in thatmeeting, a meeting with the �rm’s other partners will follow.

The objective in these meetings is not to close the sale ofthe company’s securities, but to continue to help the potentialinvestors understand the attractiveness of the opportunityand overcome their concerns. This tension between attrac-tion and concern will always be present in the company’sdiscussions with a prospective investor, and the mostimportant job of the entrepreneur is to continue patiently toanswer the VCs’ questions that are designed to uncoverreasons not to invest and to go on to the next opportunity.

At some point in this process, the VCs will conductbackground due diligence on the founders and theirtechnology. The due diligence investigation will often includereference checks on the founders, discussions with industrysources, and the assistance of paid outside technical expertsin the industry.

Also at some point in this process, the VCs may begin toact and sound more like partners and consultants, ratherthan inquisitors. This shift in tone can be a signal that aninclination to invest is strengthening.

§ 3:3 The term sheetOnce a VC �rm has made a preliminary decision to invest,

the company will be presented with a ‘‘term sheet,’’ settingforth a statement of the terms of the investment deal beingo�ered to the company and other matters involving the rela-tionship between the company and the VC investors.

Term sheets are generally nonbinding, but sometimes onewill see two provisions that are expressly made legallybinding. Often there will be a requirement that the companynot negotiate with other prospective investors for a periodintended to a�ord a reasonable window of time to eithercomplete the deal or conclude that it should be abandoned.In rare cases, the VCs will require that their expenses bepaid by the company if the deal does not close. This provi-sion can usually be resisted successfully.


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Term sheets have now become, like the de�nitive agree-ments of venture capital deals, standardized documents, us-ing terms that have well understood meaning in the venturecapital community but are rarely understood by the �rst-time entrepreneur. For �rst-time entrepreneurs, unlesscompany counsel have thought to o�er a mini-seminar inadvance, the arrival of the initial proposed term sheet oftennecessitates a crash course in Venture Capital 101. Althoughmost of the legal and business terms contained in the termsheet have become standardized, there are a number of keypoints that are both important and negotiable. The point tobear in mind is that there are no moral imperatives here—the economic terms of these investments are not inherentlygood or evil, or fair or unfair. It is a free market, andentrepreneurs are free to accept the terms o�ered by a pro-spective investor or reject them. Companies need to �rstidentify from their legal advisers what terms may be nego-tiable and focus their energy on the possible. The decision totake one VC proposal over another should be based on thevaluation o�ered, the detailed technical terms, the likelihoodof the particular investor being helpful to the company innonmonetary ways, and personal �t (not necessarily in thisorder).

In general, the term sheet will typically address the fol-lowing issues:

E the pre-money valuation proposed for the company,the amount the VC proposes to invest, and the per-centage of the company they expect for their invest-ment

E the type of security which will be purchased by theVC (virtually always convertible preferred stock ininvestments by institutional venture capital �rms,sometimes convertible notes in seed stage invest-ments by angels) and the terms of the security

E whether and to what extent ‘‘vesting’’ will be imposedon the founders’ shares

E the investors’ rights to have their securities registeredfor public sale by the company

E whether the investors will have a right of �rst refusalfor subsequent o�erings by the company

E rules regarding the composition of the company’sBoard of Directors



E the proportion of the company’s stock which must beallocated for employees (typically by means of an em-ployee equity incentive plan providing for the awardof stock options or the issuance of restricted stock)

E any conditions that must be satis�ed before fundingwill occur, including the somewhat gratuitous obser-vation that the VCs’ counsel will conduct a due dili-gence investigation

E the additional agreements that the VCs will expect tobe entered into by the company and the founders

The basic business and legal terms contained in term sheetsare discussed in detail in §§ 3:5 to 3:9 below, which alsoprovide some guidance as to the normal give and take onterms and likely outcomes.

§ 3:4 Legal due diligence and corporate clean-up

Once the investors have done their preliminary due dili-gence and a term sheet has been agreed upon, the lead in-vestor will designate a law �rm to serve as investors’ counsel.The investors’ counsel will usually draft the legal documenta-tion for the transaction. Investors’ counsel will also perform‘‘legal due diligence,’’ that is, investigate the company todetermine whether it is on sound legal footing and has noidenti�able legal risks.

The most important areas of concern for technologycompany investments include:

(1) whether the company has full rights to the intel-lectual property that will be used in its contemplated busi-ness, including whether the founders have properly as-signed any rights they may have to the company, whetherall employees and consultants who have contributed to thecompany’s technology have signed acceptable con�dential-ity and invention assignment agreements, and whetherthere have been any claims that its products infringe theintellectual property of others or any knowledge of in-fringement of its intellectual property by others.

(2) whether the founders and key employees are legallyfree to work for the company and assign to the companytheir inventions related to the company’s business. A re-lated issue is whether there are any potential violations ofprior agreements with past employers, such as noncompeti-


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tion and nonsolicitation agreements and con�dentiality orinvention assignment agreements.

(3) whether the company’s corporate records are in goodorder. Critical issues here are whether the company hasbeen duly organized, its outstanding equity securities havebeen validly issued, and all obligations to issue equity havebeen disclosed to the investors.

(4) whether there is any litigation, actual or threatened,with respect to the company’s products or operations.

(5) whether the company is in breach of any materiallicense or other agreement with vendors, customers, orcreditors.

This process is frequently initiated by investors’ counselfurnishing to the company and its counsel a legal due dili-gence request list, outlining various legal and business docu-ments that investors’ counsel needs to review. However, astart-up technology company that is represented by counselwho are knowledgeable about the VC investment processcan often manage its a�airs in a manner that will facilitatethe investors’ legal due diligence. A typical legal due dili-gence request list is appended at the end of this Chapter.

§ 3:5 The initial venture �nancing—Basic termsThe security purchased by investors in virtually all

venture capital �nancings is convertible preferred stock. Theterms of this type of stock are discussed in detail below, butthe essential elements of convertible preferred stock are: (i)a liquidation preference—the investors have priority overthe common stockholders upon a liquidation of the company,which is typically de�ned to include an acquisition of thecompany; (ii) a redemption right—at a certain point in time,if the company has not otherwise achieved liquidity for itsinvestors by an initial public o�ering or sale, the investorsmay require the company to repurchase their shares; (iii)convertibility—at the option of the investor the convertiblepreferred stock will be converted into common stock at a ra-tio that is initially set at one common share for eachpreferred share, but which is subject to adjustment uponcertain dilutive events, including a sale of stock at a pricebelow that paid by the initial investors; and (iv) voting rightson an as-converted basis.

A sample annotated term sheet for a convertible preferredstock �nancing is appended at the end of this Chapter.



§ 3:6 —Valuation—Pre-money valuation and theemployee pool

The most important deal term in a venture capital invest-ment is the valuation that the investors put on the company,frequently referred to as the ‘‘pre-money valuation.’’ Es-sentially, this is the value that the investors place on thecompany before the �nancing. The value of the company willbe higher immediately after the �nancing because it willhave additional cash—this value is referred to as the ‘‘post-money valuation.’’

One could logically assume that the price per share paidby the investors would be equal to this value per outstand-ing share. (If the value of the total enterprise is $x and thereare y shares outstanding, then the value per share of thecompany would be $x divided by y shares.) Unfortunately, itis not that simple, and one important surprise for the uniniti-ated is the methodology by which the venture communitycalculates the value or price per share of the start-upcompany. The universal practice is for the total value of thecompany to be divided not by the currently outstandingshares, but by the ‘‘fully diluted’’ number of shares outstand-ing, including for this purpose the number of shares reservedfor an employee stock option pool and any increase to thesize of this pool required by the VCs’ term sheet.

This methodology, which has no foundation in the prin-ciples of corporate �nance or accounting, includes in fullydiluted shares outstanding not only stock options and war-rants that have actually been issued (as is the case for ac-counting purposes), but also shares or options that areexpected to be issued to future employees of the company inorder to �ll out its executive, administrative, and technicalteams—the so-called ‘‘employee pool.’’ The employee pool istypically 15 percent to 20 percent (but can occasionally beeven as high as 30 percent) of the post-money capitalizationof the company. In this way, the dilution caused by the issu-ance of all of the shares reserved for the employee pool isborne by the founders and not by the VC investors.

As a simple example, assume that there are 1,000,000shares of common stock outstanding and held by thefounders, no options have been granted to employees, thepre-money valuation of the company is $5,000,000, and theVCs plan to invest $1,000,000. The results with and without


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an employee pool are as follows:

Deal Pricing Based onOutstanding Shares:

Fully Diluted Deal PricingWith Employee Pool:

$5,000,000 divided by 1,000,000 pre-deal shares equals $5 per share.

$5,000,000 divided by 1,300,000 pre-dealshares equals $3.85 per share.

VCs’ $1M buys 200,000 sharesat $5/sh.

VCs’ $1M buys 260,000 sharesat $3.85/sh.

Post-deal capitalization is: Post-deal capitalization is:

Stockholder No. of Shs. Percent Stockholder No. of Shs. PercentFounders 1,000,000 83% Founders 1,000,000 64%Investors 200,000 17% Employee Pool 300,000 19%

1,200,000 100% Investors 260,000 17%

1,560,000 100%

A common instinct of founders is to be generous to the em-ployees and make the pool as large as possible. Oddly, thismay be against the founders’ interests. At least in theory, itis in the interest of the stockholders of the company that theBoard of Directors grant stock options to employees as anincentive to attract and retain the best possible talent—butnot one option more than necessary. It is in everyone’s inter-est, VCs and founders alike, to do so, and it is thereforelikely, regardless of the pricing methodology of the deal, thatthe VCs will grant any waivers necessary to attract thistalent. Thus, starting out with a smaller pool will result inless dilution to the founders, since post-deal expansions ofthe option pool dilute the founders and the VCsproportionately.

Logical or not, the employee pool is a �xture of the venture�nancing. The actual size of the pool can depend on a numberof things, including the industry that the company is in, butis primarily related to the number and types of hires whichthe company will need to make in the foreseeable future.Thus, a company which has a complete management teamat the time of the initial convertible preferred round willusually have a smaller pool than a company which still needsto make one or more top management hires (each of whommay cost the company a signi�cant amount of options orstock from the pool, depending on the current market forsuch talent).

In analyzing the best economic deal for the founders, the


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price per share (a function of valuation and the fully dilutedcapitalization) is the most critical issue. It will dictate thepercentage of the company that the VCs acquire for a givenamount of investment.

