Securities offerings are governed by the Securities Act of 1933 and rules thereunder. The relevant rules, with respect to a private offering of a startup, are those related to exemption from registration.
Legal Restrictions According to U.S. Law
According to Section 4(2) of the Securities Act of 1933, there is no need to register shares (or deliver a prospectus) in a private sale of securities. U.S. courts have laid down certain conditions for exempting private sales from registration. Generally, the following requirements have to be met for the exemption to be available: (1) the offeree receives or is given access to material information about the company; (2) the issuance of the securities is performed directly and not via means of mass distribution; (3) the number of offerees and buyers is limited; (4) the buyers will not act in practice as distributors of the shares (in other words, they will not purchase them with the aim of reselling them in the short-term).
Most investments of private capital in startups qualify for the exemption. However, it is still best to rely on clear rules such as those contained in Regulation D. Regulation D was promulgated by the Securities and Exchange Commission (SEC) in order to provide definite (although not exclusive) rules for exemption from registration. The rules in Regulation D exempt the sale of securities by companies from registration in one of three ways:
An issuance in accordance with Rule 504 The sale of securities for a total amount of up to $1 million in a period of 12 months is exempt from registration with no other conditions.
An issuance in accordance with Rule 505 The sale of securities for a total amount of up to $5 million in a period of 12 months is exempt from registration provided that all of the investors save 35 are "accredited investors" (i.e., 35 investors may be investors that are not accredited investors). This term generally refers to the following investors: banks, brokers, institutional investors, managers and directors of the company, or individuals with net assets exceeding $1 million or an income exceeding $200,000 per year ($300,000 per household/couple).
An issuance in accordance with Rule 506 This refers to the sale of securities for an unlimited amount to "accredited investors" and to another 35 investors who are not "accredited investors." However, under this regulation, which does not limit the amount of the offering, the "non-accredited" investors are required to represent that they are able, either alone or together with their representatives, to assess the benefits and risks involved in the investment.
In order to meet the Regulation D rules, investors are customarily required to represent in the investment agreement that they are indeed "accredited investors."
How to Meet the Legal Requirements
As mentioned above, a private placement is subject to domestic and occasionally also foreign securities laws, as well as rules deriving from the law of contracts. The following discussion addresses both these sets of laws.
The number and identity of the offerees and buyers As a rule, securities should not be offered to a large number of offerees, who are not "accredited investors" under U.S. law. In any case, shares should be offered strictly to investors who are able, either alone or with the assistance of consultants, to understand the meaning of the investment and to bear the risk involved in such investment. This would also prevent claims by customers with respect to fraud or exploitation under contract law.
The offering document The document pursuant to which the securities are offered (usually the business plan or a PPM Private Placement Memorandum) should include all the material information about the company. In addition, each document should be numbered and a record should be kept of the person to whom it was given, thus proving the number of offerees and that all material issues were duly disclosed.
Personal negotiations Negotiations should be conducted in person with each investor in order to eliminate the fear that the sale of the shares will be classified as a public offering requiring the filing of a registration statement. In addition, each investor should be given the opportunity to perform a due diligence process which would prevent claims of misrepresentations and claims under the law of contracts.
The investment contract Representations should be obtained with respect to (1) the investor's experience in investments of the type in question and his or her being an "accredited investor" for purposes of U.S. law; (2) the investor's ability to bear the risk and his or her understanding of the subject matter of the investment; (3) the fact that he or she had conducted a due diligence process to his or her satisfaction; (4) his or her understanding of the restrictions imposed on the sale of shares which are not listed for trade and his or her readiness to adhere to them (see Chapter 13 on selling shares that are exempt from registration).
The Term Sheet
The delivery of a signed term sheet to the company is a substantial milestone on the path leading to an investment. The term sheet is a legal document which is non-binding except for certain clauses specified below. It determines the main terms of the investment which are later expanded in the investment agreement and the documents attached to it. The document is not binding because the investor conditions his or her investment and the signing of the ultimate agreement upon a business, legal, and financial due diligence process. Nevertheless, the document is very significant because funds do not habitually sign term sheets and carry out expensive due diligence processes if they do not intend to invest in the company. The objective of the term sheet is twofold: As mentioned above, it serves as the basis for the investment agreement and addresses the main business issues. In addition, the "no shop" clause it contains enables the investor to proceed with the investment process, including completing the due diligence process and drafting the investment contract, knowing that the company will not, at this time, turn to other investors to improve its position. On the other hand, the importance of the term sheet must not be overrated, since it is only an intermediate step en route to the investment agreement, which is the document that fixes the terms of the investment.
Many investors have standard term sheets which they use. A term sheet may be one or two pages long and contain only the most basic terms, or it may also be a 20-page document, not easily distinguishable from an investment agreement. Since most of the clauses of the term sheet are incorporated in the investment agreement, we will now focus only on the issues that are unique to term sheets.
The legal status of term sheets As mentioned above, the term sheet is not legally binding on the parties. In most cases, the term sheet includes a specific stipulation whereby it constitutes a declaration of intent and is not legally binding except for certain clauses (no shop, confidentiality, and expenses), and whereby the signing of the investment agreement is contingent upon the satisfactory completion of the due diligence process, the drafting of an investment agreement on which the parties agree, and the approval of the investor's appropriate entities.
No shop The company undertakes not to seek out other investors for a pre-determined period of time (usually 30 60 days), during which the investor conducts the due diligence process and negotiations are conducted for the investment contract. This clause is the most important binding clause in the term sheet since all of the other provisions serve only as a basis for the future investment agreement.
Confidentiality Both the investors and the company undertake to maintain in confidence all of the company's secret information, as well as any information exchanged between them during the negotiations and the due diligence process.
