The National Venture Capital Association (US) has prepared various model venture capital documents for use in the industry, including a term sheet (the “NVCA Term Sheet”). These model legal documents are available at www.nvca.org. The American Bar Association has further commented on the provisions in the NVCA Term Sheet, in particular adding commentary including outlining any differences between the California corporations law and Delaware law. A copy of the ABA comments to the NVCA Term Sheet is attached as Exhibit I to this paper.
As a further, review, the following covers the NVCA Term Sheet from a Canadian perspective. The following outlines the key terms for a venture capital investment drawing on the provisions of the NVCA Term Sheet. The following comments and review were delivered at the Ninth Annual IT.Can Conference in Montreal, Quebec on October 27, 2005.
1. General Comment on NVCA/US Terminology. The NVCA Term Sheet refers to certain terms, and is structured in a manner that is a little different in Canada than in the US. Although many of the terms that are outlined in the NVCA Term Sheet apply in Canadian deals and cross-border deals, there are some differences. For example:
- those matters that are set out under the heading “Charter” in the NVCA Term Sheet will be included in the Articles of a company in Canada, but some of the items included in the “Charter” are more likely to appear in a form of shareholders’ agreement;
- stock purchase agreement is a subscription agreement here. The subscription agreement will contain not only representations and warranties of the investee company, but also of the investor with respect to certain required securities (private placement) issues;
- “investor rights agreement” is a shareholders’ agreement; and
- Right of First Refusal/Co-Sale and Voting Agreement will all be incorporated into the terms of the shareholders’ agreement.
2. Structure of Investment
(a) Convertible Preferred Shares or Convertible Debt. In general, a VC will invest by way of preference shares or debt convertible into shares. However, depending upon the terms associated with, in particular, convertible preferred shares, an investee company may find that it ends up with an instrument that will be treated for accounting purposes as a debt instrument. That will affect the investee’s P&L statements which will have implications for its business activities and, possibly, future financing activities. Whether convertible preferred shares are equity or debt (or both) for tax purposes will depend on the ‘substance of the contractual arrangement’.(2)
In general, the ‘philosophical debate’ of whether an investor should be given the preferential protective provisions of a preferred share as well as the upside is over. Investee companies who choose to fund via the venture capital route may, if they are fortunate, have a number of interested VC’s vying for the investment, but they will be debating valuations, not whether or not a preferential security will be issued.
(b) Cross Border Tax Concerns. Canadian investee companies will, if they can, want to maintain the favourable tax treatment afforded CCPC’s(3) which will allow the entity to continue to have access to SR&ED(4) dollars and will result in more favourable tax treatment of employee options and to Canadian shareholders. A US investor may throw off the tax status of the investee company with its investment. However there are ways of structuring the investment by way of exchangeable shares that will ensure that:
(i) no non-resident holds shares with sufficient voting rights to permit the non-resident to elect a majority of the board of investee company (or have the contractual right to do so);
(ii) no group of non-residents can have effective control of the investee company; and
(iii) no non-resident can trigger an acquisition of shares that would give the non-resident voting control (in a manner that would be deemed to have been exercised from the outset).
Option holders have to be considered in this structure and in the numbers of shares outstanding for the purposes of determining residency.
To illustrate a possible structure, a US investor can invest through a US Corp (e.g. it invests in preferred shares in US Corp and US Corp invests in preferred shares of investee company with share attributes that are the same, except that with respect to votes, the preferred shares in US Corp will entitle the holders to that number of votes equal to the lesser of the percentage of votes to which the investor would indirectly be entitled on an as converted basis and 50% of the votes less the number of votes exercisable by other non-resident shareholders on a fully diluted basis. If necessary, you can also have non-US option holders hold through a US company that in turn holds an interest in the investee company, with an exchange right of options to purchase investee company shares for options to purchase US company shares.(5)
While this creates a level of complexity in both the structure of the investment (and therefore cost) the benefits of continuing to access not only SR&ED tax credits but, in particular, refunds, may make this complexity worthwhile.
(c) Milestone based investment. The ABA comments on the NVCA Term Sheet alternative of milestone based investments by VC’s, outlining that such investments may be difficult. Structuring the milestones in a clear enough manner so that there is no ambiguity as to whether or not they can be met is only one of the difficulties. The other difficulty, particularly from the perspective of the investee company is the bright-line test associated with milestones. If an investee company comes very close to its milestone but does not quite reach it, then there are no further dollars available to complete the milestone. Having said that, an investor will want to ensure that an investee uses the initial infusion of cash appropriately and so further rounds will be dependant upon demonstrable ability to meet milestones. Milestone investments are more likely to be in earlier stage investments and in certain industries, e.g. life sciences.