§ 3:7 —Board composition post-dealOne of the critical negotiating points in a VC �nancing is

the structure of the Board of Directors and the related issueof control of the company after the deal is concluded. This isoften a very sensitive issue for all parties. Majority control ofthe Board of Directors e�ectively constitutes control of thecompany. The company and its o�cers legally must followthe Board’s direction, including the hiring and �ring ofpersonnel (founders included). This is, in part, what wemeant at the outset in saying that ‘‘it isn't just your companyany more.’’ Under certain circumstances, the founders can—and sometimes do—�nd themselves dismissed from their‘‘own’’ company.

Founders are often inclined to try to maintain majoritycontrol of the Board, and VCs tend to see this as a red �ag.The founders’ typical position is that it is their company, sothey do not want outside investors to control it. The VC re-sponse (at least where they are purchasing a signi�cantshare of the company—30 to 50 percent, for example) is thatthey are unwilling to invest in a company that is controlledby the founders. In the large majority of cases, neither thefounders nor the VCs wind up with a Board majority. Thesolution is typically a compromise—the investors are entitledto nominate an equal number of directors with the founders,and those directors will jointly select one or more indepen-dent directors, ideally with relevant industry or entrepre-neurial experience. In this manner control is shared througha rough balance of power on the Board. The founders arestill at risk of being put out of their ‘‘own’’ company, but theindependent Board members will need to be convinced thatsuch an action is in the best interest of the company. Thereis strong logic to the argument that, if they can be soconvinced, it is a fair result for all of the stakeholders in thecompany. (The only consistent exception to the foregoing sce-nario is the relatively rare case in which the VCs arepurchasing a small minority share of the company, forexample, 10 to 15 percent, where they will normally be will-ing to accept one board seat out of three or �ve.)


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Because the founders will be working extremely closelywith the Board members nominated by their venture back-ers, the founders should attempt to get an informal commit-ment from the VCs as to the identity of their Board nominees.Typically, this is the senior venture investor who negotiatedthe deal, but that is not always the case. Junior sta� willsometimes serve that role, particularly in busy times. Thefounders want to be sure that they are getting what theybargained for—the wisdom, experience, and assistance ofsenior venture investors. Most importantly, founders shouldnot simply assume that the ‘‘sponsor’’ of the company at theVC fund will end up being that fund’s designee on the Board.

Under the corporate laws of Delaware and most otherstates, a majority-in-interest of the stockholders can electthe Board of Directors. Given the arti�cially arranged bal-ance of Board seats described above, this would not be a de-sirable outcome. The mechanism that is used to overridethese default provisions of the law is a voting agreement, inwhich the allocation of Board seats is speci�ed and all par-ties to the agreement (who must comprise, and continue tocomprise, the holders of a majority of the voting stock) agreeto vote their shares and take any other actions necessary toelect the nominees of the respective groups, that is, both thefounders and the investors. The same scheme applies toremovals of directors and the �lling of vacancies.

There is little to be negotiated in a voting agreement oncethe Board composition is agreed upon. However, care mustbe taken to ensure that the agreement expires upon aninitial public o�ering or an acquisition of the company. Thesearrangements have no place in a public company, and anacquiror will want to completely control the company that itjust bought.

An alternative technique that is sometimes employed toe�ect the desired Board split is to amend the company’s cer-ti�cate of incorporation (while it is being amended to createthe convertible preferred stock that is being issued in thedeal) to specify that the preferred stockholders are entitledas a class to appoint the agreed-upon number of directors.This approach is not really necessary and has undesirableconsequences. Voting agreements are enforceable, and theinvestment documents for the deal will always specify thatthe nominees of the VC investors be elected to the Board ef-fective at the closing. ‘‘Baking into’’ the charter such provi-


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sions only makes the arrangement unduly rigid and inconve-nient to change. The voting agreement/condition to closingapproach is legally and practically su�cient to ensure theproper Board split.

§ 3:8 —Founder and employee equity compensationand vesting

Another extremely important negotiable term in venturedeals is whether, at what rate, and under what circum-stances the common stock or stock options already issued tothe founders will be subject to so-called ‘‘vesting.’’ It shouldbe assumed that any stock or options held by employees,including founders, will be subject to a vesting schedule fol-lowing the VC investment, whether or not the founders haveimposed a vesting schedule on themselves.

‘‘Vesting’’ is a shorthand term referring to the vesting ofthe ownership interest of an employee stockholder or optionholder in the stock or options over the course of his or heremployment with the company. It is a generally accepted no-tion that, upon termination of employment of an employee,the company will have the right to buy back a percentage ofthe employee’s shares at the price paid for them, or in thecase of options, that the employee’s right to exercise a per-centage of the options will lapse. The percentage of shareswhich may be repurchased at cost, or of options which lapse,decreases over the employee’s tenure with the company.

The idea that the vesting concept might retroactively beapplied to stock owned outright by founders since thecompany’s organization is not intuitively obvious to manyfounders, but vesting provisions are almost universallyimposed on founders as part of an initial VC �nancing. Thisis the origin of the term ‘‘sweat equity.’’ The rationale is thatthe founders must ‘‘earn out’’ their shares by their continuedcontributions to the company. If a founder’s contributionscease, it is thought only fair that some portion of thatfounder’s equity be forfeited and made available to the suc-cessor who must be hired to perform the terminated founder’sfunction at the company. Implicit in this view is the assump-tion that the founders did not pay true ‘‘fair value’’ for theirshares but e�ectively were allowed to buy ‘‘cheap stock’’(typically at par or nominal value) because they will not bepaid market-rate cash compensation for their services.


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(Where founders invest their own funds in a venture round,they are treated identically to the other investors with re-spect to the stock so purchased.)

As a side note, it is almost always advisable for thefounders to impose vesting restrictions on themselves whenthey initially organize the company, and experienced counselwill advise them to do so. One reason �ows from the factthat vesting is a virtually universal feature of venture �nanc-ings: if the founders have already put in place a vestingscheme that is reasonable and within the normal range forthe industry, the VCs may leave this scheme in place andnot impose their own. The other reason to do so is that it isfair and makes business sense: the founders receive theirfounders’ stock not only for their role in conceiving the ideasand business plan for the company, but, as stated above, fortheir continuing e�orts on the company’s behalf. They vieweach other as making a commitment to continue theircontributions during some period that is thought to be rea-sonably necessary to ensure the company’s success. To il-lustrate the point another way, if each of three equalfounders receive an equal number of shares upon the organi-zation of the company, few would regard it as fair if onefounder quit the next day and kept all of his or her shares.

Whether there will be vesting is rarely negotiable. Theprecise terms and conditions of vesting are negotiable. Thoseterms and conditions are typically set forth in the proposedterm sheet from the VCs and will be documented in an agree-ment between the founders and the company called a stockrestriction agreement.

Conceptually, vesting provisions should be tied to theexpected performance of the founder over a period of threeor four years after the organization of the company. Lookingat it this way, the founders should attempt to agree amongthemselves what these contributions are expected to be overthe speci�ed period of time. So, in the usual case, thefounders will make a certain contribution to the company atthe outset—it is their novel ideas that form the basis of thecompany. If the founders, for example, agree that these ideasfairly represent 20 percent of the anticipated aggregate con-tribution, then the founders should be 20 percent vestedfrom the outset, or ‘‘up front.’’ The vesting would continueover the remaining period of their expected contribution.Where the founders have made signi�cant progress in


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developing products or intellectual property or in achievingsales, a common range of vesting provisions would be 20percent to 30 percent up front, with the balance vesting overthree or four years (the founders typically choosing threeyears, and the VCs normally looking for four-year vesting).If all the founders have accomplished is writing the businessplan, there may be no up-front vesting.

Vesting increments can occur annually, quarterly,monthly, or daily. Generally, a relatively frequent vestinginterval is considered preferable, both for the company andthe employee. From the company’s perspective, it is undesir-able to have an employee who has decided to leave hangingaround for the next tranche of his or her vesting, and em-ployees tend to assume the worst motives when a termina-tion occurs shortly before a vesting date. Annual vestingperiods magnify both concerns, while the amount at stake ina monthly vesting scheme is less signi�cant and thereforeless likely to control termination decisions. (A very fewcompanies even opt for daily vesting on the theory that theydo not want employees ‘‘treading water’’ until the next vest-ing date.) Perhaps the most common scheme for new hires isto have the �rst vesting installment occur after one year ofcontinuous employment at the company, with the balancevesting monthly or quarterly over two or three additionalyears. This permits the company to evaluate and, if neces-sary, terminate new employees during the �rst year ofemployment, before they become entitled to any equity.Founders, on the other hand, should seek monthly orquarterly vesting from the beginning.

The percentage of up-front vesting and the vesting periodare not the only issues that must be dealt with. Foundersmay be successful in negotiating for a partial or full accelera-tion of vesting upon an acquisition of the company (or, rarely,upon an IPO). This is a provision that has important em-ployee morale implications, as well as being a potential im-pediment to an acquisition. There are again competingconsiderations regarding acceleration clauses. With respectto acquisitions, from the company’s and a potential acquiror’spoint of view, no acceleration is best because what theacquiror is paying for in a technology acquisition is, in part,the expected continuing contribution of the company’s em-ployees, particularly the technical employees. The acquirorwants them to have an incentive to continue working and


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does not want them to get so rich as to lose the incentive tocontinue to work. The competing viewpoint is that the em-ployees have ‘‘earned’’ something from the VCs and otherstockholders by ‘‘delivering’’ an acquisition and allowing theVCs to realize value. They question why the VCs should beable to cash out while the employees are required to continueto earn out their equity. In any event, some amount of ac-celeration probably is representative of the market, at leastfor senior management and maybe even deeper into largerbusinesses.

The most common solution, at least for senior manage-ment and other key personnel, is a compromise between noacceleration and full acceleration of vesting—that is, partialacceleration upon an acquisition. Some percentage of thevesting is accelerated on an acquisition, with the balancecontinuing to vest, perhaps at an accelerated rate or with ashortened full vesting date provided the employee remainsemployed by the acquiror. A �xed number of options canvest; a percentage of the unvested options can vest; or aspeci�ed additional vesting period can be deemed to haveelapsed. There are subtle di�erences between thesealternatives. If the �rst or the second approach is used, areduced vesting rate would be speci�ed for the balance so asto continue the existing vesting schedule. If a deemed timelapse is used, the agreement should expressly provide forclarity that all remaining vesting dates are similarlyaccelerated.