Expenses If an investment agreement is executed, the company will reimburse the investor for his or her expenses, including legal expenses, up to a pre-determined amount. Sometimes, the reimbursement undertaking is not contingent upon the execution of an investment agreement.
Simultaneously with the due diligence process, the parties' legal representatives conduct negotiations for the conclusive investment agreement. The investment agreement is an agreement for the sale of shares in the company to the investors in consideration for a certain amount of money (the investment). Although the transaction appears to be a simple one (ostensibly nothing more than the sale of an asset for money, a transaction commonly made for thousands of years), an agreement for an investment in a startup company is a complex legal document which regulates many issues concerning the investment itself, and the future relationship between the company and the investors and often also with other entities such as employees, directors, and previous investors. These agreements are packed with professional terms, most of which are unclear to anyone not proficient in legal language.
There are several approaches to drafting investment agreements. The customary method is to include in the investment agreement all the issues pertaining to the investment, including the rights attached to the investor's shares and the balance of power within the company, issues which are usually regulated also in the company's organizational documents (the certificate of incorporation or the bylaws). The supporters of this approach emphasize the importance of creating one document which embraces all the relevant arrangements, even at the cost of having these issues repeated in other documents. Another advantage is the independent course of action afforded to the parties to the contract, as opposed to the situation in which these issues are regulated only in the company's bylaws, which creates a doubt as to an individual shareholder's right to sue the company alone. According to another method, the investment agreement should not repeat issues which are already regulated in other documents or agreements. Another advantage in creating separate documents is that whenever an investor joins the company, the bylaws need not be changed and it is sufficient to join him in existing agreements.
There is no uniform structure for investment agreements, but a typical structure would include the following components:
The transaction The material terms of the transaction (the sale of securities in consideration for an investment) are discussed. This chapter contains a description of the buyers, the purchased asset (securities), and the consideration (the price per share).
The company's representations and warranties This is usually the longest chapter in the investment agreement and the subject of lengthy discussions by the attorneys. "Reps and warranties" are designed to provide detailed information about the business and condition of the company and to enable the party relying on the representations to file a complaint if a representation is breached. However, where startups are concerned, as opposed to acquisition transactions involving giant companies, if a representation is breached and material damage is caused, the company will in any case not have the money required to compensate the investor. However, it is customary to require an opinion by the company's attorney with respect to certain legal representations, thus creating a "deep pocket" from which compensation can be sought in some cases, at least in theory. Over and above these representations, investors are protected against misrepresentations, fraud, or undue disclosure by standard provisions in the laws of contracts, torts, and securities. Section 10b-5 of the Securities Exchange Act of 1934 provides protection in most cases against the breach of a representation in an agreement to purchase securities. A contractual representation is, however, still legally superior since a complaint can be filed due to the breach of a contractual representation even without the presence of a state of mind (such as knowledge) or negligence by the party who made the representation.
Another substantial advantage of reps and warranties is that they compel decision-makers to pay attention to and discuss all of the issues included in them. Bringing problematic issues to the surface enables the company to deal with them and enables investors to better quantify the risks involved in the transaction.
It is customary to provide reps and warranties on many issues: the organization of the company and its organizational documents, the authority to sign the investment agreement, the company's share capital and undertakings to allot shares, its financial condition, property, intellectual property, material agreements, legal proceedings in which it is involved, taxation, employees, debts, and other issues that are unique to the company or have surfaced in the due diligence process. From the company's point of view, it is best to qualify the reps and warranties, so that only a breach having a Material Adverse Effect (MAE) on the company will entitle the investor to a remedy.
The investor's representations and warranties Except for the standard reps and warranties with respect to the investor's authority to invest and his or her financial ability to do so, it is customary to request representations pertaining to the investor's experience in venture capital investments and to his or her status as an "accredited investor," as well as additional representations supporting the classification of the transaction as a private sale which does not require the filing of a registration statement (see the section on legal restrictions for raising private capital).
The company's covenants In contrast to representations and warranties which are a declaration of facts, a covenant is a promise to perform or refrain from performing certain acts in the future. There are two types of covenants: affirmative covenants such as an undertaking to provide financial information, and negative covenants such as an undertaking to refrain from performing certain acts without the investor's approval. The material covenants are reviewed in the section on the right to control and right to information.
Conditions precedent to closing There are certain acts which the company undertakes to perform by the date of closing: usually obtaining approvals and adopting resolutions, changing the bylaws, having employees and entrepreneurs sign employment agreements, and other undertakings. If these acts can be performed relatively quickly, a shortcut may be taken by closing the transaction concurrently with the signing of the investment agreement, without holding a separate closing.
Closing In the closing, it is verified that all of the conditions precedent to closing have been met and that all of the documents which need to be delivered at the closing have been prepared. In some cases, there are several closing dates, either because the investment is made according to milestones or because additional investors are expected to join. In general, it is recommended that the transaction be closed as soon as possible without waiting for additional investors. Once the first investor is in, it is easier to attract more investors.
Indemnification It is customary for companies to undertake in the investment agreement to indemnify the investors for any damage they may suffer due to the breach of a representation or a covenant by the company. Although the parties and their attorneys dedicate much time to indemnification clauses, they are of little importance; legally, the investors are in any case entitled to a remedy under the laws of contracts or torts for the breach of a representation or a covenant. However, the company typically has no "deep pocket" from which the investors would be able to collect in case of such breach unless the company is about to make an IPO and has tangible assets and cash at its disposal. A partial solution is providing indemnification in the form of shares, not cash. From the company's point of view, it is best to try to limit, in the indemnification clause, the period of time in which a complaint can be filed for the breach of a representation. The statutes of limitation in most countries allow several years after the contract is signed, and in certain cases even after the breach is discovered, to file a contractual complaint. This exposes the company to a possible "retroactive complaint" by an investor who discovers after several years that his or her investment was unsuccessful and is looking for ways to collect his or her loss from the company. A possible solution is to limit the time frame for filing a complaint due to breaches in good faith.
