Module Description:
In this session, Ivan Gaviria of Gunderson Dettmer takes us through the 5 main legal documents behind a standard VC financing (SPA, Charter, IRA, Voting, and ROFR/Co-Sale) -- discussing the philosophy as well as watchouts.
Full Transcript:
Welcome everyone to our Ubiquity University session on the five financing documents and what you really need to know. Ubiquity Ventures is a pre-seed and seed stage firm investing in software beyond the screen. That means we back entrepreneurs who are using software to solve real world physical problems, often by leveraging smart hardware machine learning. Today we're very lucky to have Ivan Gaviria of Gunderson Dettmer talk us through the five core VC financing documents. Ivan's someone I've known for over 10 years. He's been a partner with Gunderson Dettmer for almost 20 years, and today I'll ask him to take us through his presentation on these five documents. Thank you, Ivan.
Great, thanks Sunil, I'm happy to be here. And to state the obvious, we're trying to summarize several hundred pages of documents. These are typically the ones, if you ever hear NVCA forms or something of that nature, most of the big law firms that do tech representation either have their own version of these documents or more commonly it will just start with the NVCA forms themselves. And we're gonna try to distill all of that paper down into about 10 minutes. So buckle in, it's gonna be exciting, but I think the best way to think about it is taking a step back at the outset and saying, what is a venture investment? It's fundamentally a purchase of a minority interest in a company and that minority interest is represented by shares in that company. And when you think about it that way, it really helps you understand all of these documents because they pretty much all come back to one of three things, either the investor getting their money into the company, and that's primarily a stock purchase agreement, which we'll talk about, then how the investor manages that money over time, particularly from a governance and control perspective. And again, remember what I said, minority investment. So the normal rule in a Delaware corporation is majority rules and people get often very confused about that. Founders really worry about, what if I lose more than 51%, et cetera? Not super relevant because all of this paper is designed for that minority holder VC to be able to have additional controls and governance and protections and so forth. And then the third piece is of course, liquidity. At the end of the day, these investments are made with the goal of getting a significant return upon a liquidity event, whether that's an M and A exit or whether that's a public offering. And almost everything in all of those hundreds of pages of documents can get distilled down into one of those three buckets. And so that's how we'll think about it as we go through.
Why don't we start with the stock purchase agreement? This one in some respects is sort of the least interesting because it really is a snapshot in time. All of the ongoing things that you're gonna negotiate into financing around future control, around board, et cetera, are gonna be in other agreements. This is really getting the money in and it just serves a couple of key purposes. One, the details. Hey, what is the price that the investor is paying? How much money are they putting in? What's the closing date? If you have multiple investors participating, how is the round being allocated? Those things all live in the stock purchase agreement. And so once you've negotiated your valuation and you know the price per share, et cetera, that just gets laid out in there. And it's really just to guide the deal process. The only really meaningful thing in these things from a legal perspective ultimately is what are called the reps and warranties. And if you've never done a deal before, it's essentially a laundry list of statements that are made about the company. The company doesn't have any litigation. The company owns and controls its intellectual property. The company doesn't have any employees that are threatening to sue. All these sorts of things that you think about it no differently than buying a car or buying a house. Once you've told the investor that there's a leaky foundation and the investor says, "That's okay, I factor that into my pricing and I'm buying the house," then you no longer have liability to that investor in the future. Now remember, these are venture financings and so this is somebody who's going to own a significant percentage of the company. And so it's not quite the same dynamic as selling the company where people may very well want some money back if it turns out one of those reps and warranties was false, et cetera. But nonetheless, it's an important piece of the process to disclose to the investor, hey, you've seen what you needed to see about the company. You've performed what we call due diligence in the business. You've had a chance to review all of those things and now with perfect knowledge of the company, you've gone forward and made your investment decision. So those reps and warranties are really a snapshot in time. As of the closing of this financing, these things are true. And if they're not true, I have given you disclosures to that effect. And so that's the concept of a disclosure schedule or a schedule of exceptions. You're gonna hear all of these words. And one of the tricky things about doing your first few deals in Silicon Valley is that there are many names for the same thing. Some people call it the disclosure schedule, some people call it the schedule of exceptions, et cetera, but it's basically this notion just like selling a house, hey, I told you there was a leaky roof before you closed. And that's the way to think about it. And then lastly are the closing conditions. And when you look in a stock purchase agreement, you'll see those at the end. These are the things that have to happen in order for the deal to close. In a venture financing, I almost think of it really as essentially a to-do list in order to get the deal closed. And the reason I say that is, unlike a merger where often there's a significant number of things that have to happen between signing and closing. In a venture financing, really you just kind of sign and then the very next, within the next moment you are wiring the money, et cetera. And so you don't necessarily need closing conditions, but they just are useful to outline the deal. So again, stock purchase agreement, not a lot of ongoing obligations, it's a moment in time. It lays out the specifics of this transaction, who's coming in, for how much, at what price, reps and warranties are made, disclosures are made, you meet the closing conditions and you close the financing and then you never look at that agreement again until your next round when you're updating those reps and warranties for the series B or the series C, et cetera. So that's the stock purchase agreement.