Frequently, the employee is also relieved from the threatof loss of unvested equity if terminated without cause follow-ing an acquisition—in that event there is full vesting. Someargue that if the employee is never o�ered a job with thesurvivor/acquiror, then there should be full acceleration ofvesting, either on general fairness principles or because theacquiror shouldn't care—if the employee is not wanted, thenincentives aren't needed to keep him/her on board. Theproblem with this approach is that employees who are nothired are treated better than those who are hired—an odditywith potential unwanted consequences. Further, thesurvivor/acquiror will argue that the employee not hired isin e�ect being terminated, and that he or she is only entitledto the vesting that has occurred prior to the date of suchtermination, like any other employee who is terminatedwithout cause. Another approach is to provide for full vest-


K West Group, 12/2002 3-17

ing after a transition period—say six months or one year fol-lowing the acquisition.

One further subtlety is that experienced VCs will some-times de�ne an acquisition for acceleration purposes so thatit includes only an acquisition where the consideration iscash or publicly traded stock or a combination. The thinkinghere is that the founders have not really delivered a liquid-ity event for the VCs if the company is acquired by anotherprivate company, particularly if both companies are troubled.

Considerations similar to those of acquisitions theoreti-cally would apply to IPOs. The prevailing practice, however,is not to have acceleration clauses in this case. Presumably,the controlling rationale is the possible loss of key employeeswhich may result from the acceleration and the relatedconcerns that would result from disclosure in the IPOprospectus.

Founders may sometimes be successful in negotiating morefavorable treatment in the event they are terminated by thecompany without cause or quit ‘‘for good reason,’’ as opposedto voluntary departure (that is, quitting without good rea-son) or termination by the company for cause. The advis-ability of this approach is subject to continuing debate amonglawyers specializing in representing start-ups and in venturecapital �nancings. On the one hand, it can be argued that aless harsh result is appropriate if a founder is terminatedwithout cause or leaves because the company has failed tokeep its obligations to him or her. The answering argumentis that young companies do not want to be in the position ofhaving to debate (or worse, litigate) whether a terminationis with or without cause or for good reason, and becausetermination of a founder for failure in performance deprivesthe company of the bene�t of its bargain in negotiating thefounders’ equity position in the �rst place—and a substitutemust be found and compensated in any event, termination ofa founder therefore should result in full forfeiture ofunvested shares. Both points of view are legitimate, but thelatter approach usually prevails in the negotiations.

Frequently the repurchase right for unvested shares isphrased as an option on the part of the company to repur-chase the departing founder’s shares for a speci�ed period oftime, typically 30 to 90 days. A better practice may be tomake this a �xed obligation of both parties. The circum-stances under which a company will not want to repurchase


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shares at par or nominal value are rare, and an automaticrepurchase provision avoids a trap for the unwary that o�ersno o�setting advantages: the possibility of failure to timelyexercise the repurchase option because of an administrativeoversight.

Inexperienced counsel or entrepreneurs will often imposean additional restriction on the vested shares, permittingthem to be repurchased by the company at fair market value(usually as determined by the Board of Directors) upontermination of employment. Under this scheme the odds ofone side or the other being unfairly treated are about 100percent, and the odds of litigation are needlessly multiplied.The reason is that early stage technology companies areinherently di�cult to value. There is really no adequatemethodology. The proof is in the pudding—the only real wayto determine what a company is worth is to sell it or take itpublic. In a private technology company, repurchases at ‘‘fairmarket value’’ simply don't work well.

§ 3:9 —Section 83(b)Whenever a company issues stock to an employee that is

subject to a repurchase option of the company, the employeeshould seek advice from his or her tax advisors regardingthe relative bene�ts of �ling or not �ling an election underSection 83(b) of the Internal Revenue Code. Under Section83 of the Code, an employee will recognize income in respectof property (including stock) received in connection with theperformance of services; the amount of income is the di�er-ence between the value of the stock at the time he or shereceives it and the amount he or she pays for it. However,where the stock is subject to restrictions which lapse overtime, such as a repurchase option which lapses pursuant toa vesting schedule, the employee will recognize compensa-tion (that is, ordinary) income at the time or times therestrictions lapse, again in an amount equal to the di�erencebetween the value of the stock at the time the restrictionslapse and the amount paid. Thus, an employee who is issuedstock during the start-up phase of a company that becomessuccessful, and whose stock is subject to vesting provisionsover a period of years, will become taxable, at ordinaryincome rates, on the excess of the sometimes vastly appreci-ated value of the stock over what was paid for it as thecompany’s repurchase rights lapse.


K West Group, 12/2002 3-19

If the employee believes that the value of the stock is likelyto appreciate (that is, the company is likely to be successful)and that the shares are likely to vest, a Section 83(b) elec-tion can provide signi�cant tax bene�t. If the employeemakes a Section 83(b) election, his or her receipt of the stockis the relevant tax event, and he or she is taxed at ordinaryincome rates on any excess of the value of the stock whenreceived (without regard to the vesting provisions) over theamount paid for the stock. If the initial purchase price of thestock is equal to the fair market value, then the electionresults in no tax liability. More importantly, as a result ofmaking the Section 83(b) election, the employee will recog-nize no income upon vesting, and if the employee vests, heor she will report capital gain (rather than ordinary income)upon selling the stock in an amount equal to the amountreceived in the sale over the amount paid for the stock.

Section 83 considerations may also apply in situations inwhich a founder or key employee purchases (or is granted)stock outright and then at a later date agrees to the imposi-tion of vesting restrictions in connection with a venturecapital �nancing, or in which stock acquired upon exercise ofan option is itself subject to a repurchase option.

Section 83(b) elections must be �led within 30 days afterthe date on which the restricted stock is acquired. An inad-vertent failure to �le the election is a trap for the unwarywith potentially very substantial tax consequences.

§ 3:10 Form of security—The ubiquitous convertiblepreferred stock

The virtually universal structure for a VC investment isconvertible preferred stock. Because it is convertible intocommon stock at the option of the holder, convertiblepreferred stock entitles the VC investors to their full upsidewin if the company is successful, and it entitles the investorsto the return of their investment before the founders if thecompany fails. Convertible preferred stock also permits vari-ous other protections for the investors that are discussedbelow—voting rights, antidilution provisions, various ap-proval rights, and redemption provisions.

An exception to this structure is sometimes used for earlystage companies where it is too di�cult for the investors andthe company to arrive at an agreed valuation—the investors


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have made a determination that the company is worthinvesting in, but they are unable to satisfy themselves (orcan't agree with the founders) at what price. A related excep-tion is for the more seasoned company where valuation isdi�cult because of turbulent private equity markets, orwhere a bridge loan is being extended to an existing portfoliocompany in anticipation of an impending next round, and avaluation decision is to be avoided because it will be inde-pendently set in negotiations with new VC investors in theupcoming round. In these cases, the investors and thecompany may defer the valuation decision by structuring theinvestment in the form of a promissory note that is automati-cally converted into the next round of preferred stock �nanc-ing either at the price of such round or at a discount thereto,or if such a round does not occur within a speci�ed timeframe then at a speci�ed (usually low) valuation. Thesetransactions are relatively quick and inexpensive toimplement.

§ 3:11 —Liquidation preferenceThe �rst important economic aspect of convertible pre-

ferred stock is its liquidation preference. The common themein various types of convertible preferred stock investmentsmight be dubbed ‘‘heads I win, tails you lose.’’ In so-called‘‘straight convertible preferred,’’ upon a liquidation of thecompany, the investors are entitled to whichever of two op-tions results in the greater return: (i) the amount they paidfor the stock, usually with an accruing dividend of 7 to 10percent or more on that amount, paid upon redemption oftheir preferred shares; or (ii) the amount distributable to thecommon stockholders, payable to the former preferredstockholders after conversion of their preferred shares tocommon stock. (It is important, when representing the VC,to phrase the clause as the investors’ being entitled to receivewhichever of clause (i) or (ii) ultimately turns out to be thegreater, rather than requiring the investors to make an elec-tion up front, because in some scenarios, particularly earnouttransactions, it is impossible to tell at the time of the‘‘liquidation’’ whether the preferred holders are better o�taking their liquidation preference or converting to common.Only later, when the amount of the earnout has beendetermined, is it possible to make that assessment).

In another variation of convertible preferred stock called


K West Group, 12/2002 3-21

‘‘participating preferred’’ (or more pejoratively, ‘‘double dippreferred’’), the investors are �rst entitled to receive theirliquidation preference (price paid plus accrued dividends, orin some cases a multiple thereof), and then, after they havereceived their liquidation preference, their preferred sharesare deemed to have converted into common stock so thatthey share pro rata in the remaining proceeds with the com-mon stockholders. This structure economically mirrors anote-and-warrant or note-and-common-stock structure,without the adverse credit consequences of debt in the capitalstructure.

In di�cult economic times, VC investors may also requirethat the liquidation preferences be tied to a multiple of theamount paid per share. With such a preference, the inves-tors are entitled to be paid, for example, �ve times theiroriginal investment before the common stockholders getanything. Many commentators have questioned the wisdomof this practice, even from the investors’ point of view,because of the severely negative e�ect on the chances ofmanagement and key employees realizing a return on theirinvestment. The result may be that founders and employeeswill ‘‘vote with their feet’’ and leave for better opportunitieselsewhere.

The choice of one type of liquidation preference over an-other is simply a matter of negotiation. Neither is inherentlygood or evil, fair or unfair. All things being equal, participat-ing preferred e�ectively puts a lower valuation on thecompany. Obviously, the entrepreneur should try to negoti-ate for straight convertible preferred stock rather thanparticipating preferred. If the founders receive o�ers withboth structures, they simply need to compare the economicsunder various win scenarios to see which is more favorable.The higher the multiple of the price paid by the investorsthat is received in an acquisition of the company, the lesssigni�cant is the participating preferred feature as an eco-nomic matter. Founders frequently can negotiate a cap onthe participating preferred feature. With a cap, the formula-tion would be that the investors receive the greater of (i) theliquidation preference plus their share of the remainingproceeds, but only up to a speci�ed multiple of the originalinvestment, typically three to �ve times, or (ii) the amountthe investors would have received if they had converted tocommon stock immediately before the liquidation.