Schedules and exhibits Two types of appendices are attached to investment agreements: disclosure schedules, which constitute part of the reps and warranties and provide information about the company; and additional exhibits, such as the organizational documents, employment agreements, and projected budget. Sometimes the company's legal counsel's opinion on legal matters is also attached to the agreement.
Main Issues in Investment Agreements
This section reviews the main issues addressed in investment agreements, the common practices in the market, the real meaning of legal terms which are usually clear only to attorneys who work in the field, and how to reach solutions which will meet the needs of both the investors and the company. Some of these issues are also regulated in the company's organizational documents, so that they will also be effective towards third parties who are not a party to the investment agreement. For features that are not presented in every deal, we have indicated how often they are seen in investment agreements and at what stage of financing (early or follow-up) they are being used.
Valuation and the investor's holdings The investor and the company have to agree on the company's pre-money value, from which the price per share is derived, and on the amount of the investment. Value is calculated on the basis of models which are discussed in Chapter 9. Calculations of holdings are made on the basis of the value. Holdings and value calculations are usually performed on a fully diluted basis, i.e., assuming that all of the options and rights allotted to employees, directors, and shareholders are exercised.
Employee stock option plans The percentage (usually in the range of 15 25%) of shares set aside for employees stock option plans has a direct bearing on the negotiations for the value of the transaction. Obviously, the more shares which are set aside before the investor joins the company, the more shares he or she will in effect receive in consideration for his or her investment (or, in other words, a discount on the price of the investment). For a calculation of the number of shares allotted to employees, see Chapter 9 on issuing stock to investors.
Example: A company's pre-money value is estimated at $4 million and the investor invests $1 million in the company. The company has 4,000,000 issued shares before the investment round. If no options are allotted to employees, the investor will receive 1,000,000 shares (at $1 per share), constituting 20% of the issued shares after the round. If it is determined that 20% of the company's shares before the investment should be allocated to the employee stock option plan, then the investor will receive 1,250,000 shares (20% out of a total of 6,250,000 shares after the round) in consideration for the same amount ($1 million), at the of $0.80 per share (for a further discussion, see Chapter 9 on issuing stock to investors).
Options for future investments Investors may ask for options to invest in the company in the future. Options are much more common in early rounds than in later stage ones. The use of options for future investment was a standard feature (more than 80% of the deals) in the first half of the 1990s. In the late 1990s, when money was chasing after companies, options have become less common. From mid-2001, the use of options has increased in popularity again and they are used in more than 50% of the deals. The terms of the option define the exercise price and the exercise date. Every option is, in fact, a discount on the agreed price since the option has an economic value, although this value is hard to measure in private companies (for a discussion of the valuation of options, see Chapter 5 on stock option plans).
There is a disadvantage from the company's point of view in granting options, since an option dilutes the existing entrepreneurs and shareholders and is given at a price that is considerably lower than the true value at the time of exercise. Granting an option usually serves as a precedent for future rounds, and could cause the next investors to also demand options. On the other hand, options can also serve as an instrument for bridging gaps in value estimates, since they award the investor a discount on future required investments (the exercise price). In addition, an ostensibly high value can be displayed externally, since the discount component of the option is not necessarily reflected in the information given to the press and to outsiders. The same is true with respect to other terms concerning the allotment of additional shares in case of a failure to meet forecasts.
From the investor's point of view, an option constitutes not only a discount, but also an excellent means for receiving a high Internal Rate of Return (IRR). An option enables the investor to increase his or her IRR if the investment is successful and the option is exercised, since the investment will be made only if the option is "in the money." If options are issued, it is important to address several issues: the number of options (i.e., the number of shares to be received upon the exercise of the option), the exercise price, and the term of the option.
Venture capitalists are measured according to the IRR of their investment, but this measurement is based on their portfolio as a whole. In other words, in each individual investment, they also seek a high dollar return, and not only a high IRR. For instance, although a profit of $1 on an investment of $1 over a period of one year represents a return of 100%, investors may prefer, given the limited availability of opportunities and resources, a profit of $10 on an investment of $11, although the IRR of the former investment is higher.
From the entrepreneur's point of view, the number of shares (which dilutes the entrepreneurs and the other shareholders) is more important than the exercise price. The reason for this is that the company does not usually regard the cash flow received at the time of exercise as being important, since it assumes that the option will be exercised when the company has greater resources anyway. An illustration of the insignificance of this component may be found in the fact that in many cases the investor does not infuse new cash into the company at all when exercising the option, but rather "pays" with shares received upon exercise of the option (a method of exercise known in the market as "cashless exercise").
An option should state the number of shares and not a percentage of the equity which the option holder will receive at the time of exercise. The difference between the two can be enormous, since in the latter case the investor is not diluted until he or she exercises the option. For instance: A company which has 1,000 shares can give an investor an option to buy 10 shares (case "a") or 1% of the capital at the time of exercise (case "b"). At the time of exercise, after several rounds of share allotments, assume the company already has 5,000 shares. Whereas in case "a" the investor will still receive 10 shares (1% of 1000 shares), in case "b" he or she will receive 50 shares.