3. Terms of Investment:
The following terms are ‘givens’ in a VC investment, particularly, with a US-led investment. However, while most term sheets will contain these provisions, many of them will have some areas of negotiation. They are set out below under two headings – those terms that are included in an investee company’s articles (or other similar constating documents, depending upon jurisdiction) and those terms that are included in a shareholders’ agreement. The following also assumes that the investment is being made by way of convertible preferred share.
(a) The following terms will be reflected in constating documents:
(i) Voting Rights. The preferred shares will always vote with commons on an ‘as-if’ converted basis. They, will, however, also have separate class rights. The NVCA Term Sheet suggests that the Charter will essentially contain an override to certain matters that shareholders of a particular class would otherwise be entitled to vote on. The ABA comments that, under California law, you cannot alter class rights without a special resolution of the affected class. This issue also arises in Canadian law, where the articles cannot eliminate the right of a class to vote on certain matters.(6)
(ii) Redeemable. If the preferred shares are redeemable by the investee company, the right will not be available to the investee company until the expiry of a certain period, and may also expire after a certain period. If the shares are redeemable, then both the investee company and the VC will have to consider and negotiate not only the multiple for the redemption right but also whether: (i) fewer than all of the preferred shares can be redeemed; and (ii) whether the full redemption right is paid out in full or on a payment schedule and if the latter, what the payment schedule is and what security might exist for it if any. In addition, if negotiating redemption rights, consider whether the investor will require a retraction right (see below paragraph 4(b))
(iii) Dividend Rights. Investee company’s position will be to want to have the preferred shares receive dividends pro rata with common shares. However, more likely that the preferred shares will have dividend rights that are in preference to the common shares. Whether they have cumulative or non-cumulative rights will depend upon the valuation calculation. For example, if the preferred shares have cumulative dividend rights of 8% per annum, payable on liquidation, then the liquidation preference will, over a period of time increase from the otherwise negotiated multiple (see subparagraph (iv) below). Some other issues to consider:
- after the payment of the preferred return, consider whether the preferred shares also share in the dividend rate with the common shares, for example, sharing pro rata entitlement with the common shares after the payment of its preferential return.
- consider the implications of multiple classes of preferred shares – e.g. non-cumulative dividends of 8% payable to Class B’s before Class A Preferreds and before common shares.
- what rate do each class of preferred share get?
(iv) Liquidation Right. The articles will contain provisions regarding liquidation events such as winding up, liquidation, dissolution. Preferred shares will be granted a preferential liquidation right. That preferential right might be negotiated along the following lines:
- Preferred shares are either fully participating, non-participating or capped participating. Fully participating preferred shares will get their preferred amount out first, and then participate rateably with the commons. This is the best situation for investors, although the company will argue it is ‘double-dipping’. Capped participating will set a rate for pro rata participation up to a specified level and then participate with commons up to a particular return. Generally speaking, that cap is a 1X multiple, although in Series C and D rounds that multiple might, in some circumstances, increase to a 2X to 3X multiple.
- Deemed liquidation events on: (i) sale of substantially all the assets; and/or (ii) a change of control. An acquisition is an exit event, so should the investor convert to common or get a preferential return first and then participate with commons on value of sale? A change of control that results from a future financing however, would mean the initial investors cash out even though it is not a defined exit event. The ABA comments to the NVCA term sheet exempt this type of change of control (one resulting from a future financing) from the deemed liquidation provisions.
(v) Conversion.
A. The preferred shares will always have a right to convert to common shares, generally on a 1:1 basis, subject to certain adjustments (anti-dilution protections described in more detail below).
B. In addition to a right to convert, there will be certain events that trigger a conversion (Automatic Conversion):
I. if there is an initial public offering of the investee company’s shares provided that the Automatic Conversion will only occur if the IPO meets certain criteria including that the proceeds realized from the offering result in gross proceeds to the Company of no less than a minimum threshold, that the shares are listed for trading only on certain exchanges, and that the shares are issued at a multiple of not less tha a particular multiple of the issue price;
II. if the holders of a majority of the class of Preferreds vote to convert; or
III. on certain future financing rounds where “pay-to-play” provisions exist (see below for further comment on “pay-to-play” provisions).
(vi) Anti-Dilution. The famous ratchet. The Canadian experience in the down-market did not result in the same degree of draconian ratchet provisions as the US. However, a weighted-average anti-dilution provision is common.
- Weighted Ratchets. Broad-based ratchets are typical; resulting in the effective price after the down round that is a lower price averaged over the new and previous round (total investment in both rounds divided by the number of shares of both rounds, before adjusting for the ratchet shares).
- Full ratchets only in really bad investing climates but, while protecting early round investors, it means that later stage investors when the company needs it most, will see the full ratchet as a negative. An additional consideration with this type of investor protection is consideration for the Founders and management. Consideration should be given to what may need to be done to keep them incentivized, such as re-loading their options.