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In either of these formulations, the term ‘‘liquidation’’ isde�ned to include an acquisition of the company. Untilrecently, there never were any real liquidations of VC-backedcompanies where proceeds were available to the equityholders. An acquisition is typically de�ned to include merg-ers where the stockholders of the target in their capacity assuch no longer own a majority of the equity securities and/orvoting power of the surviving corporation or its parent, or asale of substantially all of the outstanding capital stock ofthe company, or a sale of all or substantially all assets.

§ 3:12 —Dividends

The convertible preferred stock terms in VC transactionsdo not a�rmatively require payment of dividends on thepreferred stock, except in the situations described below.Rather, they prohibit payment of dividends on the commonstock, and they typically include a ‘‘cumulative’’ dividend onthe preferred (often 7 percent to 10 percent or more perannum). This dividend ‘‘accrues’’ (or ‘‘cumulates’’) and is notpayable unless (i) declared by the Board (which it never isbecause it would be hard to justify a dividend given thegrowth company’s need for cash and given that the VCs typi-cally don't control the Board); (ii) there is a liquidation event(a sale of the company is considered a liquidation event, butan IPO usually isn't); or (iii) the preferred stock is redeemed.The accruing dividend is a protective device intended toprovide a minimum rate of return, but it is usually forfeitedin the event of an IPO or upon conversion of the preferredstock to common stock (the theory being that in such casesthe return on the investment will be more than the mini-mum which the accruing dividend provides; therefore, theprotection is not needed and is forfeited). There are a numberof varieties of accruing dividends, including those that arepayable in cash and those payable in additional shares ofpreferred stock. Also, although a basic ‘‘accruing dividend’’involves a simple interest calculation, sometimes VCsrequire compound interest calculations.


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§ 3:13 —Antidilution provisions

Antidilution provisions are potentially the most threaten-ing to founders of all the aspects of convertible preferredstock. The ratio that is used to calculate the common stockissuable upon conversion is variable, with potentially severeadverse e�ects on the founders and other commonstockholders.

Antidilution provisions are of two types and accomplishtwo basic objectives, one entirely noncontroversial and theother potentially highly controversial.

The noncontroversial antidilution clauses are those thatautomatically adjust the conversion price (see below) in theevent of stock splits, stock dividends, recapitalizations, andsimilar events. These are essentially corporate housekeepingprovisions, but are nonetheless necessary because of the riskof injudicious case law that may not protect the investors insuch situations.

The other form of antidilution protection insisted upon byVCs is price antidilution. To understand how antidilutionprovisions work, �rst one must understand that, when thepreferred stock is initially issued, the conversion ratio ofpreferred into common is set at one-for-one. The formula todetermine the ratio is the original issue price of the preferreddivided by the ‘‘conversion price,’’ which originally is theprice paid so as to achieve the one-to-one ratio. When asubsequent round of �nancing is done, it is to be hoped thatthe price for the securities issued will be higher, which itwill be (market conditions and all other things being equal)if the company is succeeding. The price could also, however,be the same or lower. If the price is the same or higher, theantidilution provisions do not come into play. It is only if theprice in the subsequent �nancing is lower that the antidilu-tion provisions operate to lower the conversion price so as togive the preferred stockholders a higher number of commonshares upon conversion, on the rationale that this compen-sates them for the equity dilution su�ered when the laterinvestors buy stock for a lower price per share.

There are two basic types of price antidilution protection,‘‘weighted average’’ and ‘‘full ratchet’’ (or ‘‘ratchet’’).Weighted average antidilution mitigates the impact of theantidilution adjustment. Put simply, weighted averageantidilution protection accounts more accurately than does


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full ratchet antidilution for the actual dilutive e�ect which aparticular issuance has on the investors’ equity position inthe company: a more signi�cant adjustment in the conver-sion ratio of the preferred stock if a larger number of sharesof stock is issued at a lower price, and a less signi�cantadjustment if a smaller number of shares is issued at a lowerprice. With weighted average antidilution, upon a sale ofstock at a price lower than the conversion price, the conver-sion price is lowered to a price that is an average of the priceat which the company has sold stock, valuing the commonstock outstanding at the pre-adjusted conversion price. Anissuance of warrants, stock options, or convertible securitiesis deemed to be a sale of the underlying stock. (There is acontinuum of weighted average formulas, from broad-basedto narrow-based, the variation being in which common stockequivalents are included in the fully diluted base over whichthe dilutive e�ect is spread.)

The harsher form, full ratchet antidilution, on the otherhand, treats all later stock issuances below the investor’spurchase price as if they were the same, resulting in thesame adjustment to the conversion ratio regardless of thenumber of shares issued. The conversion price is ‘‘ratcheted’’down to the lowest price at which stock is sold after the issu-ance of the convertible preferred, even if only one share issold at that price. Thus, if the next round of �nancing is fora price that is half of the �rst round price, the conversionprice of the original preferred will be cut in half so that theoriginal preferred investors will receive twice as many com-mon shares upon conversion, all for no additional consider-ation, resulting in signi�cant dilution to the founders andother common stockholders. In this way, the originalpreferred investors are e�ectively—retroactively—given thelowest price at which the company’s stock is sold.

A representative weighted average antidilution clausereads as follows:

In the event the Corporation shall at any time after the Series AOriginal Issue Date issue Additional Shares of Common Stock,without consideration or for a consideration per share less thanthe applicable Conversion Price in e�ect immediately prior tosuch issue, then and in such event, such applicable ConversionPrice shall be reduced, concurrently with such issue, to a price(calculated to the nearest cent) determined by the followingformula:


K West Group, 12/2002 3-25

There are a number of customary exceptions to the opera-tion of the ratchet or weighted average formula antidilutionclauses. The following is sample exclusionary language list-ing issuances of stock or options where no antidilutionadjustment is permitted:

‘‘Additional Shares of Common Stock’’ shall mean all shares ofCommon Stock issued by the Corporation after the Series AOriginal Issue Date, other than:

(i) shares of Common Stock issued or issuable uponexercise of any Options outstanding on the SeriesA Original Issue Date or conversion or exchangeof any Convertible Securities;

(ii) shares of Common Stock issued or issuable as adividend or distribution on Preferred Stock;

(iii) shares of Common Stock issued or issuable by rea-son of a dividend, stock split, split-up, or otherdistribution on shares of Common Stock that iscovered by Section [E] or [E] below;

(iv) up to [———] shares of Common Stock (or suchgreater number as is approved by a majority ofthe Board of Directors, including directors nomi-nated by the holders of the Preferred Stock) (orOptions with respect thereto) (subject in eithercase to appropriate adjustment in the event of anystock dividend, stock split, combination, or other


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similar recapitalization a�ecting such shares),previously issued or issuable in the future to em-ployees or directors of, or consultants or advisorsto, the Corporation or a subsidiary pursuant to aplan or arrangement approved by the Board ofDirectors of the Corporation (provided that anyOptions for such shares that expire or terminateunexercised, or shares issued thereunder that arerepurchased at cost pursuant to the terms thereof,shall not be counted toward such maximumnumber); or

(v) shares of capital stock, or options or warrantsexercisable therefor, issued to banks, vendors, orequipment leasing organizations in connectionwith bank �nancing, vendor relationships, orequipment leasing arrangements to which theCorporation is a party, or shares of capital stockissued in connection with the acquisition of an-other business, in each case which has been ap-proved by a majority of the members of the Boardof Directors.

While it is beyond the scope of this Chapter to discuss indetail the issues of down-round �nancings, any discussion ofprice antidilution protection, particularly in the post-Internetbubble venture capital climate, should mention a devicesometimes proposed by companies to protect against earlierinvestors getting the bene�ts of full ratchet antidilutionwithout even providing more capital to the company. So-called ‘‘play-or-pay’’ provisions provide a strong incentive forexisting investors to participate in subsequent rounds. If apreferred investor subject to a play-or-pay provision does notparticipate in a new round of �nancing, some or all of theprivileges (for example, the price antidilution protection,liquidation preferences, special voting rights, or redemptionrights) attached to the investor’s preferred stock arestripped, usually by automatic conversion into a series ofpreferred stock without those privileges or by outrightconversion into common stock. Play-or-pay provisions areoften heatedly argued among di�erent investor groups.

§ 3:14 —Mandatory conversion into common stockConvertible preferred stock terms provide that upon the

e�ectiveness of a registration statement under the Securities


K West Group, 12/2002 3-27

Act of 1933 covering a �rm commitment underwritten publico�ering of common stock of the company by a nationallyrecognized underwriter, the preferred stock automaticallyconverts into common stock immediately prior to the IPOclosing. The reason for this is that the prospect of continuedexistence of the convertible preferred after the IPO wouldadversely a�ect the marketing and pricing of the IPO itself,and many of the terms and provisions of venture capitalpreferred stock are inconsistent with the operation of a pub-lic company.

In addition to the �rm commitment underwriting require-ment, the public o�ering price is usually required to be atleast a speci�ed multiple of the conversion price with speci-�ed aggregate gross proceeds received by the Company fromthe IPO. These additional requirements are probably unnec-essary as a practical matter and can be problematic in somecircumstances. One would �nd it hard to imagine an IPO bya nationally recognized underwriter that would not bewelcomed by the venture investors. Where the additionalrequirements are not quite met, the last minute scurryingaround to get the necessary waivers can be an impedimentto getting the IPO priced and closed on time. Counsel whoare experienced at doing IPOs will try to persuade theventure investors to eliminate these extra requirements fromthe outset.

§ 3:15 —Covenants and separate voting rights of thepreferred

Because the investors do not have majority control of theBoard of Directors, they believe it is necessary to have vetorights over certain major corporate actions. A typical list ofthe actions that the company will be prohibited from takingwithout the consent of a speci�ed percentage of the preferredis set forth in the following sample language:

Without the consent of a speci�ed percentage of the preferred,the Company will not:

(i) amend or repeal any provision of, or add any provi-sion to, the Company’s By-laws if such action wouldadversely a�ect the preferences, rights, privileges, or pow-ers of or the restrictions provided for the bene�t of thePreferred Stock;

(ii) pay or declare any dividend or distribution on any


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shares of its capital stock (except dividends payable solelyin shares of Common Stock), or apply any of its assets tothe redemption, retirement, purchase, or acquisition,directly or indirectly, through subsidiaries or otherwise, ofany shares of its capital stock (other than repurchase ofCommon Stock at cost upon termination of employment orservice);

(iii) reclassify any Common Stock into shares havingany preference or priority as to assets superior to or on aparity with any such preference or priority of the PreferredStock;

(iv) sell, lease, or otherwise dispose of all or substantiallyall of its assets, or properties;

(v) voluntarily liquidate or dissolve;(vi) acquire all or substantially all of the properties, as-

sets or capital stock of any other corporation or entity;(vii) enter into any merger or consolidation, or permit

any subsidiary to enter into any merger or consolidation;or

(viii) incur indebtedness for borrowed funds in excess of$[———] in aggregate principal amount any timeoutstanding.