Since the longer the term of an option, the higher is its economic value, it is in the company's interest to keep the option as short as possible. On the other hand, a long term will usually ensure that it will be worth the investor's while to exercise the option. From a purely economic standpoint, it would appear that it is better for the company if the option is not exercised. However, an option which is not exercised by the investor and expires unexercised may have a negative reputational effect which could affect the company's ability to raise other capital. In any event, it should be ascertained that the terms of option end when the company is obligated to convert all of its equity into ordinary shares (usually before the company is listed on a stock exchange, or is sold).
Mechanisms for value adjustments (claw back or ratchet) When there are disagreements with respect to the value of the company, these often result from a disagreement on (optimistic) forecasts of the company. A mechanism can be added whereby the investor's holdings will be adjusted or he or she will be required to increase his or her investment if the company's actual performance is considerably worse or better than the company's projections. In most cases, it is preferable not to be dragged into such mechanisms since they complicate subsequent investments and may also cause a conflict of interests. On the one hand, the investor is interested in the company's success and progress but, on the other hand, a lesser success at the specified date would give him larger holdings. Such a conflict of interests could be a source of future friction. Due to the complexity and conflict of interest inherent in claw back, this feature is used in less than 20% of the deals and is more common in early rounds.
Using bridge loans When the parties cannot agree on the value of the company, the financing can be provided as a convertible debt which may then be converted into equity when capital is raised from another investor, according to the value set when the additional investor is introduced (usually with a certain discount). From the company's point of view, a bridge loan enables the company's value to be increased by the subsequent round and greatly facilitates the negotiations (since the value depends on the future investor). On the other hand, investors may fear being overly dependent on a future investor and receiving inadequate compensation for the risk they are bearing at present. The uncertainty embedded in such a mechanism makes it a feature that is used in less than 25% of the deals, both in early and late stage financing.
The Rights Attached to the Securities Allotted to the Investor Protecting the Value of the Investment
The securities allotted to investors are usually preferred shares convertible into ordinary shares. Other types of securities allotted to venture capital investors are convertible debentures or ordinary shares. When preferred shares are converted into ordinary shares, usually before an IPO or a sale, the shareholders naturally cease to enjoy any special rights. The rights attached to preferred shares are also fixed in the company's organizational documents. These usually include all the rights attached to ordinary shares, including voting rights, as well as the following rights:
Preference in liquidation In liquidation, preferred shareholders are usually entitled to receive the amount of their investment, in addition to interest guaranteeing a pre-determined IRR, before any ordinary shareholder. Ostensibly, preference in liquidation is not very valuable, since when a startup dissolves it typically has no valuable assets except perhaps its intellectual property (which is, at times, subject to special arrangements). The reason for demanding preference in liquidation is that liquidation is often defined not only as actual dissolution or liquidation, but also as events that are deemed as liquidation. Such liquidation naturally includes voluntary dissolution, but also the sale of all of the company's assets, the sale of the company, a merger, restructuring, or any other act after which the current shareholders hold less than 50% of the company's shares. In such deemed-liquidation cases, the company may have many assets and funds.
The reason underlying the preference in liquidation is composed of several elements. The investor, as opposed to the entrepreneurs, invests real money in the company and wants to have his or her investment repaid before profits are distributed among all the shareholders. In addition, preference in liquidation can increase the likelihood that the investor receives a minimum IRR when he or she exits the investment. Finally, preference in liquidation prevents the entrepreneurs from selling the company at a low price, which may be appealing to them, but does not signify success from the investor's perspective.
In some cases, especially when the minimum IRR is not high, the preferred shareholders partake in another distribution together with the other shareholders, proportionately to the preferred shareholders' holdings (Participating Preferred Shares). In other words, the preferred shareholders enjoy both their preferred dividend and, together with the other shareholders, whatever remains. Such a distribution could cause directors to decline sale or merger proposals, since the share they would retain in the distribution does not provide them with a sufficient incentive. In order to prevent such an eventuality, it is customary to limit the right of preferred shareholders so that they do not enjoy a preference if their investment exceeds a specified return, typically a multiple of three to five over the investment. In other words, if the preferred shareholders would receive the minimum return agreed upon in an equitable distribution according to the holding ratios, then a single and equitable distribution will be made to all shareholders.
Example: An investor invests $1 million in a company according to a (pre-money) value of $4 million, and receives 1,000,000 class A preferred shares constituting 20% of the company's equity after the investment. The shares confer a right to a minimum IRR of 50%. Three years later, the company sells all of its assets (a deemed-liquidation event) in consideration for $10 million and transfers the consideration to the shareholders. In this state of affairs, the investor will, first of all, receive $3,375,000 representing an IRR of 50% per year on an investment of $1 million (i.e., more than one-third of the consideration even though he or she held only 20%); thereafter, the other shareholders will split the remainder of the consideration among themselves. Had the investor held participating preferred shares and had been entitled to take part in the distribution of the remainder as well, he or she would have received another 20% ($1,325,000) of such a remainder (i.e., he or she would have received, in total, approximately one-half of the consideration). On the other hand, if the assets had been sold for $30 million, the investor would have shared the amount equally with the other shareholders in proportion to his or her holdings and would have received $6 million.
Preference in the receipt of dividends Many agreements contain a requirement for preference in the receipt of dividends up to a certain rate of interest (preferred dividends). The interest is usually designed to ensure a return which will be a little above the prime interest rate. In most cases, the interest does not accrue before a dividend is distributed in order to avoid the recording of a contingent liability in the company's books, and this issue is therefore meaningless in startups which do not distribute dividends. If, however, the interest does accrue, it is added to the return on the investment as part of the preference in liquidation if the company is sold. In most cases, investors have no reason to ask for a dividend to be distributed in cash, since the main return they expect to derive from the investment results from an increase in the company's value. Any distribution of cash reduces this value since the return on cash which is invested by the company is higher than the return available in risk-free investment alternatives (otherwise, investors would not have continued to back the company). In fact, many venture capital investors demand a right to receive a preferred dividend only in order to reduce incentives for its distribution in the future.
