The National Venture Capital Association (NVCA) publishes model legal documents for venture capital financings, including a Certificate of Incorporation, Preferred Stock Purchase Agreement and Investors Rights Agreement. These documents enjoy wide industry acceptance as baseline agreements that parties and their counsel can tailor for each deal. They also include commentary on East and West Coast practice and bracketed alternative provisions to insert/omit depending on the deal terms. Perhaps most attractive to the parties, starting from a standardized form can decrease legal hours (and, more importantly, fees) from term sheet to closing.

Venture capital
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Recently, NVCA updated the model legal documents for the first time since 2014. Considering the wide use of these documents, these revisions are likely to impact future VC financings. Here are some of the key changes:

Certificate of Incorporation

  • Protective Provision for Cryptocurrency/Blockchain Issuances: VCs typically negotiate for veto rights over a company issuing additional equity and debt securities. Now, the model Certificate includes a protective provision giving investors the right to veto token, cryptocurrency and blockchain-related offerings.
  • Redemption Rights: VCs might negotiate for a redemption right, which requires the company to repurchase their preferred stock under certain conditions.  If the company does not fulfill a redemption request, the model Certificate now includes a high rate of interest on the redemption price of any shares not redeemed “for any reason”. Recent case law suggests that a board may be protected by the business judgment rule if it determines not to use funds to redeem preferred stock despite an obligation to do so.  (See e.g., TCV VI, L.P.  Trading Screen, Inc., Case No. C.A. 10164-VCN (Del Ch. Ct. Feb. 26, 2015); SV Investment Partners, LLC v. Thoughtworks, Inc., Case No. C.A. 2724 (Del. Ch. Ct. Nov. 10, 2010). Triggering an interest payment “for any reason” gives investors increased leverage and some compensation.

Stock Purchase Agreement

  • Provisions for Life Science Transactions: Life science companies are attractive to VCs due to their potential for rapid growth and significant ROI. The updated Stock Purchase Agreement includes provisions specific to life science transactions.  These include more robust treatment of milestone closings, including undersubscription procedures and penalties for an investor’s failure to close, and new reps and warranties related to government and university sponsored research, clinical trials and FDA approvals.

Investors Rights Agreement

  • Anti-Harassment Covenant: In a timely addition, the Investor Rights Agreement now includes a covenant requiring the company to adopt an anti-harassment policy and a code of conduct governing appropriate workplace behavior. NVCA recently published a set of model documents and resources addressing harassment and discrimination.

Voting Agreement

  • Drag Along Rights: A drag along provision can permit VCs to “drag” the junior preferred and common holders into a sale of the company.  Under certain circumstances, dragged shareholders can receive little or no compensation in a drag sale, which may prompt a legal challenge.  The updated drag provision is intended to more effectively implement drag transactions and reduce the likelihood of a minority stockholder claim.

Users already familiar with NVCA’s model documents will be glad to see the revisions are not extensive.  However, given the wide acceptance of these forms, it’s safe to say that the updates will be impactful. This is especially true with respect to anti-harassment policies, which is both a high-profile issue and has obvious benefits for all parties.  Stay tuned to Emerging Companies Insider for a follow-up blog addressing NVCA’s new model documents addressing harassment and discrimination.

Issuers and investors are well advised to document their deal in a term sheet.  Though generally non-binding, they add significant value.  Detailed term sheets raise issues early when there is still ample negotiating time. They also make drafting the definitive documents more efficient, saving on legal fees. However, parties must be vigilant to document the deal properly, especially when using terms of art.

Cumulative dividends
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For example, one commonly negotiated item on preferred stock is the dividend. Dividends can be cumulative (aka accruing) and either simple or compounding. The terms “cumulative” and “compounding” are sometimes (incorrectly) used interchangeably. But the differences are measurable in real dollars. 

Dividends are one feature that makes preferred stock preferable. Dividends are structured in (at least) three common ways. NVCA publishes a sample term sheet that includes these options.

  1. Dividends can be paid on the preferred when (and if) they are paid on the common. The preferred holders have no dividend preference – they are treated as common holders and paid as if converted to common.
  2. Dividends can be paid on the preferred when (and if) declared by the Board of Directors. If the Board does not declare dividends, they are forfeited.  Here, the preferred holders enjoy a preference on dividends but may not receive them.
  3. Finally, as described in detail below, dividends can be cumulative and perhaps even compounding.

Cumulative vs. Compounding

Emerging companies rarely have the ability to pay dividends to preferred holders. As a solution, companies often agree to pay dividends upon a liquidity event (e.g., sale of the company).  But how much will investors receive? This is where the terms of art (cumulative, accruing, compounding, simple) become very important.