The choice of the requisite approval percentage requirescare. Often the investors will be more concerned about beingable to block a transaction that they don't like and will setthe approval percentage quite high. Founders should try toconvince the investors that this approach is not in their owninterest—the risk of a group of investors not being able to doa deal they want to do because of an unreasonable investoris greater than the risk of not being able to block a transac-tion that the group does not want to do.

§ 3:16 —Redemption

Convertible preferred stock issued in a venture capital�nancing typically has a redemption feature. In the eventthe company has not been acquired or gone public within aspeci�ed period of time, then a speci�ed percentage of thepreferred holders can require the company to redeem theirpreferred stock at the liquidation preference amount. Thepayout of the redemption price is usually spread out overseveral years. The purpose of this clause is to give the VCs


K West Group, 12/2002 3-29

control over a situation where the company no longer ap-pears to be on a growth company track, but is instead ‘‘goingsideways.’’ Because venture capital funds have limited lives,there is some pressure on the VCs to liquidate their invest-ments within a �xed period of time—hence the redemptionfeature.

The actual use of the redemption feature is rare. It is therare growth company that has the legally available capitalto �nance a buyout. So the ‘‘threat’’ represented by theseclauses is largely illusory. Unless the company has su�cientlegal capital under the applicable business corporation stat-ute, the company will be prohibited from redeeming thepreferred. To put some teeth into this clause, investors maydemand a clause providing that, if there is a default, theinvestors will get the right to control the Board. This israrely done, in part because, out of concern for creditors’rights and similar laws, investors are reluctant to takecontrol over the Board in those circumstances. Indeed, in theroaring nineties, redemption clauses were frequently omit-ted from preferred stock terms.

Redemption features are usually phrased in terms of whatis, in e�ect, a put right, rather than an automaticredemption. The reason for this approach is that in asideways-but-slightly-up scenario, where the company isworth more per preferred share than the redemption price,the investors don't want to be limited to a redemption at a�xed price or worse, an automatic redemption feature. Anincreasingly common feature is for investors to have a putright at the higher of the liquidation preference or fair mar-ket value as determined by an agreed valuation procedure.

In sum, redemption features are probably not worth thelegal expense that it takes to create them, but are nonethe-less standard features of VC �nancings.

§ 3:17 —Ancillary agreements

In a typical venture capital closing (see the sample closingagenda for a convertible preferred stock VC �nancing ap-pended at the end of this Chapter), there are a number ofcustomary agreements that are executed implementing afairly standard suite of other business and legal terms.

— Stock Purchase Agreement. This is the agreementpursuant to which the investors agree to make their invest-


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ment in the company. It is much like any other purchaseagreement. The purchase price of the preferred investmentis speci�ed, and there are conventional representationsand warranties of the company, investment representa-tions of the investors that are necessary to comply with se-curities law private placement requirements, a�rmativeand negative covenants, and conditions to closing. Themost contentious issues with the Stock Purchase Agree-ment are whether or not the founders are required to makeseparate representations, and whether or not there will bea single funding or staged fundings based on the satisfac-tion of performance or other conditions.

As for personal representations by the founders, in a�rst-round �nancing, this practice is not unusual. In asense, for the company alone to make the representationsis meaningless. If there later turns out to be a problemwith a representation, it will be impossible to make theinvestors whole since the only cash invested in thecompany is theirs, some or all of which may have alreadybeen spent. The investor therefore would only be entitledto get a portion of their investment back if there were amisrepresentation. The approach to this problem of vari-ous VC �rms and their counsel varies widely. At theextreme, the founders are asked to jointly make the samerepresentations and warranties as the company, includingsuch things as due organization of the company, valid is-suance of its stock, and non-contravention of rights of, oragreements with, others. This is usually strongly resistedby the founders and company counsel. A more balancedand fair approach is to ask the founders only to representto those things that they should know about—that thereare no promises to issue equity other than as disclosed,that the founders themselves are not in violation of previ-ous employment, inventions, con�dentiality, and noncom-petition agreements, and that they have no actual knowl-edge of any threats related to any of the foregoing or tointellectual property matters. In subsequent �nancingrounds, after the company has been up and running for areasonable period of time, founder representations arerelatively rare.

Whether there is one or multiple fundings signi�cantlya�ects the economics of the deal. At times, investorsrequire that the obligation to advance the committed funds


K West Group, 12/2002 3-31

be staged over several closings. Whether the availability offunds is immediate or over a period of time is not theimportant issue. The real issue is on what terms the inves-tors will be excused from advancing the additional funds.Sometimes the condition to the second closing is only area�rmation of the representations and warranties,including that there has been no material adverse changein the business. If there is such a condition, care must betaken in the phrasing of the representations andwarranties. For example, if the company has representedthat a speci�c number of shares are outstanding, then thatrepresentation should only need to remain correct as of thedate it was �rst made. Otherwise, the mere issuance of ad-ditional stock will constitute a breach of that representa-tion and a failure of that condition to the subsequentclosing. Usually, there is also some variation of a ‘‘bringdown’’ of the no-material-adverse-change representation.The investors argue that it is not possible to adequatelycover all the events for which they need protection in themore speci�c representations and warranties. From thecompany’s point of view, this representation is inherentlyvague and subject to dispute. The company would alsoargue that the risk of an adverse change is one that theinvestors should be considered to have accepted in a highrisk technology company and should not be an excuse forthem to abandon the company.

Similarly, at times conditions to subsequent closingsare imposed requiring the company to meet certain perfor-mance milestones. The investors argue that they areinvesting based on management’s assurances as to theachievement of the speci�ed milestones within a certaintime frame. In e�ect, the investors are saying that theywant to put their money where the company’s mouth is.The company is in a di�cult position to argue in somecases. The more nervous management appears about themilestones, the more they risk losing the investors. In anyevent, the company needs to be very careful that it receivesenough funding at the �rst closing to achieve the mile-stones it is required to achieve before additional funds areadvanced.

— Right of First Refusal and Co-Sale Agreement. In aprivate company both the founders and the investors havea common interest in preserving the integrity of the inves-


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tor, employee, and founder group’s ownership of the equityof the company. The founders, and sometimes the inves-tors, are prohibited from selling their shares to a new in-vestor without giving—�rst to the company, and then tothe investors (and sometimes the founders)—a right of�rst refusal to purchase the securities available for sale atthe price that has been o�ered. Typically a further require-ment is imposed on the founders (but almost never on theinvestors) that if the �rst refusal rights are not exercisedin full, then the selling founder must allow the investors tosell a pro rata portion of their securities to the newinvestor. These are called ‘‘co-sale rights.’’ The rationalefor these provisions is that the investors are investing inthe company based on the participation and equity incen-tives of the founders and the founders are not supposed tobe bailing out of the company before the investors. Theseprovisions should be noncontroversial.

Sometimes an additional clause, called a ‘‘drag-along’’right, is included in these agreements. With that clause, ifa speci�ed percentage of the investors wants to sell thecompany, then the founders agree in advance to be‘‘dragged along’’ in the sale, that is to vote for that transac-tion and sign any agreements related to the transactionthat the investors sign. These clauses are dangerous to thefounders since there are many scenarios where theinterests of the investors will di�er from those of thefounders. The investors may grow tired of a sidewaysinvestment and want to sell the company for the pricethey paid for their shares. Because they have a liquidationpreference on such a sale (see Section 3:1), the investorswould realize a return before other stockholders. Thefounders may have a di�erent view of the desirability ofthe sale. One re�nement on this type of clause is to imposecertain economic and legal parameters for sales in whichthe founders can be compelled to participate.

— Investors Rights Agreement. This agreement is thevehicle for the investors to impose various a�rmative andnegative covenants on the company. The a�rmative cove-nants typically include access rights, preparation ofmonthly �nancial statements, preparation of annualbudgets, and a contractual pre-emptive right in the inves-tors to purchase new securities issued by the company inorder to maintain their percentage interest (with exclu-


K West Group, 12/2002 3-33

sions typically similar or identical to those described abovein the antidilution discussion). Negative covenants mayinclude certain company speci�c items that are either notcovered in the voting section of the corporate charter orare considered more appropriate in this agreement.

— Registration Rights Agreement. This agreementspeci�es the criteria and procedures for sales of sharesinto the public markets. The investors are the bene�ciariesof these clauses, and sometimes the founders are as well.

These agreements provide for two di�erent kinds ofregistration rights: ‘‘demand’’ rights and ‘‘piggyback’’rights.

Demand rights entitle the investors to require thecompany to �le a registration statement for all or a portionof their shares so they may sell them without restriction tothe public. These rights usually become e�ective 180 daysafter the company’s initial public o�ering, e�ectively build-ing in a ‘‘lock-up’’ for the investors that would normally berequired by the underwriters in an IPO in any event.Demand rights will sometimes purport to allow the inves-tors to force the company to do an IPO after a period ofseveral years. There is then a battle over the appropriate-ness of this clause. As a practical matter, it is not possibleto force the company to do an IPO (the participation ofmanagement is critical), so the battle (on both sides) shouldbe saved for something else. This is the perfect opportunityfor the VC to score some points as to its reasonablenessand not include the ability to force an IPO.

Once the company has been public for a period of time(currently one year), the company becomes ‘‘S-3 eligible’’and is permitted to �le a short-form registration statementwith the SEC. Because the S-3 procedures are streamlined,it is not uncommon that the VC’s require unlimiteddemand rights on Form S-3, typically with a minimum dol-lar amount of the securities required to be registered.Because the typical VC fund will have already distributedits company securities to its investors by the time thecompany is S-3 eligible, and because of the low cost of anS-3 registration statement, this clause is another one thatis not worth battling over (by either side).

Piggyback rights allow the investors and sometimesthe founders to add a portion of their shares to a registra-tion statement �led by the company at its own initiative.