Conversion Preferred shares may be converted at any time, at the investor's choice, into ordinary shares according to a conversion rate that is adjusted to any changes in the company's capital and dilution. Such conversion takes place automatically (and involuntarily) at the time of a sale, or an IPO (usually, only an IPO or a sale which meet the conditions fixed with respect to the investor's minimum return). It is important to stipulate that a conversion can also be enforced at the majority decision of the shareholders in order to prevent "extortion" by a few shareholders when a transaction is on the table which requires a conversion but does not meet the threshold conditions for automatic conversion.
Preemptive right Originally, the preemptive right was a right which existing shareholders hold, that imposes on the company the duty, when allotting additional securities, to offer the securities to the existing shareholders according to their share in the company before offering them to outside buyers. The practical expression of this right in startups is the right of existing shareholders to buy shares in any future allotment proportionately to their holdings in the company, under the same terms and conditions at which they are allotted to the new investors, in a manner preserving their proportionate share in the company's equity (see an example of an allotment in which a preemptive right is exercised in the section on issuing stock to investors in Chapter 9).
Preemptive rights exist in almost all investment agreements because they have an economic significance aside from the legal rights of control they guarantee. Preemptive rights provides investors with protection when the company wants to issue shares for a value lower than their economic worth in a manner which dilutes the investors. An issuance of shares according to a value lower than that according to which the investor joined the company is treated by anti-dilution rights (see below), but the company could still issue shares at a value higher than the previous investment, but lower than that which the investor perceives as economical. In this case, the investor can exercise his or her preemptive right and gain an economic benefit (or thwart the issuance in certain cases). Other than that, this right enables investors to increase the IRR of their portfolio by increasing their investments in successful companies.
On the other hand, this right can create several problems for the company: If all or most of the existing investors were to exercise their preemptive rights, it would either be impossible to raise capital from new investors, or such investments would unreasonably dilute the shareholders who do not enjoy a preemptive right usually the entrepreneurs. In addition, awarding a preemptive right to all the investors involves bureaucratic problems (the need to ask all the investors for a waiver in each new round of investments) and legal problems (if the right is awarded to more than 35 investors who are not defined as classified investors under the Securities Law, a prospectus will have to be published in every investment round made by the company, discussed in the section on legal restrictions on raising private capital).
Therefore, an attempt is sometimes made (only with respect to private investors) to limit this right to one round. In other words, the investor will be entitled to maintain the percentage of his or her holdings in the round following the one in which he or she invested, but not more than that. A more customary limitation on the preemptive right is that each shareholder is entitled to preserve his or her holdings only, so that if another shareholder waives the right, the other shareholders may not exercise his or her right in their favor. Another limitation is granting a preemptive right only to investors holding more than a certain percentage (for instance, 5%) of the company's equity. The goal of all of these mechanisms is to enable the company to introduce new investors into the company in the future.
Anti-dilution protection As mentioned above, preferred shares are convertible, at the investor's demand, into ordinary shares according to a pre-determined conversion rate. The conversion rate is usually 1:1 and is adjusted to any changes in the company's capital and dilution. From an economic perspective, long as the company does not raise share capital at a price lower than the conversion price, and does not allot stock options with a low exercise price, the investors are not diluted economically, although their share in the company could be diminished since the total value of the company's assets increases.
In order to prevent dilution, investors typically include anti-dilution, or ratchet, mechanisms, in the investment contracts. It is customary that shares offered at a discounted price to employees, directors, and advisors do not activate the anti-dilution mechanism. There are two customary mechanisms, full and weighted ratchet, with the former being used almost exclusively in situations with distressed companies and the latter one being more common.
Full adjustment of the conversion ratio (full ratchet) The conversion ratio is increased in accordance with the lowest price at which an ordinary share is sold (i.e., as if all of the investor's shares were bought at the lower price). In this manner, even if only a few shares were sold at a lower price and the economic dilution is not material, the existing investor receives a substantial adjustment to his or her percentage of the company's equity.
The formula for calculating the new conversion ratio is as follows:
Example: The investor invests $1 million according to a pre-money value of $4 million (the company had 4,000,000 shares before the allotment) and received 1,000,000 preferred shares (i.e., 20% of a company now worth $5 million) which he or she is entitled to convert into 1,000,000 ordinary shares at the rate of $1 per share. The company needs additional financing and, due to the conditions in the market, is forced to raise $250,000 according to a price per share of $0.50 (i.e., to allot 500,000 additional shares). The new conversion ratio is therefore 1/0.5=2, and the first investor can convert his or her shares into 2,000,000 regular shares, which would constitute more than 30% of the company's equity (2,000,000 out of 6,500,000 shares after the new allotment and the conversion of the shares). The investor has gained a windfall due to a small investment which did not materially dilute him.
Adjustment of the conversion ratio according to a weighted average (weighted average ratchet) The conversion ratio is updated according to the decrease in the weighted average of the price of all the shares after the issuance of shares at the lower price (the diluting issuance). For the purpose of the calculation, all of the shares issued before the diluting issuance are deemed to have been sold at their adjusted conversion price (the conversion price after adjustments to previous diluting events, if any).
