A. Source

The following material is excerpted from white papers issued by Mr. Andrew S. Sherman, Esq. of McDermott, Will & Emery on May 23, 2001. The papers were “Venture Capital - An Overview Of The Basic Issues And Challenges For Entrepreneurs” and “Anatomy Of A Venture Capital Term Sheet: An Overview Of Trends, Strategies And Structural Issues.”

B. Negotiating and Structuring the Venture Capital Investment

1. Objectives

The negotiation and structuring of most venture capital transactions depends less on "industry standards", "legal boilerplate" or "structural rules-of-thumb," and more on the need to strike a balance between your needs and concerns, and the venture capitalist's investment criteria.

Initial negotiations and alternative proposed structures for the financing will generally depend on an analysis of the following factors:

Your Main Concerns

• Loss of management controls;
• Dilution of your personal share;
• Repurchase of your personal share in the event of employment termination, retirement, or resignation;
• Adequate financing;
• Security interests being taken in key assets of the company;
• Future capital requirements and dilution of the founder's ownership; and,
• Intangible and indirect benefits of venture capitalist participation, such as access to key industry contacts and future rounds of capital.

Their Main Concerns

• Your company's current and projected valuation;
• Level of risk associated with this investment;
• The fund's investment objectives and criteria;
• Projected levels of return on investment;
• Liquidity of investment, security interests, and exit strategies in the event of business distress or failure ("Downside Protection");
• Protection of the venture capitalist's ability to participate in future rounds if company meets or exceeds projections ("Upside Protection");
• Influence and control over management strategy and decision-making;
• Registration rights in the event of a public offering; and,
• Rights of first refusal to provide future financing.

Concerns for Both of You

• Retention of key members of the management team (and recruitment of any key missing links);
• Resolution of any conflicts among the syndicate of investors (especially where there is a lead investor representing several venture capital firms);
• Financial strength of the company post-investment; and,
• Tax ramifications of the proposed investment.

2. Structure

Negotiation regarding the structure of the transaction will usually revolve around the types of securities involved and the principal terms of the securities. The type of securities ultimately selected and the structure of the transaction will usually fall into one of the following categories:

a. Preferred Shares
This is the most typical form of security issued in connection with a venture capital financing of an emerging growth company. This is because of the many advantages that preferred shares offer an investor - it can be converted into common shares, and it has dividend and liquidation preference over common shares. It also has anti-dilution protection, mandatory or optional redemption schedules, and special voting rights and preferences.

As valuations shrink, it is critical to factor these preferences into your own exit strategy. For example, if you have raised $10 million in venture capital so far and the company is about to be sold for $11 million, the venture capitalists will typically be “made whole” first (i.e. take out their paid-up capital and “guaranteed return”), leaving only $1 million to be divided among the common shareholders, which include the founders of the company as well as all of the key employees who may have participated in the company's share option plan.

b. Convertible Debentures
This is basically a debt instrument (secured or unsecured) that may be converted into equity upon specified terms and conditions. Until converted, it offers the investor a fixed rate of return and offers tax advantages to the company (for example, deductibility of interest payments). A venture capital company will often prefer this type of security for higher-risk transactions because they'd prefer to enjoy the position of a creditor until the risk is mitigated or in connection with bridge financing, whereby the venture capitalist expects to convert the debt to equity when additional capital is raised. Finally, if the debentures are subordinated, commercial lenders will often treat them as equity on the balance sheet, which enables the company to obtain institutional debt financing.

c. Debt Securities With Warrants
A venture capitalist will generally prefer debentures or notes in connection with warrants often for the same reasons that convertible debt is used, namely the ability to protect downside by being a creditor and ability to protect upside by including warrants to purchase common shares at favorable prices and terms. A warrant enables the investor to buy common shares without sacrificing the preferred position of a creditor, as would be the case if only convertible debt was used in the financing.

d. Common Shares
Venture capitalists rarely choose to initially purchase common shares from a company, especially at early stages of its development. You see, straight common shares offer the investor no special rights or preferences, no fixed return on investment, no special ability to exercise control over management and no liquidity to protect against downside risks. Finally, you should be aware that common share investments by venture capitalists could create "phantom income.” This would have adverse tax consequences for employees if shares are subsequently issued to them at a cost lower than the price per share paid by the venture capital company.