Cumulative (aka accruing) dividends provide investors with a certain annual return, typically expressed as a percentage of the original per share price of the preferred stock (e.g., “8% of the Series A Original Issue Price”).  Thus, the term “cumulative” refers to the fact that dividends accrue over the years and will be paid upon a liquidity event.

Cumulative dividends can be calculated on a simple or compounding basis.  “Simple” means the dividend is based only on the original per share price.  “Compounding” means the dividend is based on the original per share price plus the dividends that accrue over time.  Thus, the terms cumulative and simple refer to how cumulative dividends are computed.

For example:

Cumulative and Simple (aka Non-Compounding):

Suppose an investor invests $50,000 and receives 100,000 shares of preferred stock ($0.50 per share) with an annual 8% cumulative, simple dividend. In 5 years, the company is sold. The 8% annual dividend is calculated on the original per share price. The investor has earned $4,000 in dividends each year and, upon liquidation, the company must pay the investor $20,000 in dividends.

Cumulative and Compounding:

Suppose the same facts, but dividends are now cumulative and compounding. The 8% annual dividend will be calculated on the original per share price and on the accrued and unpaid annual dividends that accumulate over the years. This is similar to a promissory note with compound interest: the original per share price is like “principal” and the 8% annual dividend is like a compounding 8% interest rate. In this scenario, the investor earns $23,466.40 in dividends.

Clearly, there is a measurable difference between simple and compound dividends. And at first glance, the $3,466.40 difference may not seem overly significant. But the proper use of term sheet terminology has a greater value. A detailed and thoughtful term sheet helps maintain deal flow and good will during negotiations, can decrease legal fees and helps avoid disputes down the road.  For issuers and investors at the outset of a long friendship, these benefits can be immeasurable.

Assuming that a startup company and an investor are comfortable with the recently formulated Simple Agreement for Future Equity (“SAFE”) as the investment vehicle to finance the startup company’s early operations, the parties are then faced with the question of which version of SAFE is appropriate for the investment. Fortunately, the possible list of answers should be familiar and revolve around concepts identical to those used in convertible note financings: valuation caps, discounts, most-favored nation provisions, and combinations thereof.

  • SAFE with a Valuation Cap
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Copyright denphumi / 123RF Stock Photo

The “standard” SAFE contains solely a valuation cap, with no discount rate applied to the investment. This means that at the time of the next applicable round of equity financing, the investors will be entitled only to the number of shares of preferred stock calculated with the valuation limitation and not a higher pre-money valuation. However, it is important to note that because the preferred stock the investor receives in the applicable equity financing will contain a liquidation preference that equals only the amount invested in the SAFE (as opposed to a liquidation preference equal to the price of the shares preferred stock issued to the new investors), the investor will receive a separate series of preferred stock than the new investors, with the only difference being a per share price attributable to the preferred stock. Below is an example provided by Y Combinator of how the “Valuation Cap Only” SAFE will practically be converted in an equity financing:

Valuation Cap Only SAFE Example

  • The investor has purchased a SAFE for $100,000. The valuation cap is $5,000,000.
  • The company negotiates with new investors to sell $1,000,000 worth of Series A Preferred Stock at a $10,000,000 pre-money valuation. The company’s fully-diluted outstanding capital stock immediately prior to the financing, including a 1,000,000 share option pool to be adopted in connection with the financing, is 11,000,000 shares.

The company will issue and sell 1,100,000 shares of Series A Preferred at $0.909 per share to the new investors.  The company will issue and sell 220,000 shares of Series A-1 Preferred to the SAFE investor at $0.4545 per share.

In the SAFE, the Series A Preferred is referred to as “Standard Preferred Stock” and the Series A-1 Preferred is referred to as “SAFE Preferred Stock.”  The table below sets forth a comparison between the Standard Preferred Stock and the SAFE Preferred Stock, as each would be described in the company’s certificate of incorporation:

Standard Preferred Stock SAFE Preferred Stock
Liquidation preference on a per share basis: $0.909 $0.4545
Aggregate payout in a change of control transaction (each series pari passu with the other): $1,000,000 $100,000
Conversion price and original issuance price at the time of the Series A Preferred financing: $0.909

(initially converts into 1,100,000 shares of common stock)

$0.4545

(initially converts into 220,000 shares of common stock)

  • SAFE with a Discount

A different version of the SAFE includes only a discount, which will be applied to the price per share a Standard Preferred Stock sold in the equity financing, which will be equally applied to the conversion of the SAFE into shares of SAFE Preferred Stock. Below is an example provided by Y Combinator of how the “Discount Only” SAFE will practically be converted in an equity financing:

Discount Only SAFE

  • The investor has purchased a SAFE for $20,000. The discount rate is 80%.
  • The company has negotiated with new investors to sell $400,000 worth of Series AA Preferred Stock at a $2,000,000 pre-money valuation. The company’s fully-diluted outstanding capital stock immediately prior to the financing is 10,500,000 shares.