Let's switch to the next one. Certificate of incorporation. Again, remember the nomenclature point. Some people call this the charter, some people call it the certificate of incorporation. Oddly, Delaware likes the word certificate. California and other states sometimes call it articles. So you'll hear that interchanged. So your articles, your certificate, your charter, your charter documents, everyone is really talking about this thing that gets publicly filed with the secretary of state of whatever state your business is incorporated in. And it really lays out the legal rights and preferences of the preferred stock. Backing up for a minute, and this is something we can talk about on another occasion. Generally speaking, for venture financings, investors are purchasing preferred stock and founders and management stock option plan, et cetera is gonna be common stock. And we could talk about that in more detail. But for purposes this of this discussion, the preferred stock terms live in this document called the certificate of incorporation. That's filed with the Secretary of State, again, typically Delaware as you can see here. The number one thing that you really care about in the certificate of incorporation is the liquidation waterfall. Now, when you hear preferred stock, what does that mean? Generally speaking, it's a two things. It's certain rights that allow those preferred stockholders to have more control than they might as a mere minority holder. And then secondly, it goes back to this thing we talked about the very beginning, which is liquidity, getting your money out, et cetera. A liquidation preference is exactly what it sounds like. In the event you are liquidating the company. Those preferred holders have a preference, they get their money out first ahead of the common, there's a lot more nuance to it than that, but that's the core. And so two things to fundamentally understand is that in these venture financing documents, we're not just talking about a wind down or dissolution of the company, liquidation in this context is defined in those long documents to include an exit event, a sale of the company, a sale of its assets, et cetera. So this is the critical thing that comes in of where does the money go when there's a sale of the company? And you can get into lots of details about whether it's senior, you know, does the C get their money before the B, before the A? Does the, do they get participation, do they get to get their liquidation preference? And on top of that, their pro rata share, et cetera. There's a little more detail than we can get into in a 10 or 15 minute run through of the documents, but it's a critical section of the certificate incorporation. It defines how you divide the pie. The reason it's called a waterfall is this sort of this metaphor I guess of if you had the series C getting paid first, then the series B, then the series A, or in a simple case it might just be the preferred and then the common, but it kind of, I guess, gives you the image of a waterfall. But you'll hear that a lot, what's the waterfall? The other section that's critical in this document is the protector provisions. So going back to where we started, these are minority investments. If you, you know, make up a a typical venture financing, you're raising $2 million and you're selling 20% of the company. What that essentially means is you're backing into this notion of, oh, your pre-money valuation was 8 million, your raise of 2,000,000, eight plus two is your post money valuation of 10 and the raise over the post-money is that 20% ownership. So that's a super simple example, but that's the basic algebra that goes into these things is pre-money valuation plus the raise equals the post-money valuation. And that's the negotiation of what percentage of the company you're giving up. And so again, minority position, if you didn't have protective provisions, if you didn't have all these agreements, the investor would be completely exposed because everything they negotiated for in the financing could be taken away from them by a majority vote under Delaware law. And so what you institute in this document is a separate layer of votes to protect that minority interest. These are called protective provisions and you'll see them in virtually any venture financing. And they're the things that you can imagine. They are things like you can't sell the company without the approval of the preferred as a separate group, not just majority of the whole company, but a separate vote of the preferred. You also need that vote for a next round of financing if the new series is going to take away or change the rights of the prior series or if it's gonna be layered on top in a way that is to their detriment. Typically, it'll be things like changing the size of the board, paying out dividends. So there's a series of actions that basically give those preferred stockholders an extra set of protections in this essentially contract that trumps what would be the otherwise norm, which is majority rule under Delaware law. And we can have an advanced class where you can see how once you have early stage A investor or seed investor at a low valuation and you've got a growth investor at a super high valuation, there's not always gonna be alignment there. So you can get into all kinds of interesting and fun discussions around series votes and super majorities and all the sorts of things you can write into this. But the