3. The Term Sheet

The nature and scope of the various rights, preferences and privileges that will be granted to the holders of the newly authorized preferred shares will be the focus of negotiation between you and the venture capitalist. Specifically, the terms and conditions of the voting rights, dividend rates and preferences, mandatory redemption provisions, conversion features, liquidation preferences and the anti-dilution provisions (sometimes referred to as "ratchet clauses") are likely to be hotly contested. In addition, if any portion of the financing from the venture capitalist includes convertible debentures, then negotiations will also focus on term, interest rate and payment schedule, conversion rights and rates, extent of subordination, remedies for default, acceleration and pre-payment rights and underlying security for the instrument.

Once you and your potential investors have analyzed all of the key relationship, financial and structural factors from a risk, reward and control perspective, the end result is a Term Sheet. The term sheet sets forth the key financial and legal terms of the transaction, which will then serve as a basis for preparation of the definitive legal documentation. The term sheet may also contain certain rights and obligations for both parties, such as an obligation to maintain an agreed valuation, to be responsible for certain costs and expenses in the event the proposed transaction does not take place, or to secure commitments for financing from additional sources (such as the supplemental debt financing that a growing company may seek prior to closing). Often these obligations will also be found in the conditions precedent section of the Investment Agreement.

While there are a number of “standard term sheet” clauses that need to be understood, there are two in particular that seem to attract significant discussion:

a. Ratchet Clauses
“Ratchet clauses” or “anti-dilution protection” refer to a mechanism venture capitalists employ to protect themselves from significant dilution. For example, let's say that several majority shareholders of the company are your family members, and that in the past you've authorized certain issuances of common shares at low prices to relatives. To protect against dilution upon conversion of the preferred shares (or the convertible debentures), the venture capitalist may require that certain "ratchet" provisions be built into the conversion terms of the preferred shares when you amend the company's corporate charter. These provisions will adjust the conversion price of the preferred shares to allow the venture capitalist to receive a greater number of common shares upon conversion than originally anticipated. A "full ratchet" adjusts the conversion price to the lowest price at which the share issuable upon conversion has been sold. Here's an example of such a provision:

"Adjustment of Conversion Price From the Issuance or Deemed Issuance of Additional Shares of Common Share. If and whenever the Corporation shall issue or sell, or is, in accordance with the provisions of this subparagraph, deemed to have issued or sold any shares of Common Share for a consideration per share less than the Conversion Price in effect immediately prior to the time of such issue or sale, then forthwith upon such issue or sale the Conversion Price shall be reduced to the price at which such shares of Common Share are issued or sold or are deemed to have been issued or sold. Shares issued without consideration shall be deemed issued or sold at a price of $0.01 per share or the then par value of a share of Common Share of the Corporation, whichever is less."

There are several other types of ratchet clauses, generally known as "partial ratchets", which adjust the conversion price based on some weighted average formula where shares issuable upon conversion have been issued at a variety of different prices. This type of partial ratchet is generally fairer to you and your shareholders. Finally, you may wish to negotiate certain types of share sales, such as those pursuant to an incentive-based employee share option plan, which will be exempt from the ratchet provisions.

b. Liquidation Preferences
A second type of common protection is the use of “liquidation preferences”, and the “double dip” or “triple dip.” Simply stated, these clauses stipulate how many “times” the venture capitalist must be repaid the initial investment capital before other investors are allowed to participate in the liquidation proceeds. It is not uncommon for venture capitalists to require a two or three times liquidation preference. In 2000 and 2001, being concerned by pre-money valuations climbing to all-time highs, venture capitalists commonly sought even greater liquidation preferences, sometimes as high as six or eight times.

