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Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth.
The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. We’ve already gone through the charter terms. Those are the terms that involve changes to the startup’s certificate of incorporation, and included items like redemption rights, anti-dilution, pay-to-play, and liquidation preference. All very important, and if you are just joining the series now and if this topic interests you, I hope you will make time to review those earlier posts (there are 10 of them!!).
Today we are going to start tackling the “Stock Purchase Agreement” section of the model Term Sheet. In a Series A investment, the startup is issuing preferred stock to the investors. As part of the transaction, the startup and the investors sign a contract called a stock purchase agreement, which contains a variety of terms applicable to the transaction.
This part of the model term sheet has three components:
- Representations and warranties
- Conditions to closing
- Counsel and expenses
Today we will cover the reps and warranties. While these can be fairly extensive and detailed, we will just cover a few to give you a flavor. You can see a broader, more representative list of reps and warranties in the NVCA model stock purchase agreement.
Representations and Warranties
Typically, each side will make various representations and warranties to the other side. Most of these are pretty straightforward. For example, the startup will represent that it is duly incorporated, in good standing, authorized to carry on its business, and qualified to transact business in every relevant jurisdiction. This seems pretty basic, but if the company hasn’t paid attention to these corporate formalities, it can delay the closing. If the company is incorporated in Delaware (as it should be), but its main office is in Cincinnati, the company needs to qualify to transact business in Ohio as a “foreign corporation.” This is often overlooked by startup companies.
The investors will want reps and warranties as to the company’s capitalization, so that there are no surprises as to the number and classes of authorized shares. Sometimes the company’s stock ownership records can be a mess. Keeping good records of how many shares have been issued and to whom will save everyone a lot of trouble (and legal fees) later. The investors will want to know about any pending or threatened litigation. Investors also will want reps and warranties that the company owns the rights to any IP. This can be a problem if the company failed to get founders to assign all their relevant IP to the company, or if there aren’t adequate provisions governing IP ownership in employment and consulting agreements.
Another provision that might cause problems is the representation that the company holds all necessary licenses and permits for the conduct of its business. It would be very interesting to see how Lyft and Uber dealt with that particular term, given the controversy over whether they should be licensed in the states and cities in which they are operating. Finally, the company will be asked to make reps and warranties regarding its data privacy practices, so it is a good idea for startups to address data privacy issues as early as possible.
The investors will make reps and warranties, as well. The investors will typically represent that they have the authority to invest in the company, that they are purchasing for their own account, and that they have had an opportunity to discuss the company’s business plan, management, and financial condition. It is advisable to have the investor represent that it is an accredited investor, within the meaning of Regulation D. Many of the investor reps and warranties are designed to address compliance with securities laws, including qualification for a private placement exemption.
Next time we will talk about the various conditions to closing. Thanks for reading!
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