Anatomy of a Term Sheet – Conditions to Closing
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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.
We’ve gone through the charter terms that involve changes to the startup’s certificate of incorporation, and now we are working on the Stock Purchase Agreement section of the model Term Sheet. In a Series A investment transaction, 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 application to the transaction. In the last installment, we looked at the reps and warranties that each side makes to the other. Today we look at conditions to closing and counsel/expenses.
Conditions to Closing
This is what the closing conditions term looks like in the model term sheet:
Standard conditions to Closing, which shall include, among other things, satisfactory completion of financial and legal due diligence, qualification of the shares under applicable Blue Sky laws, the filing of a Certificate of Incorporation establishing the rights and preferences of the Series A Preferred, and an opinion of counsel to the Company.
The financial and legal due diligence can be a time-consuming process, as the investors will want to thoroughly investigate the company’s business. In addition, if the company has been sloppy in its corporate housekeeping, time must be spent cleaning up the corporate records.
Qualification of the shares under Blue Sky Laws means ensuring that there is an applicable exemption from registration under federal and state securities laws. Rule 506(c) of Regulation D under the federal Securities Act provides an exemption for private placements, so long as the startup business offers the securities only to accredited investors. There is no limit on the size of the investment, and the prohibitions against general solicitation and advertisement do not apply. In addition, Rule 506(c) largely preempts state securities laws; the company only has to do a notice filing on Form D, consent to service of process, and pay a filing fee.
The company will have to file an amended Certificate of Incorporation, containing the new class of preferred stock and outlining the rights and preferences of the holders of the preferred stock. If the company had been set up as an LLC, it will have to convert to a C corporation, which can delay the closing and raise the legal costs. This is why startups that are thinking about raising venture capital money should incorporate as a C corporation from the outset.
Finally, the investor may require the startup’s lawyer to provide an opinion letter stating that (a) the company is validly existing, in good standing, and authorized to do business where located; (b) the company has the authority to enter into the various agreements involved in the transaction, and that they are enforceable against the company; (c) the performance by the company of the transaction, including the issuance of the preferred stock, will not violate state of federal law; (d) the capital structure of the company is as described; (e) all shares are validly issued; and (f) there is no litigation threatening the transaction. Since the startup’s lawyer is incurring potential liability in issuing the opinion letter, the lawyer will have to conduct some due diligence on the company before signing off. There can be problems when the investors try to push their own due diligence obligations onto the startup’s counsel, to save money.
Counsel & Expenses
Venture capital financings are unusual, in that the startup company pays not just its own attorney fees, but also the investors’ legal fees:
Company to pay all legal and administrative costs of the financing [at Closing], including reasonable fees (not to exceed $[_____])and expenses of Investor counsel[, unless the transaction is not completed because the Investors withdraw their commitment without cause].
One reason for this is the capital structure of venture capital firms. If the VC firm paid its own attorney fees directly, the money would come out of the VC firm’s management fee, reducing the income to the VC partners. Another reason is to create an incentive for the startup company not to negotiate too vigorously over terms that the investor will not remove or change. If there are multiple investors, it also saves them from having to argue about how to split the legal bill among them.
In any case, it has become an industry standard for the startup company to pay the investor’s legal fees out of the financing proceeds. Rather than trying to change this, the best option for the startup is to try to cap the amount of investor legal fees it will pay. Since you are paying the investor’s lawyers to negotiate against you, putting a cap on their fees gives them an incentive to be more reasonable, rather than argue until they are blue in the face. It is typical to set the cap between $10,000 and $20,000.
In some deals, the startup company is also responsible for drafting all the documents. This is another odd duck term, because in typical transactions (leases, acquisitions, mergers, etc.), the party with greater leverage drafts the documents. Usually, the first draft is going to be more favorable to the party that prepared the draft. While having the startup’s lawyers draft the documents will raise the startup’s attorney fees, keep in mind that nobody is drafting these documents from scratch. There are numerous model documents that provide a starting point, including the NVCA documents we have been using in this series.
That is it for the Stock Purchase Agreement terms. Next time we will dive into the Investor Rights Agreement terms, including registration rights, among other important terms. Thanks for reading!
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Kinetic Law LLC
Formerly Law Office of Paul H. Spitz
810 Sycamore Street, 5th Floor,
Cincinnati, OH 45202