The inclusion of multiple “dips” refers to the number of times the venture capitalist is allowed to participate in the liquidation proceeds. By way of example, a Series B preferred share may be convertible into common shares after the initial liquidation preference is satisfied, and then participate on an equal footing in the liquidation proceeds remaining to the common shareholders. In other words, the “first dip” refers to the Series B's liquidation preference. The “double dip” refers to the subsequent participation as a common shareholder.

A “triple dip” can occur if the Series B preferred shares first convert to Series A preferred shares and participate equally in that class' liquidation preference, and then convert again into common shares to participate the remaining liquidation proceeds.

Here's an example of such a common Liquidation Preference provision:

“In the event of any liquidation, dissolution or winding up of the Company, the holders of Series A Preferred Share will be entitled to be paid as follows: First, the holders of the Series A Preferred Share shall be entitled to receive in preference to the holders of Common an amount (“Liquidation Preference”) equal to the Original Purchase Price plus any dividends declared on the Series A Preferred but not paid. Second, the holders of Series A Preferred Share and the holders of Common will be entitled to receive pro rata, on a pari passu basis with the Series A Preferred Share being deemed to have been converted to Common immediately prior to such liquidation, the remaining amounts or assets to holders of capital share of the Company, provided that the holders of the Series A Preferred Share shall not be entitled to receive pursuant to this sentence an amount in excess of three times the Original Purchase Price. The effectuation by the Company or third-party acquirors of a transaction or series of transactions in which more than 50% of the voting power of the Company is disposed of to a single person or group of affiliated persons or the consolidation or merger of the Company with or into any other corporation or corporations or the sale of all or substantially all of its assets shall be deemed to be a liquidation, dissolution or winding up for purposes of the liquidation preference.”

C. Understanding the Legal Documents

The actual executed legal documents described in the term sheet must reflect the end result of the negotiation process between you and the venture capitalist. These documents contain all of the legal rights and obligations of the parties, and they generally include:

• Share Purchase Agreement ("Subscription Agreement");
• Shareholders Agreement;
• Employment and Confidentiality Agreements and Intellectual Property Assignments, and Share Repurchase Agreements;
• Warrant (where applicable), Debenture or Notes (where applicable);
• Preferred Share Resolution (to amend the corporate charter) (where applicable); and,
• Contingent Proxy, Legal Opinion of Company Counsel and a Registration Rights Agreement.

1. Subscription Agreement
This is where you'll find all of the material terms of the financing. It also serves as a form of disclosure document because the Representations and Warranties portion of the Subscription Agreement cover the relevant financial and historical information you make available to the investor. The Representations and Warranties (and any exhibits) also provide a basis for evaluating the risk of the investment and structure of the transaction.

The Subscription Agreement will also provide for certain conditions that you must meet prior to the closing. These provisions require you to perform certain acts at or prior to closing as a condition to the investor providing the financing. The conditions to closing are often used in negotiations to mitigate or eliminate certain risks identified by the investor, but usually are more of an administrative checklist of actions which must occur at closing, such as execution of the ancillary documents discussed below.

Perhaps the most burdensome aspects of the subscription agreement, and thus the most hotly negotiated, are the various affirmative and negative covenants that will govern and restrict your future business affairs and operations. Affirmative covenants might include an obligation to: maintain certain insurance policies, protect intellectual property, comply with key agreements, prepare forecasts and budgets for review and approval by the investors and ensure that certain investors are represented on the board of directors of the company.

Negative covenants might include obligations not to: change the nature of your business or its capital structure, declare any cash or asset dividends, issue any additional share or convertible securities, compensate any employee or consultant in excess of agreed amounts or pledge any company assets to secure debt or related obligations.

In most cases, you can't undertake the acts covered by the various affirmative and negative covenants without the express prior approval of the investors, and such restrictions on activity will last for as long as the venture capitalist owns the securities purchased in the financing.

