Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.
In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor. Check out an overview here.
Here it is, the end of our “Financing Term Sheet Deep Dive” series. In this post, we’ll discuss a few “straggler” term sheet provisions and offer concluding thoughts on the whole term sheet/financing process.
As we have these past months, we’ll begin each section by first looking at the model language itself.
Let’s get started.
As soon as practicable following the Company’s acceptance of this Term Sheet and satisfaction of the Conditions to Closing (the “Closing”). [provide for multiple closings if applicable]
“Closing Date” is a non-controversial concept. Stock has to be sold and money exchanged at some point in time. The date on which these transactions occur is, simply, the “closing date”.
What is worth focusing on here, however, is the bracketed proviso regarding “multiple” closings. One of the most common ways to structure a financing (and one not expressly contemplated in the model terms, other than in this bracketed note) is to allow for more than one closing; i.e., that the Company can sell a certain amount of stock to Investor X on Date X and a certain amount of additional stock to Investor Y on Date Y.
While a standard concept, it is equally important to note that allowing for multiple closings will require the inclusion of additional protective language for both Company and Investor.
In particular, from the Investor side, the Company should specify a “minimum” amount of investment that will trigger the initial closing and a “maximum” that it will be permitted to accept at all such closings. This ensures for the Investor that the Company does not take “half measures” and receive funds insufficient for its proposed business plans (the “minimum”), as well as that the Investors’ interest is not diluted by more funds than are required (the “maximum”). The Company too will want language to ensure that the Investors are “made” to transfer their funds at a specified closing, particularly if, as a result of the closing process, the Company is collecting “commitments” rather than checks as part of organizing the funding.
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].
Not much to add to the language here, except to note that it is absolutely market standard practice for the Company to pay for the Investors’ cost of drafting and negotiating the financing documents. This can be rather agitating for the Company if the Investors are represented by expensive coastal or urban firms (particularly if the Company is neither coastal nor urban), but the amount is capped to allow for certainty in the expense.
Management Rights Letters
A Management Rights letter from the Company, in a form reasonably acceptable to the Investors, will be delivered prior to Closing to each Investor that requests one.
Management Rights Letters are not used in every financing. They are generally only required to be issued if an investor is (or is anticipated to be treated as) a pension or other retirement plan subject to federal regulation (ERISA). Such letters take a variety of forms, but the basics are that they grant the Investor receiving the letter certain consulting and inspection rights in respect of the Company that permit the Investor to state (under ERISA) that they have some say in the management of the Company. They are generally fairly non-controversial and not heavily negotiated.
Any [Major] Investor [(who is not a competitor)] will be granted access to Company facilities and personnel during normal business hours and with reasonable advance notification. The Company will deliver to such Major Investor (i) annual, quarterly, [and monthly] financial statements, and other information as determined by the Board; (ii) thirty days prior to the end of each fiscal year, a comprehensive operating budget forecasting the Company’s revenues, expenses, and cash position on a month-to-month basis for the upcoming fiscal year[; and (iii) promptly following the end of each quarter an up-to-date capitalization table. A “Major Investor” means any Investor who purchases at least $[______] of Series A Preferred.
In almost every state’s corporation (or LLC) laws, equity holders in an enterprise are given a statutory right to “inspect the books and records” of the Company, generally for the purpose of ensuring that the Company is doing what it is supposed to be doing under its governance documents and to ensure that the equity of the Company is properly recorded. Such “books and records” laws have a nebulous history of enforcement, however, with Companies and Investors clashing over the years over just what information must be disclosed and what can be kept confidential as a business or trade secret (even from the individuals financing operations).
And so today, virtually every set of financing documents includes specific, express rights granted to significant investors to (i) audit the Company, and (ii) receive periodic financial reports. These terms are generally lightly negotiated to ensure that audits are conducted at reasonable times, and to ensure that the Company can meet whatever timing requirements are imposed on the creation of its financial statements.
Each Founder and key employee will enter into a [one] year non-competition and non-solicitation agreement in a form reasonably acceptable to the Investors.
Not found in every financing, but found often enough, Founders should not be surprised if they are asked to execute documents limiting their ability to compete with the Company both during and after their relationship. While some Founders view the request as an affront, it is really a statement of the value represented by the Founder to the Investors. That notwithstanding, negotiation of such terms will absolutely be required, as the meaning of “competition” can vary from party to party (and from agreement to agreement). Given the Founders’ personal interest, their own counsel may also need to be involved.