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Because the sale of these ‘‘secondary’’ shares is a sensitivemarketing issue in an IPO, registration rights agreementsuniversally have a so-called ‘‘underwriter cut-back’’provision. This provision cedes to the underwriters the de-termination whether inclusion of secondary shares in theo�ering is feasible from a marketing point of view. If, inthe lead underwriter’s judgment, only a portion of therequested shares can be included, the registration rightsagreement will frequently contain a priority allocationscheme among various tiers of investors and sometimeseven among the founders.

These agreements also contain elaborate provisionsdealing with registration procedures, indemni�cation forsecurities laws liabilities, and similar matters. These pro-visions are relatively standard and noncontroversial.Indeed, the registration rights agreement itself should notbecome the focus of too much attention or loss of good will.In an IPO or other public o�ering, as a practical matter,the underwriters call all of the shots, and the registrationrights agreement is rarely taken out of the drawer otherthan to waive provisions objected to by the underwriters.

— Other Agreements. Other agreements required byVCs include: (i) so-called employee con�dentiality andinvention assignment agreements requiring all employeesto maintain the con�dentiality of the company’s con�den-tial information and to assign to the company, at no cost,all inventions made by the employee that are related tothe company’s business or that were made on companytime or with use of the company’s resources, and (ii)noncompetition agreements from the founders and keymanagerial and technical personnel.

§ 3:18 Subsequent �nancing roundsFrom a practical and legal perspective, subsequent con-

vertible preferred stock �nancings should be, and usuallyare, less time-consuming and costly than a �rst-round�nancing. Typically the spoken or unspoken commitment onboth sides is to complete the deal as expeditiously and simplyas possible. Hopefully most of the major contentious issueswill already have been worked out in the �rst round. It isusually agreed among counsel, particularly if the investorsare largely the same as in the �rst round, to use the same


K West Group, 12/2002 3-35

forms of documentation agreed upon in the �rst round.Normally, in order to keep the company’s compliance require-ments as simple as possible, all of the principal agreementsare amended and restated and signed by all parties so thatthere is one integrated, completely consistent set ofdocuments. In the corporate charter, the documentationmerely requires adding the new series into a handful of ap-propriate points.

There are, however, a few new issues that arise in connec-tion with a subsequent round �nancing. First, the relativepriority of the two series of preferred stock must be agreedupon—that is, whether the new series ranks equally, or ‘‘paripassu,’’ with the prior series with respect to liquidation,dividends, and the like. Also, the Board composition must beagreed upon to include one or more designees of the newinvestors. Lastly, the various a�rmative and negative cove-nants negotiated for the bene�t of the �rst-round investorsmust be integrated into the new documentation. Thepreferred alternative for the company in that respect is tohave only one set of covenants which are able to be waivedby a speci�ed percentage of the old and new investors as agroup. The new investors may insist on their own separateset of covenants waivable only by a speci�ed percentage ofthe new investors. In our view this is a shortsightedapproach. In most cases any advantage to the new investorsin having their own covenants to block certain actions thatthey disagree with will be outweighed by the ability of theother series of investors to block a transaction favored by thenew investors. The best approach, in our view, is to inte-grate the covenants and provide for a waiver that allows anaction to proceed if a majority (or if necessary a super-majority) of investors favors the action.

§ 3:19 ConclusionThe legal aspects of venture capital investments are

perhaps the least important. The most important aspects areto secure a sound �nancing platform for the company’sgrowth with investors that the founders believe they canwork with and trust. The advantages gained or lost in thelegal details rarely a�ect the success or failure of the invest-ment from either the company’s or the investors’ point ofview. That is not to minimize the key legal and economicprovisions of a venture capital �nancing—valuation, Board


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control, antidilution, and so forth.—but rather to point outthat most of the documentation has become fairlystandardized. The e�ort of all parties should be to focus onthose few issues that are negotiable, and reach a promptagreement on them so that everyone can get back tobusiness.

§ 3:20 Sample legal due diligence request list

Sample Legal Due Diligence Request List

XYZ, INC.

Preliminary Legal Due Diligence ChecklistIn each case, the requested information should be provided

for the Company; for each of the Company’s subsidiaries, ifany; and for any entities a�liated with the Company wheresuch information is material to the business of the Companyor would otherwise be relevant.

A. Corporate Records1. Corporate charter, as amended to date, including

pending amendments.2. By-laws or equivalent document, as amended to

date, including pending amendments.3. Minutes/other records of all proceedings of the Board

of Directors (or equivalent body) and stockholders ofthe Company.

4. List of jurisdictions in which the Company doesbusiness, owns or leases real property, or otherwiseoperates and all foreign quali�cation documents.

5. List of subsidiaries and other entities in which theCompany has an equity investment, if any.

6. Corporate records for subsidiaries.B. Stock Records/Documents

1. Stock record books.2. Current stockholder list, with names and addresses.3. Copies of all employee stock option plans or other

equity incentive plans, related agreements and alist of all outstanding stock options, including vest-ing schedules, exercise prices and dates of grant.

4. Copies of any agreements to which the Company is


K West Group, 12/2002 3-37

a party relating to:(a) a commitment to issue or sell securities;(b) a commitment or option to repurchase securi-

ties;(c) past issuances or repurchases of securities (debt

and equity);(d) rights of �rst refusal;(e) preemptive rights;(f) restrictions on transfer of stock.

5. Warrants or other rights to purchase securities.6. Voting trusts or voting agreements to which the

Company is a party or of which it is aware.C. Financial Records

1. Audited �nancial statements for the last three �scalyears.

2. Most recent internal business plan.3. Reports, studies, or appraisals on �nancial condition

or business of the Company.4. Auditors’ management letters with respect to the

last three �scal years.5. Latest internal �nancial statements.6. Copies of all materials sent to all directors and/or

all stockholders within last 12 months relating tothe Company.

7. Tax returns and other correspondence with taxingagencies for the preceding three years.

D. Financing Matters1. Credit agreements, loan agreements, and lease

agreements.2. Security agreements, mortgages, and other liens.3. Guarantees by the Company of third-party

obligations.4. Agreements restricting the payment of cash

dividends.E. Material Contracts, Agreements, and Policies

1. All agreements between the Company and its direc-tors, o�cers, subsidiaries, or a�liates (including in-formation regarding unwritten commitments orunderstandings).

2. All (a) supply agreements, (b) VAR agreements, (c)distributorship agreements, (d) marketing agree-


3-38

ments, and (e) product development agreements.3. Documentation relating to:

(a) Investments in other companies or entities;(b) Acquisitions of companies or assets;(c) Disposition of assets.

4. Joint venture, cooperative, franchise, or dealeragreements.

5. List of principal or exclusive suppliers and vendors.6. Any document restricting an issuance of the Compa-

ny’s securities.7. Any standard customer terms and conditions of sale

or license.8. All other material contracts, agreements, and

policies.F. Personnel Matters

1. Employment and consulting agreements.2. Nondisclosure, development, assignment, and non-

competition agreements with any employee, consul-tant, or independent contractor and list of employ-ees who are not parties to such an agreement.

3. Employee bene�t plans, programs, or agreements(pension, health, deferred compensation, bonus,pro�tsharing, and any other bene�t plans).

4. Loans and guarantees to or from directors, o�cers,or employees.

6. Personnel policies, manuals, and handbooks.7. Resumes for all senior management of the Company

(including all vice presidents).8. List of all o�cers, directors, and key employees of

the Company, including a schedule of all salaries,bonuses, fees, commissions, and other bene�ts paidto such persons (or accrued) for the latest �scal year.

9. Agreements with unions, collective bargainingagreements, and other labor agreements.

G. Intellectual Property Matters1. Schedule of all trademark, copyright, and patent

registrations or applications, and related �lings.2. A catalog of each computer program used by the

Company in the conduct of its business (the ‘‘Soft-ware Programs‘‘), including, but not limited to, thetitle and description of each such Software Program.


K West Group, 12/2002 3-39

3. All records and documentation maintained by theCompany documenting the development, author-ship, or ownership of the Software Programs andrelated technology.

4. List of all third-party software or other items ormaterials (including work under U.S. Governmentownership) incorporated in the Software Programs.

5. List of all agreements or understandings with thirdparties, whether now in e�ect or terminated, for thedesign, development, programming, enhancement,or maintenance of the Software Programs.

6. List of agreements involving disclosure of sourcecode relating to the Software Programs.

7. Description of the devices, programming, or docu-mentation required to be used in combination withthe source code relating to the Software Programsfor the e�ective development, maintenance, andimplementation of the Software Programs (forexample, compilers, ‘‘work-benches,’’ tools, andhigher-level or ‘‘proprietary’’ languages).

8. List of agreements, options, or other commitmentsgiving anyone any rights to acquire any right, title,or interest in the Software Programs or relatedtechnology.

9. List of unregistered trademarks and service marks.10. License and technology agreements.11. All documents, materials, and correspondence relat-

ing to any claims or disputes with respect to anyintellectual property rights of the Company or anyof its subsidiaries or any third party.

H. Real and Personal Property Matters1. List of all o�ces and other facilities.2. Leases or subleases of real property.3. Deeds and mortgages.4. Purchase or lease agreements for material equip-

ment or other personal property.I. Insurance Matters

1. Summary of insurance coverage (casualty, personalproperty, real property, title, general liability, busi-ness interruption, workers’ compensation, product li-ability, key person, automobile and/or directors’ ando�cers’ liability, and self-insurance programs).


3-40

2. List of any insurance claims (whether or not settled)in excess of $20,000 since incorporation.

3. Indemni�cation agreements.J. Legal Matters

1. Threatened or pending litigation, claims, andproceedings.

2. Consent decrees, settlement agreements, andinjunctions.

3. All attorney’s ‘‘auditors letters’’ to accountants sinceincorporation.

4. Consents, decrees, judgments, orders, settlementagreements, or other agreements to which theCompany is bound requiring or prohibiting anyactivity.

K. Compliance with Laws1. Material government permits and consents.2. Governmental proceedings or investigations threat-

ened, pending, settled, or concluded.3. Reports to and correspondence with government

agencies.4. Regulatory �lings since inception.5. All internal and external environmental audits.

L. Business Information1. Press releases, articles, or promotional materials

published about the Company since incorporationwhich are in the Company’s possession.

2. Any external or internal analyses regarding theCompany or its products or competitive companiesor products.

3. Current backlog levels.4. Copies of advertising brochures and other materials

currently used by the Company.5. Budgets or projections.6. Product literature.