basic takeaway for this is, hey, if these protective provisions provide a series of rights to this minority group that now is a made investor in your company in order to manage through certain major actions of the company that would otherwise be simply approved by the board and the all of the stockholders including the the founders, et cetera. Lastly, there's this notion of conversion. A couple things there. Automatic conversion is a feature of preferred stock and that's simply a function of the fact that capital markets public markets, if you're ever one of the fortunate few to take a company public, the underwriters and the investment banks that go take those deals out to Wall Street, they like a simple clean cap table with just common stock. And so, it's always been the case in Silicon Valley deals that if the company goes public at a certain valuation that's going to yield an appropriate amount of liquidity to the investors, the preferred stock will automatically convert to common stock when it hits that trigger amount. So you can already hear, I'm sure you can negotiate little things in there, what's the trigger amount? Does it have to be on the NASDAQ? Can it be on the New York Stock Exchange? How about the Toronto Exchange? So there's, in everything I say, there's a million different nuances that you can play with, but this is again just to get the high level feel of it. So there's two types of conversion. There's the automatic conversion which happens on upon an IPO, and then there's also the right to just simply vote as a group of preferred stockholders to convert to common. That gets into a lot of advanced class things like you may have heard the phrase pay to plays and recaps and so on. There are instances in which not everybody in the syndicate of investors is aligned. And there may be types of deal structures where converting one or more groups to come and comes into play. So there's always the ability to convert into common. And then when you go back to that liquidation waterfall scenario, if you think about it, if I'm a series A investor and I own 20% of the company that I bought for $2 million, if the company gets sold for $2 million, I don't get 20% of that. I get a 100% of it because the company didn't get sold for enough to yield additional proceeds above the liquidation preference. But what you want to happen is a much higher valuation where I'd much be much happier getting 20% of the deal value. So if you sell the company for a 100 million in that example, that series a investor is gonna want 20% or 20 million, not the liquidation preference of 2 million. So they're gonna convert to common and take what they would get on an as converted basis. So the last piece on conversion, which you may have heard of, is anti-dilution. And so the anti-dilution concept basically addresses you sold shares to a preferred investor and then in a future round the price actually went down. And so that investor wants some kind of offset for that. And the way that works is you adjust that conversion ratio. So in norm, the starting point for conversion is preferred stock typically converts one share of preferred to one share of common. But there's a formula you put into these documents that allows you to tweak that so that a one share of preferred can convert into more than one share of common. And that mechanism and formula by which you do that is what we call the anti-dilution protection because it allows preferred to get a little more ownership upon that conversion to kind of make up for the fact that they were unfairly, if you will, diluted by the fact that instead of things going up and to the right, they went up and then they went down. And so these things all live in the certificate of incorporation because they're core features of the preferred stock. The liquidation waterfall goes to how that stock gets paid on an exit. The protective provisions are voting rights of the shares of stock that allow them to protect their minority interest, the conversion and anti dilution rights, further protect the economics of that stock and then also address the company's need to have a clean cap table when it goes public. And so, all of these things are laid out. Certificate of incorporation, the most important in my opinion, document of the five because it really goes to those core economics. And you notice I didn't mention dividends, those are also in that agreement. But what you'll find pretty quickly in the venture world is the vast, vast majority of venture-backed startups never pay a dividend because to the extent that they have an operating surplus, they're typically reinvesting that in growth. And the types of investors that put money into these companies, they're not doing it for, you know, a three or four or 5% dividend. This is not an income generating investment. They're looking for a big return at an exit. And so, generally speaking, surplus and profits are gonna get reinvested in the business and not paid out to stockholders as a dividend. And in most venture financings, there's no mandatory dividend or cumulative dividend. And you'll just see some language in there that says, hey, if this is the odd chance where a dividend gets paid, you gotta pay the preferred as a certain percentage dividend before you pay the common a dividend. But been doing this a long time, it comes up pretty rarely. So skipping forward, we've covered the stock purchase agreement certificate of incorporation.
