By: Sean Valle
If your startup is gearing up for your first Preferred Stock financing round, you are likely beginning to realize how exciting and daunting the process can be. Here, we provide a general overview of the process.
Before we dive into details, it’s worth remembering what motivates investors who will purchase Preferred Stock. There are various types of investors that may contribute to your company’s growth throughout its lifecycle: friends and family, the “crowd”, accelerators, angel groups, banks, non-profit organizations, venture capitalists, and private equity investors all have different motivations and interests in supporting your company. At the Preferred Stock financing stage, the primary motivation for most investors–especially venture capitalists–will be to ensure they receive a return on their investment. To that end, Preferred Stock financings are complex undertakings and involve robust purchase documents because these financing rounds involve significant amounts of capital and the potential for either significant gains or losses for investors. Investors want to make sure they fully understand the risks associated with their investment and have a full picture of your company’s profitability.
With that in mind, let’s walk through some of the stages of the Preferred Stock financing process. Specifically, we’ll review the following:
- The pitch process
- Term sheet negotiations
- Corporate cleanup and due diligence
- Financing document drafting
- Closing and securities filings
- Red flags to watch out for
- Some additional resources
The pitch process:
By now, you’ve likely pitched your company to at least one potential investor or strategic partner. The pitch process can be incredibly stressful. Your idea will be challenged and tested. You may face rejection or invalidation of your work. And, when your company is at the right stage and you’ve found the right lead investor, you may be rewarded with a valuable, supportive addition to your company, potential strategic partnerships and connections, and the capital to propel your company forward.
Keep in mind that investors are approaching these investments from a risk-mitigation perspective. Any criticism or rejection is their own subjective assessment of the risks associated with your idea and the market. It doesn’t mean your company has no value to someone else or even to that investor as a consumer. Make sure to prioritize your mental and physical wellbeing during this time. Turn to yourself and your friends, family, co-founders, advisors, therapist, and other community members for support and encouragement. Carve out time for rejuvenating physical activity, movement, and mindful reflection. For tips about maintaining fitness as an entrepreneur, check out Fourscore’s downloadable whitepaper on Fitness & Founders.
To make your time and effort as effective as possible, we recommend capitalizing on your existing network to help facilitate introductions to targeted investor groups. Many investor groups specialize in specific industries or technologies. Try to establish a personal connection to investors that invest within your industry and who actively engage with companies at your stage of growth. Avoid blindly distributing your pitch deck to a scattered audience. Fourscore can help you deliberately target and connect with potential investors. Talk to your Fourscore attorney about gathering a detailed report of investors who regularly invest in your industry along with those investors’ contact information, details about their previous investments, and their expectations for an ongoing relationship with their portfolio companies.
The term sheet:
Depending on the investment groups you’re pitching to, you may want to prepare your own version of a term sheet ahead of time to send to an investor after you’ve established a relationship or the investor may follow up your presentation with a term sheet offer of their own. Talk to your legal counsel about the best approach for the particular investment groups. Your counsel may be able to provide you with a sample term sheet to review.
Selling Preferred Stock usually involves (among other things): (1) preferential treatment to preferred stockholders if you sell or liquidate the company or issue dividends, (2) granting a Board of Directors seat to the lead investor(s), and (3) subjecting certain significant future company actions (such as selling new stock, selling the company, or expanding the option pool) to the approval of lead investor(s). Keep this in mind when drafting or negotiating your term sheet.
Corporate clean-up and diligence:
Once you’ve finalized a term sheet with your lead investor, that investor will begin a thorough review of your financial, legal, and business information. This will help that investor ensure it is comfortable investing in your company. Your attorneys and other service providers will help you compile any necessary diligence documents into a data room. Some of this work might involve drafting clean-up documents, such as Board or Stockholder Consents or ratifications that were not previously executed, proprietary information and invention assignment agreements for your employees and contractors to sign, and state business qualifications that have not yet been filed with the appropriate states where you do business.
Generally, the investor will send you and your attorney a diligence request list that outlines the documents and other information they need. Your attorney will work with you to determine the appropriate documents to share, how to respond to other investor requests, and how to quickly and cost-effectively clean up any outstanding documents.
During diligence, you can expect the investor to ask you questions about your company’s performance, structure, and growth plan. Keep in mind that it’s always best to disclose as much as possible. Avoid misrepresenting or exaggerating about any company information. You want to give investors a clear picture of your company. If the investors later learn information that was not properly, fully or truthfully disclosed, they could sue your company, raise securities law violations, and potentially subject you and your company to substantial financial and criminal risks.
Financing document drafting:
The financing documents involved in a Preferred Stock Financing are lengthy, complicated, and robust. Selling Preferred Stock involves granting significant rights and privileges to your investors in exchange for their capital. The financing documents aim to protect both your company and the investors from risks associated with such a major endeavor. Typically, for a large financing, you will see some version of five primary documents:
- The Amended and Restated Certificate of Incorporation (or Articles of Incorporation, depending on your state of organization) will outline all of the rights of the various classes of stock your company will have moving forward, including rights to distribution, liquidation payouts, the setup of the Board of Directors, and conversion of Preferred Stock to Common Stock upon the occurrence of certain events.