K West Group, 12/2002 3-41

§ 3:21 Sample term sheet for a �rst round venturecapital �nancing

Sample Term Sheet for a First Round VentureCapital Financing

TERM SHEET

FOR SERIES A ROUND OF FINANCING OF XYZ, INC.

Amount ofInvestment:

$3,000,000

Investors: ABC VenturesDEF Capital

Type of Security: Series A ConvertiblePreferred Stock.

Pre-MoneyValuation:

$7,000,000.1

CapitalStructureFollowingSeries A Round:

Existing holders of CommonStock

55%

Option Pool 15%2

Holders of Series APreferred Stock

30%

Total 100%Use of Proceeds. The Company shall use the

proceeds from this �nancingfor working capital purposes.


3-42

Dividends: The Company will not paydividends on its shares ofCommon Stock or any otherstock which is junior to theSeries A Preferred Stockunless a like dividend ispaid on all shares of SeriesA Preferred Stock on a prorata ‘‘as converted’’ basis.3

Conversion: Each share of Series APreferred Stock shall beconvertible, at any time, atthe option of the holder, intoshares of Common Stock, atan initial conversion ratio ofone share of Common Stockfor each share of Series APreferred Stock. Mandatoryconversion of the Series APreferred Stock upon thee�ectiveness of aregistration statementcovering a �rmly and fullyunderwritten public o�eringof Common Stock of theCompany by a reputableunderwriter acceptable tothe Investors at a pricewhich equals or exceeds �vetimes the purchase price pershare of the Series APreferred Stock and wherethe aggregate gross proceedsreceived by the Companyexceeds $25 million (a‘‘Quali�ed Public O�ering‘‘)4.


K West Group, 12/2002 3-43

Antidilution: The terms of the Series APreferred Stock will containstandard ‘‘weighted average’’antidilution protection withrespect to the issuance bythe Company of equitysecurities at a price pershare less than theapplicable conversion pricethen in e�ect, subject tostandard and customaryexceptions.5 The conversionrate of the Series APreferred Stock into commonstock will be adjustedappropriately to account forany stock splits,recapitalizations, mergers,combinations and assetsales, stock dividends, andsimilar events. Antidilutionprotection shall not betriggered by the issuance ofup to 1,000,000 shares ofCommon Stock (or optionstherefor) issued inaccordance with theCompany’s Stock OptionPlan.


3-44

Voting Rights: On all matters submitted forstockholder approval, eachshare of Series A PreferredStock shall be entitled tosuch number of votes as isequal to the number ofshares of Common Stockinto which such shares areconvertible. In addition, theCompany shall not, withoutthe prior consent of theholders of at least a majorityof the then issued andoutstanding Series APreferred Stock, voting as aseparate class:

a) issue or create any seriesor class of securities withrights superior to or on aparity with the Series APreferred Stock orincrease the rights orpreferences of any seriesor class having rights orpreferences that are juniorto the Series A PreferredStock so as to make therights or preferences ofsuch series or class equalor senior to the Series APreferred Stock.

b) pay dividends on sharesof the capital stock of theCompany.


K West Group, 12/2002 3-45

c) e�ect any exchange orreclassi�cation of anystock a�ecting the SeriesA Preferred Stock or anyrecapitalization involvingthe Company and itssubsidiaries taken as awhole.

d) repurchase or redeem, oragree to repurchase orredeem, any securities ofthe Company other thanfrom employees of theCompany upontermination of theiremployment pursuant toprior existing agreementsapproved by the Board ofDirectors of the Company.

e) enter into any transactionwith management or anymember of the board ofdirectors, except foremployment contractsapproved by the Board ofDirectors and transactionsentered at arms-lengthterms which are no lessfavorable to the Companythan could be obtainedfrom unrelated thirdparties.

f) e�ect any amendment ofthe Company’s Certi�cateof Incorporation or Bylawswhich would materiallyadversely a�ect the rightsof the Series A PreferredStock.


3-46

g) incur or guarantee debt inexcess of $100,000.

h) voluntarily dissolve orliquidate.

i) e�ect any merger orconsolidation of theCompany with or intoanother corporation orother entity (except one inwhich the holders of thecapital stock of theCompany immediatelyprior to such merger orconsolidation continue tohold at least a majority ofthe capital stock of thesurviving entity after themerger or consolidation) orsell, lease, or otherwisedispose of all orsubstantially all or asigni�cant portion of theassets of the Company.

j) change the size of theBoard of Directors orchange any procedure ofthe Company relating tothe designation,nomination, or election ofthe Board of Directors.


K West Group, 12/2002 3-47

k) amend, alter, or repealthe preferences, specialrights, or other powers ofthe Series A PreferredStock so as to adverselya�ect the Series APreferred Stock.

l) make capital expendituresof more than $50,000 in asingle expenditure or anaggregate of $100,000 inany 12-month period.6


3-48

LiquidationPreference:

The holders of Series APreferred Stock shall havepreference upon liquidationover all holders of CommonStock and over the holdersof any other class or seriesof stock that is junior to theSeries A Preferred Stock foran amount equal to thegreater of (i) the amountpaid for such Series APreferred Stock plus anydeclared or accrued butunpaid dividends, and (ii)the amount which suchholder would have receivedif such holder’s shares ofSeries A Preferred Stockwere converted to CommonStock immediately prior tosuch liquidation. Thereafter,the holders of CommonStock will be entitled toreceive the remaining assets.For purposes of this section,a merger, consolidation, saleof all or substantially all ofthe Company’s assets, orother corporatereorganization shallconstitute a liquidation,unless the holders of at leasta majority of the Series APreferred Stock voteotherwise.7


K West Group, 12/2002 3-49

Board ofDirectors:

The Board of Directors ofthe Company shall becomprised of �ve members.Of these �ve members, theholders of the Series APreferred Stock shall havethe right to designate twodirectors (one of such twodirectors to be designated byABC Ventures, the other byDEF Capital) and thefounders of the Companyshall have the right todesignate two directors. Theremaining director shall bedesignated by such fourdirectors.8

Options andVesting:

All stock and options held byfounders, management, andemployees shall vest over afour-year period. Stockcurrently held by founderswill be considered to be 25percent vested as of theclosing of this �nancing withthe balance to vest in equalmonthly installments overfour years. All others shallvest in equal monthlyinstallments over four yearswith a one-year cli� at thebeginning of the vestingterm. Change of controlprovisions to provide for nomore than an additional 50percent for founders andselect management and oneyear for all others.9


3-50

RegistrationRights:

Commencing on the earlierof three years from theclosing or six months afterthe e�ective date of theCompany’s �rst publico�ering, holders of shares ofSeries A Preferred Stock orshares of Common Stockissued upon conversionthereof (‘‘Registrable Stock‘‘)shall have the right todemand two ‘‘S-1’’registrations with aggregategross o�ering price in excessof $10,000,000, uponcustomary terms andconditions.

The holders of Series APreferred Stock will also beentitled to unlimited‘‘piggyback’’ registrationrights on Companyregistrations.

The holders of Series APreferred Stock willadditionally be entitled tounlimited registrations onForm S-3 with at least$1,000,000 in aggregategross o�ering price, oncustomary terms andconditions.

The Company will bear allexpenses related to allregistrations andunderwritings.


K West Group, 12/2002 3-51

A�rmativeCovenants:

While any Series APreferred Stock isoutstanding, the companywill:

a) maintain adequateproperty and businessinsurance;

b) comply with all laws,rules, and regulations;

c) preserve, protect, andmaintain its corporateexistence; its rights,franchises, and privileges;and all properties necessaryor useful to the properconduct of its business;

d) submit all reportsrequired under Section1202(d)(1)(C) of the InternalRevenue Code and theregulations promulgatedthereunder;

e) cause all key employees toexecute and delivernoncompetition,nonsolicitation and non-hire,nondisclosure, andassignment of inventionsagreements for a term oftheir employment with theCompany plus one year in aform reasonably acceptableto the Board of Directors;


3-52

f) not enter into relatedparty transactions withoutthe consent of a majority ofdisinterested directors;

g) reimburse all reasonableout-of-pocket travel-relatedexpenses of the Series APreferred Stock directors.10

FinancialStatementsand Reporting:

The Company will provideall information andmaterials, including, withoutlimitation, all internalmanagement documents,reports of operations, reportsof adverse developments,copies of any managementletters, communications withstockholders or directors,and press releases andregistration statements aswell as access to all seniormanagers as requested byholders of Series A PreferredStock. In addition, theCompany will provide theholders of Series A PreferredStock with unauditedmonthly and quarterly andaudited yearly �nancialstatements, as well as anannual budget.


K West Group, 12/2002 3-53

Redemption: Commencing with the datethat is �ve years from thedate of closing and on eachone-year anniversary of suchdate thereafter, holders of atleast a majority of the thenissued and outstandingshares of Series A PreferredStock may request theCompany to redeem theirshares at a price equal tothe original purchase pricefor such shares plus anydeclared but unpaiddividends, with 1/3 of theshares to be redeemed onsuch redemption date, anadditional 1/3 on the datethat is one year from suchdate, and the remaining 1/3on the date that is two yearsfrom such date.11

Right of FirstRefusal:

Holders of Series APreferred Stock shall have apro rata right, based ontheir percentage of fullydiluted equity interest in thecompany, with anundersubscription right upto the total number ofshares being o�ered, toparticipate in subsequentstock issuances.12


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Right of FirstRefusal andCo-Sale:

In the event that any of thefounders and existingexecutive managementpropose to sell their stock tothird parties, the Companyshall have the �rst right topurchase the securities onsubstantially the sameterms as the proposed sale;the Series A PreferredStockholders shall next havesaid right according torespective percentageownership of Series APreferred Stock or to sellproportionate percentagepursuant to co-sale rights.Such rights shall terminateupon a Quali�ed PublicO�ering.

Other Provisions: The purchase agreementshall include standard andcustomary representationsand warranties of theCompany and the otheragreements prepared toimplement this �nancingshall contain other standardand customary provisions.De�nitive agreements willbe drafted by counsel to theInvestors. This term sheet isintended by the parties to benonbinding.13


K West Group, 12/2002 3-55

Expenses: The Company will reimbursethe holders of Series APreferred Stock forreasonable legal fees inconnection with thetransaction, payable atclosing and only in the eventthat the transactionscontemplated by this termsheet are consummated, upto a limit of $25,000.14

Conditions toClosing:

Closing shall be subject tothe standard and customaryconditions, including thecompletion of due diligenceand the delivery to theinvestors of a legal opinionof counsel to the Company,regarding standard andcustomary matters andsatisfactory to the Investorsand their legal counsel.15

1Equals the value the new investors are placing on theenterprise prior to their investment. In calculating the price pershare that will be paid by the new investors, usually all of theoutstanding stock of the company, together with any outstandingoptions and warrants or other rights to buy stock of the companyand any additional shares which may be reserved under theoption pool, will be included in this pre-money valuation.

