The 5 most important legal documents in a Corporate Venture deal simply explained
So you’ve secured some good contacts with potential investors, and they are now throwing a bunch of documents at you, expecting you to comment upon them. Knowing what they are, their purpose, and what they entail for your company may prove useful in your business discussions.
Overtime, the venture capital industry has developed a rather standard set of legal documents that entrepreneurs should expect to come across.
The following will take a look at the various documents involved with venture capitalist investments for each stage of the deal.
But first, let’s take a look at the various forms that a VC investment can take.
· A VC investment is a deal whereby an investor or group of investors will inject money in your company in exchange for some equity or a security interest in it.
· The investment will either translate into an equity security (common stock or preferred stock), or a debt instrument (such as a promissory note which may then be converted into security).
Terms and designations may vary but in all cases, all VC investments begin with a term sheet and end with a closing.
Term sheet
Typically, the first piece of legalese you’ll come across is the Term sheet. This is the stage where entrepreneurs and investors agree to agree on the main structure of the deal, the closing date, the amount of the investment, how many piece of stocks will be issued, and the terms of the conversion (if any). Sometimes accompanied by a letter of intent, the purpose of this two-page long document is pretty straight forward: setting out the basic terms of the investment structure should the deal move forward.
Because this comes at the early stages of the investment process, the Term sheet is not intended to be binding on the parties.
“Not legally binding” doesn’t mean that there’s no agreement or contract. There is in fact a contract between the parties to use the terms set forth in the Term sheet and letter of intent as the basis for their dealing, if and when the parties decide to go through with the transaction.
Although the Term Sheet is only a summary of the structure of what the definitive document will contain, the bulk of the negotiation process will be concentrated at this point. A significant request for change in the later documents that hasn’t been raised at the time of the term sheet will have very little chance of success at a later stage.
In addition, some provisions of term sheets are actually meant to be binding. For instance, this is the case, when the term sheet includes an undertaking on the entrepreneur’s part to refrain from shopping for other opportunities while negotiations are underway.
Should the negotiations go well and the parties agree to the provision of the term sheet, the next stage will consist in the review and negotiation of the main and definitive agreement between the parties materializing the investment.
Promissory note or stock-purchase agreement
Depending on the structure of the deal (on whether common stock, preferred stock, promissory notes or convertible notes will be issued by your company), the main agreement will either be:
· A Securities Purchase Agreement (or Preferred Stock Purchase Agreement) which materializes the commitment from the investor to purchase newly issued securities of the company based on the terms agreed to in the term sheet, or
· A Convertible promissory note, a form of debt which may convert into equity (new shares for the investor) upon the occurrence of a particular event (usually another round of financing).
Each form has its own particularities and will be materialized in a different type of agreement.
These documents, once executed, are binding upon the parties.
Beyond the financial commitment and the number of stock issued, these final documents also contain the representations and warranties of the company as to the material facts relating to its organization and business.
These must be carefully dissected to ensure they adequately reflect what the entrepreneur actually knows and is confident with affirming as a fact. This requires from the entrepreneur a complete disclosure of what he actually knows and full anticipation of what he is expected to know. While some legal documents will go as far as asking for the entrepreneur to warrant, say, that the company’s IP will not infringe upon the rights of anybody, these kind of catch-all warranties (both from a geographical and temporal standpoint) are unrealistic and should be negotiated down to limit liability to actual knowledge or negligence.
The other key provisions that should be reviewed thoroughly in the main agreement are the affirmative and negative covenants of the company, as they determine the amount of leeway the entrepreneur will be left with once the transaction is completed and new investors are in the house. Among other restrictions, they usually impose limitations on the amount of debt the company will be allowed to carry and/or on key managers’ compensation.
Alongside the main agreement, new entrants will want to compile a set of rules that will govern their future relationship with the founding members of the company and investors from a previous round as stockholders of the company.
This is the purpose of the stockholders agreement.
