With the Summer 2022 Y Combinator Demo Day being held September 7 and 8, a new group of startup companies will have investors approaching them with term sheets for preferred stock financings. For many companies, the key points of the term sheet will be a breeze, as their main focus will be on the proposed amount to be invested and the valuation. But, what about the rest of the term sheet? Protective provisions, liquidation preference, voting rights, registration rights, rights of first refusal, etc. — these concepts may be foreign to some executives, while others that are more familiar with the concepts may be concerned that they’re agreeing to terms that are “off-market.”
Not to fear: the National Venture Capital Association (NVCA), has produced a standard suite of legal documents that are utilized to draft the core legal documents in most venture capital financings. Below, we provide a brief summary of the key documents and workstreams you will encounter when conducting your initial preferred stock financing.
What Documents?
The below table includes each of the key legal documents that will be executed in connection with your financing, the basic function of each document and a few key considerations related to each document.
What Else?
Other Legal Documents
In addition to the above, you may also be required to provide the lead investor with a management rights letter, which provides the lead investor with further information rights and a board observer if the lead investor doesn’t have a nominee serving on the board. You will also likely enter into a standard indemnification agreement with the lead investor’s director nominee. At the outset, you should also review your outstanding convertible notes or other investor documentation, if any, for any notice requirements or waivers you must solicit prior to the consummation of the financing.
Investor Data Room
Prior to the execution of the term sheet, you will field questions from investors that are contemplating (and hopefully competing!) to be the lead investor in the financing. These questions are often related to your operations, previous results, projections, customer agreements and diligence concerns. To address these inquiries, most companies set up a data room and give each investor access to a specific folder that contains the requested materials.
Capitalization Table
You will be required to produce a capitalization table while the term sheet is being negotiated, along with a pro forma capitalization table at the agreed-upon pre-money valuation to determine the price per share in the round. The initial capitalization table will need to include all issued and outstanding shares of common stock, all outstanding equity grants, all shares that are reserved for issuance pursuant to your equity plan, and your outstanding convertible notes and details related to how such notes convert. After a valuation is agreed upon, you will need to update the capitalization table to pro forma for (a) the conversion of the convertible notes into the round and (b) the increase of the equity plan pool. This fully diluted total (Pre-Money Total) will then be divided by the agreed-upon pre-money valuation to determine a price per share. After that price is determined, the number of shares to be sold in the round is determined by dividing that price by the proposed investment amount. Summing the number of shares in the Pre-Money Total with the number of shares sold in the round and multiplying by the price per share in the round will produce your post-money valuation.
The VC firm’s counsel will conduct a due diligence review of your capitalization table to ensure that all securities that are reflected in the capitalization table are supported by the appropriate documentation (stock certificates, option grants, convertible notes, etc.) and to confirm that all issued shares, equity grants and notes are reflected in the capitalization table. It may be worth conducting your own due diligence review of your capitalization table prior to the financing to ensure that the proper supporting documentation exists and that your capitalization table is accurate. Your counsel will typically need to provide a legal opinion on your capitalization, and you will want to get their diligence done early in the deal process so no surprises derail the deal.
Form D and State Securities Filings
You have 15 calendar days after the first investor irrevocably contractually commits to invest in the financing (typically the day that the stock purchase agreement is executed) to file a Form D with the SEC, which is a notice of an exempt offering of securities. If you have not yet conducted any SEC filings, you will need to file a Form ID with the SEC to obtain EDGAR codes prior to filing your Form D, which usually takes two to three business days. Additionally, after filing the Form D, you should have your counsel make the requisite state securities filings to comply with the relevant fee and notice requirements in jurisdictions where accredited investors purchased shares in the financing.
Then What?
After the financing is complete and the requisite filings have been conducted, you will continue to operate as-is, likely with a new board set-up and potentially with a few operational updates in process to comply with the terms of the financing documentation (and with some additional cash in the bank!). Additionally, after taking professional investor capital, companies typically upgrade their governance and corporate formalities to ensure they can meet their go-forward investor obligations and lead the company through its next chapter of growth.