In order to avoid a situation in which the entire diluting effect will be borne by the founders, it is possible to require that the number of shares used to calculate the average be on a fully diluted basis, including common shares (broad based weighted average). In this manner, the dilution effect will be spread over a larger number of shares. This calculation is the proper one from an economic perspective, since the preferred shares were allotted to the investors on a fully diluted basis from the outset.
The formula for calculating the new weighted price is as follows:
The new conversion rate is therefore calculated as follows:
Example: Using the data of the previous example (with respect to the full ratchet mechanism), the weighted price is 0.954, and the new conversion ratio will be 1.05 and the investor will therefore be compensated for the diluting issuance by receiving only 50,000 additional shares.
If a full ratchet mechanism is nevertheless fixed in the contract, it is customary to limit the protection provided by this mechanism to a pre-determined period of time, after which all of the investors will bear the risk according to the weighted average ratchet mechanism. This intuition of this restriction is fairness, because if a diluting issuance does indeed take place after the investor has been with the company for a long time, and therefore had an opportunity to influence the direction taken by the company and the value of the investment round, he or she should share the impact of dilution with the other shareholders.
Investors in early phases who invested according to low valuation often agree to waive the ratchet clauses. Investors in later stages, however, who join the company based on a higher value, usually demand this mechanism, since at these stages there is a higher risk that the company will have to raise capital based on a lower value.
Right of redemption Some (less than 20%) investment contracts contain clauses which entitle investors to sell their shares to the company (in practice, put options) if the company fails to meet certain targets. In practice, the right to sell the shares to the company is rarely exercised, since in most cases the investor is entitled to sell his or her shares to the company under the terms of the put option only when the company fails to meet certain targets, in which case the company is unable to pay for the shares. Nevertheless, it is common to see clauses dealing with pricing adjustments on the conversion prices of the preferred shares.
Group voting In most cases, it is possible that waivers or group decisions will be required of the investors. A clause should be drafted whereby an appropriate majority of the investors (a special or a simple majority, in accordance with the resolution) may waive or exercise rights afforded to investors, thus avoiding bestowing a veto power on individual investors. Without delving into strategic issues from game theory, which are beyond the scope of this book, group-voting mechanisms can become complicated and are also affected by the number and character of the investors. The fewer and more sophisticated the investors, the less is the need for complex voting mechanisms.
Prohibition of sales Founders are almost always subject to a full or partial prohibition from selling shares for a fixed period of time (referred to as "lock-up;" see the section below on founders and managers). In addition, the organizational documents usually prohibit shareholders from selling shares to competitors of the company without the approval of the board of directors.
Right of first offer The right to be the first to whom an offer to sell shares will be addressed. Strategic investors sometimes demand this right in order to be able to buy the company before their competitors do.
Tag along Most of the deals have a provision to the effect that if one shareholder sells his or her shares to a certain buyer, the other shareholders may join him and sell shares to the same buyer, proportionately to their holdings in the company. Investors usually demand this right in order to prevent the entrepreneurs from exiting the company and leaving the investors without the company's main asset (namely, the entrepreneurs). The rationale underlying this demand is that an investment in the company is an investment in the entrepreneur and, therefore, if the entrepreneur has found a way to maximize his or her investment in the company, he or she must share it with the person who financed it.
Bring along Most corporate state law has a provision that enables a majority of shareholders selling their shares to compel other shareholders to join them. The right is designed to enable a sale to be forced upon an extortionist minority. In some cases, there is a contractual provision under which a supermajority consent is required for a sale to be forced on other shareholders. In addition, investors may demand that a forced sale be allowed only if the sale achieves a certain pre-determined minimum return on the investment.
Right to Control and Rights to Information
Over and above creating an equity structure designed to bring the interests of managers and investors closer together, investment agreements provide several mechanisms designed to give the investors a certain degree of control over the company. These means include representation on the company's board of directors and the granting of voting rights and rights of control. In addition, investment agreements include an undertaking by the company to provide the investor with a multitude of information and financial statements and to seek the investor's approval before undertaking certain acts. In many cases, these rights expire with the IPO.
Using the investment consideration and milestones Investors will usually demand that the agreement specify to what use the company will apply their money. When the amount of the investment is considerable, or the uncertainty is high, the investment is sometimes not made immediately upon the signing of the investment agreement, but rather in stages defined in advance by the company and the investor (staged pay-in). This mechanism provides the investor with the ability to control the use of the money and the company's progress. The milestones can relate to development (for instance, completing the development of a beta version), management-recruitment (for instance, the recruitment of a VP of Marketing), regulatory approvals (customary in the medical field), commencement of sales, or any other issue which is important to the investors.
These mechanisms are typically not recommended, because they not only encumber the company's activity by forcing it to adhere to an action plan which could become irrelevant with time, but also place the investor in a conflict of interests. On the one hand, the company's success is important to the investor but on the other hand, he or she would "profit" from a failure to meet a milestone, since it would enable him to pressure the company into increasing his or her holdings for a lower valuation. Even when the investor acts in good faith, friction could be caused due to the fear of a conflict of interest. These drawbacks make the use of milestones by experienced investors less common at times of flourishing capital markets, and rather common during difficult times in the market.
Voting rights It is customary that preferred shares confer the same voting rights as ordinary shares, with the number of shares being calculated on a converted basis (see earlier section for a discussion of conversion rights). In some situations, preferred shares confer enhanced voting rights, for instance, when the company fails to meet pre-determined targets.