Stockholders Agreements
A Stockholders’ agreement is meant to govern the relationship of all or part of the investors detaining stock in the company. The purpose of this document is to set forth the rules and restrictions that will apply to any transfer of the stock. They usually provide for rights of first refusal on proposed transfers, as well as for co-sale rights (provisions that determine the conditions under which stockholders may tag along certain sale of stock by the entrepreneur or other key management stockholders). They can also provide for buy-back rights in the event of the death or termination of employment of a key management stockholder.
Key employees are also at the center of a couple of other documents VCs will most certainly always require to ensure the preservation of their investment.
Employee and non-compete Agreements
During the early stages of building a company, the only assets an entrepreneur can really put forth to convince investors of the company’s potential are Intellectual Property rights and Key personnel. Investors know that a crucial factor in the success of the company resides in the continued presence of certain key personnel within the company.
This is why Investors will usually want key employees, including the entrepreneur, to enter into a written employment agreement with the company (in common law countries such as the US, where employment at will is the rule and written contracts the exception). Oftentimes, key employees will also be required to agree to refrain from competing with the company’s business (during and/or after employment). Investors may also include as part of the employment package confidentiality obligations together with a work made for hire provision (whereby all IP rights arising out as a result of employment are assigned onto the company).
This is meant to address ownership over IP created after the transaction and can either be addressed in the employment agreement or in a separate document. But sometimes VCs will require that IP already developed by the company at the time of the closing serve as a collateral to secure their investment.
Security interests (using IP as a collateral)
Like key personnel, IP rights often constitute the core assets of a start-up company. As such, investors will often attempt to use them as collateral. This why, as part of the closing documents, entrepreneurs should expect to be asked to enter into security interests covering each piece of IP developed by the company.
The security interest will afford the investor a priority ranking among other creditors of the company upon the occurrence of a given condition (such as bankruptcy filings or a sale of all or substantially all of the companies’ assets). In some countries such as the US, to be perfected IP security interests must be recorded using a UCC filing (if the IP is not registered) and with the USPTO (if and when the IP becomes registered). This is meant to inform other creditors that the IP asset is already burdened.
Be aware that a burdened IP asset may significantly hinder other investors’ appetite and may thus deter further rounds of investments.
G. Rochenoir
- Term sheet
- Promissory note or stock-purchase agreement
- Stockholders' agreement
- Employee and non-compete agreement
- Seurity interests
So you’ve secured some good contacts with potential investors, and they are now throwing a bunch of documents at you, expecting you to comment upon them. Knowing what they are, their purpose, and what they entail for your company may prove useful in your business discussions.
Overtime, the venture capital industry has developed a rather standard set of legal documents that entrepreneurs should expect to come across.
The following will take a look at the various documents involved with venture capitalist investments for each stage of the deal.
But first, let’s take a look at the various forms that a VC investment can take.
· A VC investment is a deal whereby an investor or group of investors will inject money in your company in exchange for some equity or a security interest in it.
· The investment will either translate into an equity security (common stock or preferred stock), or a debt instrument (such as a promissory note which may then be converted into security).
Terms and designations may vary but in all cases, all VC investments begin with a term sheet and end with a closing.
Term sheet
Typically, the first piece of legalese you’ll come across is the Term sheet. This is the stage where entrepreneurs and investors agree to agree on the main structure of the deal, the closing date, the amount of the investment, how many piece of stocks will be issued, and the terms of the conversion (if any). Sometimes accompanied by a letter of intent, the purpose of this two-page long document is pretty straight forward: setting out the basic terms of the investment structure should the deal move forward.
Because this comes at the early stages of the investment process, the Term sheet is not intended to be binding on the parties.
“Not legally binding” doesn’t mean that there’s no agreement or contract. There is in fact a contract between the parties to use the terms set forth in the Term sheet and letter of intent as the basis for their dealing, if and when the parties decide to go through with the transaction.
Although the Term Sheet is only a summary of the structure of what the definitive document will contain, the bulk of the negotiation process will be concentrated at this point. A significant request for change in the later documents that hasn’t been raised at the time of the term sheet will have very little chance of success at a later stage.
In addition, some provisions of term sheets are actually meant to be binding. For instance, this is the case, when the term sheet includes an undertaking on the entrepreneur’s part to refrain from shopping for other opportunities while negotiations are underway.
