Capital for your startup typically comes from one of three places: self-funding, debt financing, or equity financing. If you’ve chosen to raise capital through equity financing that means you are most likely relying on investors. Money is never free; even Uncle Sam gets his share if you win the lottery. Investors expect a certain amount of return and/or equity in your company when they invest. Yet, you still need to protect your interests and not give away the farm. Protecting your stake in your startup requires clear and formal documentation to solidify any agreement you make with investors.
Proper documentation is even more important if this is your first time starting a business. A solid foundation will help you avoid nefarious investors who might try to take advantage of your lack of experience. Below is a broad overview of some of the most common legal documents used with investors:
One of the first documents you’ll come across is called a “Term Sheet.” Depending on the investor (or transaction as a whole) a term sheet may or may not be legally binding. Regardless, a Term Sheet can serve as evidence of each party’s intent, in the case of a dispute. A Term Sheet contains many (if not all) of the elements of an agreement with an investor, which will be referenced in other documents. An investor should provide you with a Term Sheet to formalize his or her offer. It can include things such as intended purchase price, exclusivity, indemnification rights, and closing conditions.
Amended & Restated Corporate Documents
Whether you are receiving seed capital or Series A financing for your startup, it’s likely you will need to promise preferred stock to your investor(s). This means you (may) need to prepare certain director/shareholder resolutions as well as amend and restate your; (i) By-laws and (ii) Certificate of Incorporation. These actions will allow you to authorize the creation of different classes of stock if you have not already done so. Your investors might also request other changes to various agreements you have, so it’s imperative you consult with a startup lawyer.
Preferred Stock Investment Agreement
The details of the Preferred Stock Investment Agreement, sometimes called a Stock Purchase Agreement, typically come from the Term Sheet. This document formalizes much of the term sheet and has very specific terms including purchase price, representations, indemnification, and closing conditions, such as liquidation preference.
Investor Suitability Questionnaire
In some cases, the Securities and Exchange Commission (SEC) requires investors to complete an Investor Suitability Questionnaire (example here). The SEC explains, “The purpose of this questionnaire is to solicit certain information regarding your financial status to determine whether you are an ‘Accredited Investor,’ as defined under applicable laws.” Soliciting an investor from an individual who is not an Accredited Investor could have serious consequences for your startup. It’s important to do your due diligence and follow applicable state and/or federal securities laws.
Investor’s Rights Agreement
Possibly one of the most important documents in a venture capital deal for your startup company is the Investor’s Rights Agreement. The title suggests it protects the investor, but the specific terms in the agreement are the legal documentation that guides almost all aspects of the agreement besides the purchase of stock. This agreement outlines protective provisions for preferred stockholders. These provisions can include:
- Participation rights refer to an investor’s right to receive proceeds upon the sale of the company. Preferred stockholders receive their initial investment, but can also negotiate to participate in net proceeds with common stockholders.
- Redemption rights belong to the investor (shareholder) and allow them to force you to repurchase their shares. Investors include this provision as a way out if your business fails.
- Registration rights. Startup businesses typically rely on exemptions to avoid the costly and burdensome process with the SEC. If an investment agreement includes registration rights, this means your investor can force you to file a registration statement with the SEC.
- Conversion rights refer to the right of investors to convert their Preferred Stock to Common Stock in certain events. The most common event to trigger conversion is a company’s initial public offering (IPO). The investor’s rights agreement typically includes a negotiated multiplier—that a number times the Preferred Stock Price to determine the number of Common shares they receive.
You need capital to grow and scale your start-up, but it’s important to protect your company’s interest. Contact The Law Office of Elliot J. Brown for your questions about investment agreements.