Finally, the subscription agreement will provide remedies for any breach of the covenants or misrepresentation you make. These remedies may require a civil action, such as a demand for specific performance, a claim for damages or a request for injunctive relief. In other cases, the remedies will be self-executing, such as an adjustment in the equity position of the investor, a right of redemption of the investment securities, rights of indemnification, super majority voting rights or a right to foreclose on assets securing debt securities.

2. Amendment to Corporate By-Laws
In all likelihood, you'll need to amend your corporate by-laws to create the Series A preferred shares. The articles of amendment will set forth the special rights and preferences that will be granted to the holders of the Series A preferred shares such as special voting rights, mandatory dividend payments, liquidation preferences and in some cases, mandatory redemption rights.

3. Shareholders' Agreement
Venture capitalists will normally require your principal shareholders to become parties to a shareholders' agreement as a condition to closing on the investment. At the Seed Stage, it is not uncommon for investors to require that the shareholders' agreement be unanimous (i.e. all shareholders execute it). Any existing shareholders' or buy/sell agreements will also be carefully scrutinized and may need to be amended or terminated as a condition to the investment. The shareholders' agreement will typically contain certain restrictions on the transfer of your company's securities, voting provisions, rights of first refusal and co-sale rights in the event of a sale of the founder's securities, anti-dilution rights, and optional redemption rights for the venture capital investors.

For example, the investors may want to reserve a right to purchase additional shares of your preferred shares to preserve their respective equity ownership in the company in the event that you later issue another round of the preferred shares. This is often accomplished with a contractual pre-emptive right (as opposed to such a right being contained in the corporate charter, which would make these rights available to all holders of the preferred shares), which might read as follows:

"Each of the investors shall have a pre-emptive right to purchase any Common shares or any securities which the company shall issue which are convertible into or exercisable for Common shares. In determining such right, each investor holding Preferred shares shall be deemed to be holding the Common shares into which such Common shares or Preferred shares are convertible. Such pre-emptive right must be exercised by each investor within fifteen (15) days from the date that each investor receives notice from the company stating the price, terms, and conditions of the proposed issuance of the shares of Common shares and offering an opportunity to each investor an opportunity to exercise its pre-emptive rights."

4. Various Employee Related Agreements
Venture capitalists will also often require key members of a management team to execute certain agreements as a condition to the investment. Normally, these agreements include:

• Employment Agreements;
• Non-disclosure and Intellectual Property Assignment Agreements; and,
• Share Repurchase Agreements.

These agreements will define each employee's obligations, the compensation package, the grounds for termination, the obligation to preserve and protect the company's intellectual property, and post-termination covenants, such as covenants not to compete or to disclose confidential information. Share repurchase agreements apply specifically to the company's key founders. Essentially, they operate like a “reverse option” where the company retains the right to repurchase a declining number of your founders shares if your employment is terminated before the end of the share repurchase period.

5. Contingent Proxy
This document provides for a transfer to the venture capitalist of the voting rights attached to any securities held by a key principal of the company upon his or her death. The proxy may also be used as a penalty for breach of a covenant or warranty in the subscription agreement.

6. Registration Rights Agreement
Many venture capitalists will view the eventual public offering of your securities pursuant to a registration statement filed with the SEC as the optimal method of achieving investment liquidity and maximum return on investment. As a result, the venture capitalist will protect his or her right to participate in the eventual offering with a Registration Rights Agreement. Generally, these registration rights are limited to your common shares, which would require the venture capital investors to convert their preferred shares or debentures prior to the time that the SEC approves the registration statement.

The registration rights may be in the form of "demand rights," which are the investors' right to require you to prepare, file and maintain a registration statement, or "piggy back rights," which allow the investors to have their investment securities included in a company-initiated registration. The number of each type of demand or piggyback rights, the percentage of investors necessary to exercise these rights, allocation of expenses of registration, the minimum size of the offering, the scope of indemnification and the selection of underwriters and brokers will all be areas of negotiation in the registration rights agreement.

Source: Ottawa Capital Network