The company will issue and sell 2,100,000 shares of Series AA Preferred at $0.19047 per share to the new investors. The 20% discount applied to the per share price of the Series AA Preferred is $0.15237. Accordingly, the company will issue 131,259 shares of Series AA-1 Preferred to the SAFE holder at $0.15237 per share.

  • SAFE with a Valuation Cap and a Discount

A SAFE may also contain both a valuation cap and a discount, but only either the valuation cap or the discount rate will apply when converting the SAFE into shares of SAFE Preferred Stock, not both. In this scenario, like with a Discount Only SAFE, the discount rate will be applied to the per share price of the Standard Preferred Stock in the applicable equity financing; and if this calculation results in a greater number of shares of SAFE Preferred Stock for the investor, the per share price imposed by the valuation cap. Below is an example provided by Y Combinator of how the “Valuation Cap & Discount SAFE” will practically be converted in an equity financing:

Valuation Cap & Discount SAFE

  • The investor has purchased a SAFE for $100,000. The valuation cap is $8,000,000 and the discount rate is 85%.
  • The company has negotiated with new investors to sell $1,000,000 worth of Series A Preferred Stock at a $10,000,000 pre-money valuation. The company’s fully-diluted outstanding capital stock immediately prior to the financing, including a 1,000,000 share option pool to be adopted in connection with the financing, is 11,000,000 shares.

The company will issue and sell 1,100,000 shares of Series A Preferred at $0.909 per share to the new investors.  The company will issue Series A-1 Preferred to the investor, based on the valuation cap or the discount rate, whichever results in a lower price per share. The 15% discount applied to the per share price of the Series A Preferred is $0.77272. The valuation cap results in a price per share of $0.72727.  Accordingly, the company will issue 137,500 shares of Series A-1 Preferred to the investor at $0.72727 per share. The discount rate will not apply.

  • SAFE with a Most Favored Nation Provision

Regardless of whether a SAFE contains neither, either or both a Valuation Cap or a Discount feature, a SAFE may contain a “Most Favored Nation” provision (“MFN Provision”). The MFN Provision allows the holder of that SAFE to amend the terms of the SAFE to include terms in a latter-issued SAFE that the holder of the SAFE identifies as being more advantageous than the terms of the SAFE with the MFN Provision. For example, if an investor holds a SAFE with an MFN Provision and a Valuation Cap of $10,000,000, and subsequent to the issuance of that SAFE, the company issues to a new investor a SAFE with an $8,000,000 Valuation Cap, the first investor will have the opportunity to amend the terms of the SAFE with the MFN Provision and $10,000,000 Valuation Cap to include the $8,000,000 Valuation Cap.  It is important to note, however, that if the subsequently-issued SAFE does not also contain an MFN Provision, the MFN Provision will essentially be “amended away” by exercising the MFN Provision in the original SAFE.

Investment
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Investors typically do not finance an early stage or middle market company with the intent to ultimately call for a redemption of the preferred shares that it receives from the company in connection with the original financing.  Such a situation signals a failed investment, as the return of the original purchase price for the investor’s preferred shares represents zero appreciation on the original investment.  However, there are circumstances where redemption is appropriate as a last option.

A recent Delaware Chancery Court decision in TCV v. TradingScreen provided some insights into Delaware’s approach to determining the circumstances under which a corporation is legally permitted to fulfill a demand for redemption, meshing the statutory concept of “surplus”, as such term is used in the Delaware General Corporation Law, and the common law concept of “funds legally available.”  The Delaware courts had previously left unanswered the question of whether the statutory standard of “surplus” was somehow different than the common law standard of “funds legally available.”  According to the Chancery Court in TCV v. TradingScreen, there is a difference.  While a calculation of “surplus” basically consists of net assets in excess of capital, “funds legally available” is to be determined on the basis of a “going concern/insolvency” analysis (i.e., would the company’s payment of the redemption amount to the investor impair the company’s ability to continue as a going concern and pay its debts when due?).  The risk to investors is that the viability of a contractual redemption right with respect to its preferred shares may be closely tied to the timing of the demand for redemption of those shares.

Final word on the matter will be provided by the Delaware Supreme Court, as the Chancery Court decision in TCV v. TradingScreen has been appealed.  In the meantime, companies and investors should be cognizant of the implications of the Chancery Court’s decision when negotiating the terms of a redemption provision and the remedies available to the preferred stockholders if the company is not able to satisfy a mandatory right of redemption.