NOTE: This is the ninth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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With this post we move away from the Charter provisions to discuss the Stock Purchase Agreement (SPA), the primary purpose of which is evident from its title: it is the contract where the investors agree to buy the shares of stock the company is offering to sell. The importance of the SPA, however, lies is in the terms and conditions it places on the financing, which serve primarily to protect the investors.
Representations and Warranties
The primary way in which the SPA protects investors is through the inclusion of “Representations and Warranties” (R&Ws) about the company’s business. R&Ws are statements about facts existing at the time a contract is signed that are made by one party to induce the other party to enter into the agreement (for a more detailed description of R&Ws, see this post). In a financing, a company is typically required to make R&Ws about everything from the company’s capital structure to its ownership of relevant intellectual property and its compliance with applicable laws to ensure it has disclosed to the investors all information that might materially impact their decision to invest. If any of the R&Ws are later found to be incorrect, the company may be liable to the investors for damages. Note that it is generally accepted that investors will make R&Ws to the Company confirming their eligibility to participate in the offering (usually this means confirming they are “accredited investors”), though these R&Ws are not typically mentioned in the term sheet.
In most financings, the lawyers spend more time negotiating the R&Ws than any other section of the financing documents, but at the term sheet stage the only thing entrepreneurs usually need to worry about is whether and to what extent the company’s founders are being asked to personally make R&Ws about the company’s business. Founders’ R&Ws are most common where the founders are receiving some liquidity in the transaction or where there is particular concern over an important topic of disclosure, such as intellectual property. The principal rationale for requiring founder R&Ws in addition to company R&Ws is economic: any damages paid by the company to compensate the investors also reduce the value of the company, and therefore of the investors’ shares, while damages paid directly by the founders have no impact on the value of the company. In some cases, investors may insist that the founders put some or all of their shares of company stock in escrow as security in case there is a breach of the R&Ws.
There are many ways in which founder R&Ws, and the founders’ liability for breaches of R&Ws, can be limited, for example by: (a) limiting the categories about which the founders are required to make R&Ws, (b) providing that the R&Ws don’t survive (i.e. can’t be enforced) after a certain date (the typical range for drop-dead dates is 6-24 months after the financing) or (c) capping the founders’ liability (often at an amount equal to the value of the founders’ ownership interest in the company). The appropriate type and scope of the limitations is, however, closely tied to the language of the R&Ws to be negotiated by the lawyers, so if an investor insists on providing for founder R&Ws in the term sheet, entrepreneurs are usually best off simply seeking to add language that those R&Ws will be subject to limitations to be negotiated and included in the final transaction documents. Finally, note that founder R&Ws are almost never appropriate beyond a Series A financing.
Conditions to Closing
Conditions to Closing can protect the investors by requiring the completion of certain tasks and/or the occurrence of certain events between the time the SPA is signed and the actual completion of the transaction (called the “closing,” which is when the investors actually pays for their shares). For instance, the SPA may require that as a condition to the investors’ obligation to close, the founders’ must sign non-competition agreements. In practice, however, conditions to closing often never come into play because the parties do not sign the SPA until all of the would-be conditions have already been satisfied, so entrepreneurs should not worry about this provision in the term sheet unless it includes a condition that is clearly outrageous or unlikely to be satisfied (ex. the Cubs winning the World Series).
Counsel and Expenses
This section serves two purposes: (a) to specify which party’s lawyers will initially draft the transaction documents; and (b) to establish the extent to which the company will pay the investors’ legal fees. First, note that any advantage generally conferred by drafting is significantly diminished where, as in a typical Series A financing, the range of terms is fairly well understood and accepted; so if the investors insist that their counsel prepare the initial drafts of the financing documents, it is generally not worth arguing unless you believe it would be significantly more cost effective to have your lawyers draft the documents. Second, company payment of investor legal fees is also standard in venture financings (though not in earlier stage financings), but there are two ways in which companies often seek to limit their responsibility for such fees: by placing a cap on the dollar amount of the fees and/or by limiting or eliminating the obligation to pay fees if the transaction isn’t completed. Avoiding payment of fees if the transaction doesn’t close is typically more important to a company than capping the fees because absent completion of the financing, the company likely will not have sufficient funds available to pay its own lawyers, much less the investors’ lawyers. Even if the company is not required to pay fees if the transaction doesn’t close, however, a fee cap is still a reasonable request and can serve to discourage over-lawyering.