Should the negotiations go well and the parties agree to the provision of the term sheet, the next stage will consist in the review and negotiation of the main and definitive agreement between the parties materializing the investment.
Promissory note or stock-purchase agreement
Depending on the structure of the deal (on whether common stock, preferred stock, promissory notes or convertible notes will be issued by your company), the main agreement will either be:
· A Securities Purchase Agreement (or Preferred Stock Purchase Agreement) which materializes the commitment from the investor to purchase newly issued securities of the company based on the terms agreed to in the term sheet, or
· A Convertible promissory note, a form of debt which may convert into equity (new shares for the investor) upon the occurrence of a particular event (usually another round of financing).
Each form has its own particularities and will be materialized in a different type of agreement.
These documents, once executed, are binding upon the parties.
Beyond the financial commitment and the number of stock issued, these final documents also contain the representations and warranties of the company as to the material facts relating to its organization and business.
These must be carefully dissected to ensure they adequately reflect what the entrepreneur actually knows and is confident with affirming as a fact. This requires from the entrepreneur a complete disclosure of what he actually knows and full anticipation of what he is expected to know. While some legal documents will go as far as asking for the entrepreneur to warrant, say, that the company’s IP will not infringe upon the rights of anybody, these kind of catch-all warranties (both from a geographical and temporal standpoint) are unrealistic and should be negotiated down to limit liability to actual knowledge or negligence.
The other key provisions that should be reviewed thoroughly in the main agreement are the affirmative and negative covenants of the company, as they determine the amount of leeway the entrepreneur will be left with once the transaction is completed and new investors are in the house. Among other restrictions, they usually impose limitations on the amount of debt the company will be allowed to carry and/or on key managers’ compensation.
Alongside the main agreement, new entrants will want to compile a set of rules that will govern their future relationship with the founding members of the company and investors from a previous round as stockholders of the company.
This is the purpose of the stockholders agreement.
Stockholders Agreements
A Stockholders’ agreement is meant to govern the relationship of all or part of the investors detaining stock in the company. The purpose of this document is to set forth the rules and restrictions that will apply to any transfer of the stock. They usually provide for rights of first refusal on proposed transfers, as well as for co-sale rights (provisions that determine the conditions under which stockholders may tag along certain sale of stock by the entrepreneur or other key management stockholders). They can also provide for buy-back rights in the event of the death or termination of employment of a key management stockholder.
Key employees are also at the center of a couple of other documents VCs will most certainly always require to ensure the preservation of their investment.
Employee and non-compete Agreements
During the early stages of building a company, the only assets an entrepreneur can really put forth to convince investors of the company’s potential are Intellectual Property rights and Key personnel. Investors know that a crucial factor in the success of the company resides in the continued presence of certain key personnel within the company.
This is why Investors will usually want key employees, including the entrepreneur, to enter into a written employment agreement with the company (in common law countries such as the US, where employment at will is the rule and written contracts the exception). Oftentimes, key employees will also be required to agree to refrain from competing with the company’s business (during and/or after employment). Investors may also include as part of the employment package confidentiality obligations together with a work made for hire provision (whereby all IP rights arising out as a result of employment are assigned onto the company).
This is meant to address ownership over IP created after the transaction and can either be addressed in the employment agreement or in a separate document. But sometimes VCs will require that IP already developed by the company at the time of the closing serve as a collateral to secure their investment.
Security interests (using IP as a collateral)
Like key personnel, IP rights often constitute the core assets of a start-up company. As such, investors will often attempt to use them as collateral. This why, as part of the closing documents, entrepreneurs should expect to be asked to enter into security interests covering each piece of IP developed by the company.
The security interest will afford the investor a priority ranking among other creditors of the company upon the occurrence of a given condition (such as bankruptcy filings or a sale of all or substantially all of the companies’ assets). In some countries such as the US, to be perfected IP security interests must be recorded using a UCC filing (if the IP is not registered) and with the USPTO (if and when the IP becomes registered). This is meant to inform other creditors that the IP asset is already burdened.
Be aware that a burdened IP asset may significantly hinder other investors’ appetite and may thus deter further rounds of investments.
G. Rochenoir