Representation on the board of directors The composition of the board of directors usually changes after the investment, in a manner reflecting the new ownership structure. By being represented on the board of directors, the investor can monitor the company's activity and contribute to it from his or her experience. Venture capital funds ascribe much importance to being represented on the board of directors, not due to aggressiveness and a desire to control (since the fund will almost never control the board of directors), but usually due to an honest desire to take part in what goes on in the company, to help the management lead the company forward, and to monitor management. Broadening the board of directors by boosting it with knowledgeable and reputable persons is important to the company and contributes to its growth. The holding of regular meetings of the board of directors, in which an in-depth discussion is conducted on the central issues concerning the company should be viewed favorably and not as a formal nuisance. In many cases, it is determined that the entrepreneurs will remain members of the board of directors regardless of their holdings and that the investors' right to appoint a representative to the board of directors will, on the other hand, be according to their holdings.
Veto rights Investors demand a right (either on the board of directors or as shareholders) to veto certain resolutions of the company in order to protect their investment against resolutions which may prejudice them. It should be taken into account that managers of startups are sometimes inexperienced in making decisions in the management and financing of large-scale companies, and it is understandable that investors want to monitor their decisions. It is important to remember that a single investor rarely controls the company and the veto rights are usually used, among other things, to protect the minority.
The scope of the issues in which investors have veto rights is different from one company to another and depends on the phase at which the company stands (the more advanced the company in its development, the less do investors tend to intervene), its managers' experience, the investors' policy, and so on. The issues on which investors may demand veto rights typically include: a change in the organizational documents; a material change in the company's business; the approval of annual plans; share allotments; a merger or sale of material assets; large investments; large loans; encumbering the company's property; distributing dividends; dissolution; the appointment of directors; transactions with interested parties; the appointment of an attorney and a CPA; rights pertaining to an IPO, such as the right to prevent such an issuance below a certain value; and influencing the choice of underwriters.
There are two types of veto rights. On the one hand, there are rights to veto minor issues (such as expenses above a certain amount, or the authority to open lines of credit in the ordinary course of business) which may disrupt the proper management of the company and impose liability on the investor as a manager of the company (as opposed to the diminished liability imposed on shareholders). On the other hand, there are veto rights over material issues such as additional investments in the company (any additional allotment) and mergers and acquisitions (M&A). The company usually objects to giving investors these rights, claiming that they are already protected against subsequent investments by the preemptive right and the anti-dilution mechanisms. As for vetoing sales, investors are in any case entitled to a minimum return on their investments by virtue of the preference in deemed-liquidation events. Investors believe, however, that events such as soliciting investments and sales have a crucial impact on the value of their investment in the company, and therefore demand an ability to monitor them. It is possible at times to take a middle course between the two perspectives in the form of a veto right which is limited by the value of the investment. For instance, the investor would be entitled to veto an investment or a sale at a value lower than three times the value according to which he or she joined the company. Giving such veto rights to reputable venture capital funds does not pose a problem. The interests of such funds are similar to those of the company, and in any case they would be unlikely to act in an opportunistic manner since they have a reputation to maintain in the market. It is far more problematic to give such rights to unsophisticated private investors who may use them to blackmail the company later on, or to strategic investors whose interests may not be identical to those of the company.
In any case, it is important to limit the veto rights until the IPO, since such rights are unacceptable in public companies (due to market perception and various SEC rules).
Rights to information Investors will demand to receive detailed information which would allow them to better monitor the company. Except for the annual and quarterly statements, which are reviewed or audited by an independent CPA, the investor will demand that the company give current reports to the board of directors, present a budget, and allow him or her to monitor the degree of adherence to such budget. Investors will also demand access to the company's documents and regular visits at its place of business.
Right of first negotiation Strategic investors demand priority in negotiations for the sale of the company.
The Founders and the Managers
The importance of the founders' holdings The founders, at least initially, are the company's most important asset. Some investors tend to forget this fact and are tempted to take advantage of the fact that they own the capital to appropriate large shares of the company at the founders' expense. It is important to leave sufficient holdings in the hands of the founders to motivate them to develop the company. On the other hand, it is important for investors to fix arrangements which would guarantee the founders' commitment to the company and would solve the agency problem between the founders and the investors. The "agency problem" reflects the conflict of interests inherent in any relationship in which a representative manages the affairs or the money of another; in this case, the entrepreneurs and directors manage the investors' money. Some of these arrangements are fixed in the investment agreement and others in the employment agreements between the company and the entrepreneurs, the signing of which is usually required as a condition in the investment agreement. These arrangements are described in this subsection.
Reverse vesting When the investment is made at an early phase, the investors usually require that the founders' right to their shares vest over a certain period of time (usually around three years). To this end, it is required that the employment contract of each entrepreneur include the company's option to buy his or her shares for no consideration, or for a price significantly lower than the market price, in case he or she departs the company. This mechanism addresses two problems: First, it provides an incentive to the entrepreneur to continue working with the company (despite the existence of an employment contract, the entrepreneur cannot be coerced to work for the company, not even through the courts); second, if the entrepreneur leaves, his or her shares may be used to compensate the substitute managers who will replace him. It is also possible to consolidate the founders' right to their shares based on performance (performance vesting), i.e., depending on the achievement of pre-determined goals.
Earn-up This is an arrangement which entitles the managers to increase their holdings if the company's performance exceeds a pre-defined threshold. Similar to claw back, such clauses are rare.
Lock-up In almost every deal, there is full or partial prohibition of the sale of shares by the founders for a fixed period of time. However, entrepreneurs are sometimes allowed to sell a certain amount of shares every year without any restrictions on such sale in order to provide them with a certain degree of liquidity. There are also other sale restrictions, as discussed in the section on protecting the investment.