- The Stock Purchase Agreement outlines the overarching sale of Preferred Stock and the representations and warranties made by the company and the investors.
- The Investors’ Rights Agreement outlines certain rights afforded to major investors, such as ongoing financial and information rights, the right to participate in future equity sales, the right to appoint a Director to your Board of Directors, and “veto” rights over significant company decisions moving forward.
- The Right of First Refusal and Co-Sale Agreement gives investors a first right to purchase any shares that founders and other key common stockholders might propose to sell to third parties in the future. Additionally, it allows investors to join such a third-party sale.
- The Voting Agreement outlines how the investors, founders, and key common stockholders must vote on future decisions, including decisions related to Director appointment and the potential future sale of the company.
There may be numerous other ancillary documents that your attorneys will draft as well, including a disclosure schedule outlining specific representations, warranties and acknowledgements about the company, Management Rights Letters or side letters granting individual investors specific rights, amendments to your company’s option plan or stock incentive plan, Board and Stockholder Consents approving the financing, officer and secretary certificates to further attest to the representations and warranties, and indemnification agreements for incoming Board members.
Your attorney will work directly with your lead investors’ counsel to negotiate and revise the above documents. You can expect to have several rounds of back and forth with your attorney to discuss any issues and considerations necessary to protect the company’s interests. Additionally, your attorney will need your help to ensure that all information disclosed in the documents is accurate.
Closing and securities filings:
Once all documents are finalized, the closing of the financing itself is relatively straightforward. Prior to closing, the attorney will distribute signature packets and hold all parties’ signatures in escrow, to be released during the closing. The morning of closing, your attorney will file the company’s Amended and Restated Certificate of Incorporation with the appropriate Secretary of State on a same-day filing turnaround. Once that document is successfully filed, all signatures will be released, the documents will be deemed final, and the investors will wire their funds to you. Your attorney can help you communicate with investors to ensure everyone receives final documents and understands their exact investment amounts.
After closing, your attorney will work to make all appropriate federal and state securities filings. Once you receive wires from investors, your attorney will issue electronic stock certificates to those investors representing their ownership in the company. Additionally, they will compile a comprehensive electronic closing binder containing all of the finalized documents, signature pages, and government filings.
Red flags to watch out for:
If you are discussing potential investment with an investor group, keep an eye out for the following red flags. If these situations come up during term sheet negotiations or throughout the diligence process, talk to your attorney about whether the investor is the right fit for you.
- The investor demands too much control over company action moving forward. This is your company. It’s common for the investor to get certain controls, information rights, and protections, but if you’re uncomfortable with the amount of control you’re giving up, it’s okay to push back.
- The investor requires that their legal counsel will draft the financing documents. It is standard practice that the company’s legal counsel draft the documents necessary to effect the Preferred Stock sale. For large fundraises, these documents are usually based on a standard set of documents from the National Venture Capital Association. It is most efficient for your company’s counsel to draft these documents, because your counsel is already familiar with your company and can more easily tailor the documents to protect your needs and considerations. Sometimes investors, especially investors who ask for unique or demanding terms, expect their counsel to draft documents. This usually increases the overall fees in the transaction, results in investor-favorable documents, and requires your counsel to spend significantly more time reviewing the drafts and ensuring they are not unreasonably restrictive or unfavorable to the company.
- The investor requires your company to pay for more than $50,000 in the investor’s legal fees. It’s common for the company to cover a portion of the investor’s legal fees. However, if these fees are capped at more than $50,000–or if they’re not capped at all–you should push back. It is very rare that an investor’s legal counsel should need more than $50,000 to conduct its legal diligence and document review. Often, investors use incredibly expensive law firms that will eventually send you a bill for the full capped amount. This money will effectively come from the investment amount when it could otherwise go towards your working capital.
Fourscore has a few resources that can help you understand this process even better.
- Our Venture Financing Timeline outlines the various stages of the financing process from corporate cleanup and preparation to term sheet drafting and negotiations to post-closing securities filings.
- We recently launched our Preferred Stock Financing Services that aim to condense the initial drafting process and perform that work on a flat fee in order to substantially reduce financing costs. As you’ll notice in the Venture Financing Timeline, there are numerous moving pieces when undertaking such a substantial fundraising effort. Legal document drafting, consulting, and compliance efforts are a significant portion of that process and are a major contributor of the costs incurred by startups.
- Fourscore attorney, Sean Valle, discussed various approaches to and considerations regarding Preferred Stock financings with the startup community “Entre”. You can watch the video of his presentation here.
If you’re interested in learning more about Fourscore’s Preferred Stock Financing Services or the general Preferred Stock financing process, please contact a Fourscore attorney to set up a time to chat. The first call is on us!
Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.