2The size of the option pool that venture capital investors willlook for ranges between 15% and 30% of the capital structure ofthe company. This percentage is calculated including the shares ofSeries A Preferred Stock being sold in the �nancing. The actualsize of the pool can depend on a number of things, including theindustry that the company is in, but is primarily related to thenumber and types of hires which the company will need to makein the foreseeable future. Thus, a company which has a completemanagement team at the time of the Series A round will likelyneed a smaller pool than a company which has one or more topmanagement hires to make (each of whom may cost the companya signi�cant amount of options or stock from the pool).


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3Often, venture capital investors also ask for an ‘‘accruing’’dividend of between 7% and 10% or so per annum. This dividend‘‘accrues’’ and is not payable unless (i) declared by the Board, (ii)there is a liquidation event (a sale of the company is considered aliquidation event, but an IPO usually isn't), or (iii) the preferredstock is redeemed. The accruing dividend is a protective deviceintended to provide a minimum rate of return but is usuallyforfeited in the event of an IPO or otherwise upon conversion ofthe preferred stock to common stock (the theory being that insuch cases the return on the investment will be more than theminimum which the accruing dividend provides; therefore, theprotection is not needed and is forfeited). There are a number ofvarieties of accruing dividends, including those that are payablein cash and those payable in additional shares of preferred stock.Also, although a basic ‘‘accruing dividend’’ involves a simpleinterest calculation, sometimes investors request a compoundinterest calculation.

4Preferred Stock should convert into common stockautomatically at the company’s IPO. The special rights generallyaccorded to preferred stock sold to early-stage investors couldcreate problems for a public company. The concept of a Quali�edPublic O�ering is designed to protect the investors from a forcedconversion and loss of other rights if a small public o�ering isdone which does not result in su�cient liquidity of the commonstock.

5These provisions are designed to protect an investor against‘‘equity’’ dilution (later sales of stock at a price lower than whatthe investor paid). Although the ‘‘weighted average’’ version is themost common, an alternative is ‘‘full ratchet’’ antidilutionprotection. Full ratchet antidilution protection is far moreadvantageous to the investor (but punitive to the company) thanweighted average, but is usually reserved for very early stagedeals or other situations where there is signi�cant concern as towhether the valuation will hold up over the long term. Putsimply, weighted average antidilution protection accounts moreaccurately for the actual dilutive e�ect which a particularissuance has on the investor’s equity position in the company.Weighted average antidilution adjustment provides for a moresigni�cant adjustment in the conversion rate of the preferredstock in the event of the issuance of a signi�cant number ofshares of stock at a lower price and a less signi�cant adjustmentin the event of the issuance of a small number of shares at suchlower price. Full ratchet antidilution protection, on the otherhand, treats all later stock issuances below the investor’spurchase price as if they were the same, regardless of the numberof shares issued. Thus, full ratchet antidilution adjustmentresults in the same adjustment to the conversion rate (to the pricepaid per share for the later issued shares) regardless of thenumber of shares actually sold.


K West Group, 12/2002 3-57

6Although there are venture capital investors that ask for otherveto rights, this list covers some of the most frequently occurring.You may not have to provide veto rights with respect to each ofthese matters. The key here is to try to limit these to majorcorporate events and to try to avoid turning day-to-dayoperational matters into matters for a preferred stockholder vote.Thus, for example, (g) and (l) could be problematic if the dollarlimits are too low. Often a compromise may be reached withrespect to a request for a veto right on an operational matter byagreeing that such would be subject to the veto of the Series APreferred’s director but not at the stockholder level, therebykeeping the issue at the board level—where it belongs.

7This is a so-called ‘‘straight’’ liquidation preference. Analternative is the ‘‘participating’’ liquidation preference(sometimes referred to pejoratively as a ‘‘double dip’’ liquidationpreference) which provides that the preferred stock gets anamount equal to its money back (plus any accrued dividends ifthere is an accruing dividend) and then participates with commonstock on an ‘‘as-converted basis.’’ A participating liquidationpreference is a pricing term most often seen only in early-stagedeals or in ‘‘down rounds.’’

8Working out what the Board will look like following the SeriesA round will be one of the most important matters to deal with.Generally, the Series A investors will ask for and receiverepresentation on the Board. The questions will be how manyseats do they get and what e�ect will that have on the founders’and management’s Board representation. In the end, everybodyinvolved will need to participate in, and be satis�ed with, thedecisions regarding board structure.

9Venture capital investors will likely impose a vesting scheduleon stock and options held by founders, management, andemployees as a condition to investment. If shares or options aresubject to vesting, they are subject to being lost if the personceases to work for the company for any reason. Venture capitalinvestors impose such vesting requirements in order to providethe company’s people with a reason to stay with the company.Also, if a person ceases to work for the company for any reason,the non-vested shares are available for grant to his or herreplacement. The theory here is, of course, that the best businessplan is worth nothing without the people to execute it.

10This list includes items frequently and consistently looked forby venture capital �rms.


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11This is simply a right to achieve liquidity in the event that thecompany does not otherwise reach a sale or IPO by the end of theselected time period. Since the company cannot redeem stock if todo so would render the company insolvent, this right is onlyuseful in situations in which the company has become some sortof a sideways play. Usually the redemption price is the price paidfor the stock plus the accruing dividend if there is one.Occasionally, venture capital �rms will request that theredemption price be at the greater of such price and the then fairmarket value of the stock. The only thing to really watch out forhere is to make sure that the company can pay the redemptionout over time (three payments over two years is so common as tobe almost standard).

12While this is generally asked for and received by venturecapital investors (who can give you a yes or no quickly withoutthe need for elaborate disclosure documents to comply with thesecurities laws), a company should think about resisting thisrequest if it comes from individual investors.

13The term sheet should be nonbinding (with the exception onlyof the exclusivity provision, if there is one, and any provisionsregarding con�dentiality).

14How much usually depends on where the lawyers are from.Make sure that there is a cap. You may also want to resist anyrequest to pay ongoing fees for the cost of complying withrequests for waivers, etc., after the closing (except to the extent towhich they incur fees because the company breaches itsobligations to them).

15Be on the lookout for any exclusivity provisions (which may beacceptable, but only to a point). Usually, these exclusivityprovisions require the company to refrain from taking aninvestment from anyone else for a set period of time after theterm sheet is signed. While an exclusivity provision may beacceptable (and is often imposed), be sure to pay attention to thetime period. It should be no longer than is necessary to completethe transaction with a little extra time for possible delays. Thirtydays should be acceptable in most instances; 60 days is pushing itin most instances; and 90 days is probably unreasonable in almostall cases. Also, make sure that the exclusivity periodautomatically ends in the event that the deal is called o� byeither party before the period expires.

By:––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––– By:–––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––


K West Group, 12/2002 3-59

§ 3:22 Sample closing agenda for a convertiblepreferred stock �nancing

Sample Closing Agenda for a Convertible PreferredStock Financing

Xyz, Inc.

Sale and Purchase ofSeries A Convertible

Preferred Stock

Closing Agenda

[Date]

Abbreviations

XYZ, Inc., a Delaware corporation Company

Purchasers

FoundersCompanyCounselInvestorsCounsel


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Transaction Documents Responsibility

1. Series A Convertible Preferred StockPurchase Agreement dated [———] byand among the Company, the Purchas-ers, and the Founders (the ‘‘PurchaseAgreement’’)

InvestorsCounsel as to

drafting;Company

Counsel as tosignatures fromCompany and

Founders

2. Financial Statements furnished pursu-ant to the Purchase Agreement

Company

3. Disclosure Schedule to the PurchaseAgreement

Company;CompanyCounsel

4. Amended and Restated Certi�cate ofIncorporation


drafting;Company

Counsel as tosignature from

Company

5. Right of First Refusal and Co-saleAgreement


drafting;Company


Founders


K West Group, 12/2002 3-61


6. Investors Rights Agreement InvestorsCounsel as to

drafting;Company

Counsel as tosignature from

Company

7. Registration Rights Agreement InvestorsCounsel as to

drafting;Company


Founders

8. Stock Restriction Agreements InvestorsCounsel as to

drafting;Company


Founders

Corporate Organization, Existence,Quali�cation, and Authority

9. Board resolutions of the Company CompanyCounsel

10. Stockholder resolutions of theCompany

CompanyCounsel

11. Certi�cate of Good Standing of theCompany from the Secretary of Stateof the State of Delaware

CompanyCounsel


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12. Certi�cate of quali�cation to do busi-ness of the Company from the Secre-tary of State of [———]

CompanyCounsel

Closing Documents

13. Certi�cate of the Secretary or the As-sistant Secretary of the Company as to(i) Certi�cate of Incorporation, (ii) By-Laws, (iii) Board of Directors andStockholders resolutions, and (iv)incumbency

CompanyCounsel

14. Certi�cate of an O�cer of theCompany as to (i) representations andwarranties, and (ii) conditions requiredto be performed

CompanyCounsel

15. Opinion of Company Counsel CompanyCounsel

16. Form of Employee Nondisclosure andDevelopments Agreement by and be-tween the Company and each em-ployee

CompanyCounsel

17. Form of Key Employee Noncompeti-tion, Nondisclosure, and DevelopmentsAgreement by and between theCompany and each Key Employee

CompanyCounsel

18. Stock Restriction Agreements be-tween Company and each Founder

CompanyCounsel

19. Consent and Waiver pursuant to Sec-tion [———] of the Purchase Agreement

CompanyCounsel


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20. Wire instructions provided by theCompany

Company

21. Series A Preferred Stock certi�catesissued to the Purchasers

CompanyCounsel

22. ‘‘Blue sky’’ state securities �lings inconnection with sale of shares of SeriesA Preferred Stock

CompanyCounsel

23. Form D �led with the SEC in connec-tion with sale of shares of Series APreferred Stock

CompanyCounsel

24. ‘‘Blue sky’’ state securities �lings inconnection with sale of shares of SeriesA Preferred Stock

CompanyCounsel


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Economy & Finance

Chapter 3 Venture Capital Financings of Technology Companies