Registration Rights Agreements
Almost every investment agreement with an institutional entity is accompanied by a registration rights agreement of one sort or another. A registration rights agreement enables the shareholders to force the company to make a public offering in which the investors' shares will be sold or, alternatively, enables the investors to sell some of their shares in a public offering made by the company. Most registration rights agreements refer to the U.S. market as the target market, although the same principles apply, with certain modifications, to other markets as well. It is important to know that, in practice, registration rights agreements are almost never enforced by investors since a successful public offering is impossible without the genuine cooperation of the company's managers. Furthermore, these agreements usually change when an IPO is performed at the demand of the underwriters.
The Need for a Registration Rights Agreement
The need for a registration rights agreement is derived from the fact that it is illegal to sell securities to the public in the United States (except for some exemptions granted to private sales) without registering the securities with the SEC. Since venture capital investments are usually made with an eye to exiting the investment within several years, and since only the company can decide to make an IPO or a secondary offering, it is important that the registration rights agreement determine the investor's rights with respect to the registration of his or her shares in a manner enabling him to exit the investment. It is important that the company will have only one registration rights agreement to which all the investors will join. The existence of several registration rights agreements which are signed separately with each investor creates inconsistencies and may impose a double burden on the company. Registration rights are applicable only after an IPO. In the U.S. market, there are restrictions on the sale of securities bought from the company or from an affiliate of the company other than in a public offering (which is mostly the case with respect to shares bought by the fund). The sale of such securities in the secondary market without registration can be made either in a private sale which is exempt from registration, or in a sale outside the United States (pursuant to Regulation S) or in a sale subject to the restrictions of Rule 144 promulgated under the Securities Act of 1933 (see Chapter 13 for a discussion of sales which are exempt from registration).
Types of Registration Rights
There are three types of rights which investors customarily seek:
Demand registration right The investors' right to demand registration imposes a heavy burden on the company since every registration involves significant expenses and requires a considerable investment of time by the company's management. This right is usually limited to no more than twice (for all investors together) and it is required that at least one half of the persons entitled to the registration ask for it. In practice, this right is almost never exercised since there is no practical way of forcing a company's managers to conduct a registration process against their will.
Piggy-back registration right This is a right granted to shareholders to sell additional shares when the company is in any case registering shares for itself. This right does not impose a particular burden on the company, and the main restriction is on the number of shares which the shareholder will sell so as not to "flood" the market and prejudice the offering.
Restrictions on Registration Rights
The company will usually require that the registration right be limited in several ways: (1) The right will not exist before an IPO is performed (in other words, the company may not be compelled to make such an IPO); (2) Restrictions on the period of time in which a demand registration right may be exercised and the number of times this may be done; (3) A requirement of a minimum percentage of investors for demand registration; (4) A restriction on the number of shares to be sold, as determined by the underwriters (the underwriters will refuse to commit to selling a very large number of shares which could cause the price of the share to decline) and the fixing of an arrangement according to which the shares will be sold; (5) Other restrictions required by the underwriters, such as a prohibition of the sellers to sell shares (lock-up) for 90 270 days following the public offering.
Other Matters Regulated in Registration Rights Agreements
Registration rights agreements regulate several additional issues, principally the following:
Indemnification Registration rights agreements contain mutual indemnification clauses. On the one hand, the company is required to indemnify the shareholders due to damage they may suffer as a result of misrepresentations in the registration statement. On the other hand, the investors are required to indemnify the company for damages it may suffer due to incorrect information provided by the investors.
Expenses This is a provision specifying that the company will bear the costs of the offering.
Transfer right This addresses the question of whether the registration right is transferred with the shares if the investor sells his or her shares.
Choice of underwriters Investors may demand the right to choose the underwriters in the case of demand registration.
There are several other issues which are regulated in the investment agreement or in the supplementary agreements.
Other Matters Regulated in Investment Agreements
Confidentiality and non-competition Both the entrepreneurs and the investor undertake to maintain all of the company's secret information in confidence. All of the company's employees are usually also required to sign confidentiality agreements. Sometimes key employees are required to sign non-competition clauses, preventing them from competing with the company for a fixed period of time after their departure from the company.
Intellectual property The founders are required to transfer to the company all of their rights to the product. All of the company's employees are required to sign agreements whereby any intellectual property developed while working for the company belongs to the company. Investors may also require a right of first refusal for buying the intellectual property in cases of liquidation.
Investors will usually require that the founders sign an employment agreement fixing the entrepreneurs' rights and obligations (position, salary, benefits, managers' insurance, etc.) and regulating issues such as: justified causes for termination (usually criminal convictions, misuse of the company's property, and recurrent breaches of orders given by the board of directors), advance notice of the non-renewal of the contract, severance pay, restrictions on occupation and competition (prohibition from competing with the company for several years after ceasing to work for the company), intellectual property rights, and buyback in case they leave the company (the entrepreneurs are required to sell their shares to the company at a discounted price if they breach the employment agreement). Where a clause of non-competition by entrepreneurs is concerned, it should also be ascertained whether such non-competition obligation is not prohibited by the antitrust laws or by state law.
In some cases, issues relating to the relationship between the shareholders such as restrictions on sales (see the section on protecting the investment) are separated from the investment agreement and regulated in a shareholders agreement. So long as these issues are also regulated in the company's organizational documents in order to make them effective against third parties who are not a party to the contractual set of agreements, it is inconsequential whether their regulation in the context of the relationship between the investor and the company is made in the investment agreement or in a separate shareholders agreement (for a further discussion of shareholders agreements, see Chapter 2 on incorporation documents).
Employee Stock Option Plans
Investors may demand that the company adopt a stock option plan granting employees shares in the amount and under the terms determined in the investment agreement. It is usually customary that 10 25% of the company's shares are set aside for employees who are not founders (for a discussion of employee compensation, see Chapter 4).