The next one is the voting agreement. So voting agreement, very simple. In order to trump majority rule, you have a contract where everybody agrees to both their shares in support of a negotiated board, whether that's two founders and two investors and an independent whatever the thing is that all gets put in the voting agreement as well as the size of the board. And the last piece is the drag along. And so that's the notion that everybody agrees that if there are certain transactions, so for example, if the board, a majority of the preferred investors and a majority of the founders all agree to sell the company, then all the minority holders have agreed in this voting agreement that they will sell their shares in that transaction. So it's just to facilitate consummating an M and A or asset type sale transaction. So the voting agreement's all about the board plus the drag along.
The investor rights agreement has a number of features to it. Probably the most important, well we'll skip reg rights 'cause as I said here, they don't really matter. They are generally related to selling your shares in a registered offering after an IPO, it comes up relatively rarely. We can skip ahead on that. The information and pro-rata rights are two key rights of the investors. It's the right to get updated financial statements periodically from the company. Those are the information rights. And then the pro-rata right is the right to participate in subsequent rounds of financing so that if I bought 10% of the company in the A round, I want to have the right to maintain my 10% ownership by buying a piece of the next round. And so, the information and pro rattle rights are captured in this investor rights agreement that unlike the stock purchase agreement, which is a snapshot in time, this is kind of a living document that you're constantly referring to over time because of these rights that are ongoing. There's usually additional covenants if there's any side deals about, you know, what things that require special board approval or things you're gonna do with your employees. Those things all get factored into the investor rights agreement. And the last piece that's important here is that those information rights and pro rata rights, there's often a threshold of ownership and they commonly referred to as major holder or major investors, something of that nature that says, hey, we're not gonna give everybody who put 10,000 bucks in the same level of information and pro rata rights. And so often you'll have a negotiation around there over what's the line to get those, to get those special rights that major investors hold.
Last and frankly least the ROFR Co-Sale Agreement is really around controlling the cap table and liquidity opportunities. And so typically, the founders or other very large common stockholders will grant the investors a right of first refusal. Basically, if I'm walking down the street, Sunil offers to buy my founder shares for a dollar a share. Before I can sell them to Sunil, I have to go back to my investors and say, anyone wanna buy these shares at a dollar a share? And so it really, and then co-sell right, is a secondary right. This is a little different. This is same example. Sunil is willing to buy a hundred shares from me for a dollar a share. I need to go to the investors and say, would you like to sell some of your shares for a dollar a share? And if so, Sunil is still gonna buy a hundred shares, but he's gonna buy some from me and some from the investors. And that's gonna be allocated kind of on a pro rata basis in accordance with our relative ownership. So this is an opportunity for the investors to manage and the company to manage who ends up on the cap table when people sell. And it's also an opportunity to make sure that if someone, anyone gets a liquidity opportunity, everyone kind of can sort of share on that liquidity opportunity. And the only other feature that's in that agreement is obviously with all of these things, there are exceptions and these are a little bit more relevant in this case because often it comes down to the ability of a founder typically to consummate a sale without having to jump through the hoops of offering it first to the investors offering co-sale rights to the investors. And so there are some normal things you would expect in there like estate planning transfers, you're doing some planning for your kids, et cetera. And then sometimes you can have a negotiation over whether there should just be a little piece of your ownership that you can sell without having to ask anyone else's permission. And so that really is the core of the rot of first refusal and co-sale agreement. And that is your very quick and aggressive tour through the five main financing documents.
Ivan, I really appreciate that. I realize a term sheet, which is the start of the whole financing process can be a page or two, but what you just went through is about a hundred pages of documents. So thank you for summarizing what you really need to know about those five financing documents. We appreciate that. We appreciate your help with Ubiquity and I think it's pretty likely we'll do a follow up session to go deeper here. Again, this has been our Ubiquity University session on the five major financing documents, what you really need to know. We would love to hear from you. If you'd like to set up a meeting with Ubiquity, you can visit us at Pitch Ubiquity VC. I'm available at Sunil at Ubiquity.vc and I know that if you have questions for Ivan or would like an introduction, I'm more than happy to make that possible. So thank you again, Ivan, appreciate the time.