Each current and former Founder, employee and consultant will enter into a non-disclosure and proprietary rights assignment agreement in a form reasonably acceptable to the Investors.
If you are following our Start-Up Entrepreneur Series as well as this one, you know that it is best practice for a Company (particularly one founded on technology or other IP value) to ensure that its founders and other employees commit to making anything they invent or discover on the Company’s dime, the Company’s property. If these best practices are not initially followed, however, Founders can expect to have them imposed in language similar to the above by the first set of Investors.
[Immediately prior to the Series A Preferred Stock investment, [______] shares will be added to the option pool creating an unallocated option pool of [_______] shares.]
Both Company and Investor have incentives to ensure that the employees of the Company are satisfied with their compensation and that they have “ownership” in the success of the Company and its endeavors. In modern companies this incentivization is achieved through the creation and maintenance of a stock option and/or restricted stock “pool” out of which the Company is permitted to issue stock to its employees. Because, like any other equity issuance, the granting of stock options (or restricted stock) is naturally dilutive to every other stockholder’s interests, the “pool” concept allows the Company to set aside a specific number of shares which both Company and Investor can count as effectively “issued” when determining the price of the shares to be sold to Investors.
Generally, both Company and Investor would like to see the pool maintained at a level to ensure there is enough “space” to adequately incentivize the Company’s employees (generally between 10-20% of the fully diluted equity of the Company), but because any increase in the pool is dilutive, the Investors usually ask that any such increase take place “before” the Series A investment (though, in truth, while the calculation takes place “before” the investment, as the math does not change, the increase itself can take place before or after).
The Company agrees to work in good faith expeditiously towards a closing. The Company and the Founders agree that they will not, for a period of [______] weeks from the date these terms are accepted, take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company [or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company] and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing. [In the event that the Company breaches this no-shop obligation and, prior to [________], closes any of the above-referenced transactions [without providing the Investors the opportunity to invest on the same terms as the other parties to such transaction], then the Company shall pay to the Investors $[_______] upon the closing of any such transaction as liquidated damages.]The Company will not disclose the terms of this Term Sheet to any person other than officers, members of the Board of Directors and the Company’s accountants and attorneys and other potential Investors acceptable to [_________], as lead Investor, without the written consent of the Investors.
There’s a lot of legalese there, but the upshot is that once the Company signs the term sheet, it can’t try to get someone else to buy its interests (or the Company on the whole). The reason for this is that once the term sheet is signed, the Investors are going to start spending a fair bit of time and money reviewing the Company’s operations and drafting definitive purchase documents. They want to be sure that the Company does not go out of its way to use the Investors as a “stalking horse” or other mechanism to make the Company more attractive to another party.
Note that despite the sensitive issues at play here, the middle section of the model terms’ language (detailing a liquidated damages penalty provision) is not standard. Such a provision can appear in certain deals where the leverage is heavily skewed towards the Investors, but more often, the exclusivity provision lives on its own (without a stated damage term). Breach of a standard exclusivity term (without such a “penalty” provision) would require the aggrieved Investors to prove and seek damages in court.
And that does it for our “deep dive” of the model terms. Over the course of the past few months, we have discussed virtually every aspect of the financing process, from share price calculations to voting agreements. That said, the term sheet is just the start.
Once the parties have agreed on terms, a lengthy process akin to a medical exam will take place whereupon the company will have to detail almost every aspect of its operations to its new prospective financial partners. This process of “due diligence” is, in some ways, one of the most logistically difficult (especially for a small company), and is one we will discuss in more detail in future posts.
Following (or simultaneous to) the diligence process, the real work begins (from a lawyer’s point of view). A hundred pages or more of purchase agreements, ancillary agreements, disclosure schedules, and side letters need to be drafted, negotiated, and approved before money changes hands, and every small detail that was elided at the term sheet stage is open for debate. It is where the lawyers truly add value, provided they know better than to treat every $2M financing like the RJR Nabisco takeover. (Believe me, some don’t.)
If you’ve made it this far, finally I’d like to thank you very much for joining me in putting together Hoeg Law’s first (and hopefully not last) “deep dive” series. As always, if you’d like to discuss this post, the series, your own company’s financing experiences, or anything you’d like to see us tackle next, please don’t hesitate to leave a comment down below or contact me at firstname.lastname@example.org.
The discussions in this series were based on certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.