- What’s excluded? There are two sides to the anti-dilution equation and equally important are those matters which need to be excluded Shares issued to employees under approved stock option plan (always); subdivision of shares etc. (always); securities issued under already issued convertible securities. The NVCA term sheet also includes non-financing share issuances, e.g. equipment financing or banks (do not see this in Canada). The ABA adds others (particularly important if you have to diminish the potential impact of a ratchet) such as “strategic and not a financial nature” (hard to control); securities issued to a target co. as part of the consideration (would add that this is a major event that the investors will want some say in pursuant to a shareholders’ agreement and will participate in at the board level); and securities that are essentially not covered by the protective provisions (in unanimous shareholders’ agreements, all the shares will be covered).
- Inter-connected parts. Consider ‘pay-to-play’ provisions (‘old’ investors with ratchets have to participate in the new financing to trigger the issuance of ratchet shares)(see below) or weighted average anti-dilution provisions connected with more extensive liquidation provisions (the pessimist’s view - at some point, liquidation is the next step after a severe downround). Future round investors may put pressure on initial investors with anti-dilution protection to drop or change their protective provisions.
(vii) Protective Provisions. Can be in Articles, but can also be in shareholders’ agreement. Requirement for a class vote for any major transaction, anything that alters not only its own class rights (which would require a vote in any event) but any other class; redemption or repurchase of shares; changes board size or composition; issuance of any dividends; commitment to any debt (over a particular amount)[note that other than those matters that deal with the Articles or share rights, size of board or nominations, decisions such as payment of dividends are director decisions and would appear in a shareholders’ agreement if the shareholders are to fetter the directors’ discretion] .
(b) Reflected in Shareholders’ Agreement:
(i) Board Participation. Board size/composition/quorum. Board that includes investor representatives. Certain number of nominees for a particular class (e.g. A Preferreds) to sit on the board. Could also have board related rules including number of meetings and committees as well as disclosure e.g. the company will prepare and table every quarter a summary of statutory remittances, source deductions made, notice of litigation, and, if applicable to type of company (ie a concern), environmental compliance.
(ii) Information Rights. Minimum threshold of investment (e.g. 5%) will entitle investor to monthly/quarterly financial statements (the investors are entitled regardless of size to annual financial statements unless they waive (whether voting shares or not) the right to receive such statements)(7) Also – budget information, cap table and access?
(iii) Major Decisions. Certain matters that would otherwise be director or management decisions can require shareholder input. Selling assets, taking on debt and/or granting security interests in assets; management-related decisions including hiring/firing of senior/executive officers; changing the business of the company; selecting an underwriter for IPO or financial advisor for sale.
(iv) Registration and Corresponding Rights Under Canadian Securities Laws. Demand registration rights (confirm if there is a minimum amount raised before this kicks in; how many times company must effect this right and ‘blackout’ period); piggyback registration (subject to rights of company and underwriters to reduce the number proposed to be registered (not to exceed an agreed upon amount).
(v) Pro Rata Participation Rights. Also known as ‘pre-emptive rights’ here(8). Future equity offerings, investors can participate pro rata (note – assuming conversion of all preferreds to commons and, as ABA points out – options and warrants). Also right to purchase any shares not taken up by pro rata right exercise of other investors.
(vi) ROFR’s. The NVCA Term Sheet contemplates a right of preferred shareholders to acquire Founder common shares. Typically, include these provisions here in the ‘restrictions on transfer/right of first refusal’ sections of a shareholders agreement. Term sheet might set out the basic requirements for operation of the ROFR e.g. what time frame for exercise, whether right-holders can acquire more if not all taken up (e.g. two rounds).
(vii) Co-Sale/Drag Along/Tag Along Rights. The NVCA Term Sheet puts these rights in a right of first refusal/co-sale agreement. This would be in a shareholders’ agreement with the investors and founders; but consider drag along rights in the Articles (e.g. percentage of shareholders on a fully diluted basis – 66 2/3%) can require all shareholders to sell. Also consider implications in Option Agreements – they should be part of the drag-along. Also consider in a tag along (or piggy back) two separate thresholds – e.g. a lower one for Founder (or identified key employee/officer) shares (small percentage sold by such person will trigger the Investor tag along) versus a general tag along right e.g based on change of control.
(viii) Employee Matters. Set aside a certain portion, or recognize an already established, employee stock option plan. Key person insurance? Requirement (could be a condition precedent) that each [key] employee has entered into employment agreements/non-competition/non-solicitation agreements/confidentiality/assignment of IP agreements. Have to determine who ‘key’ is – and it may be more than the founders and/or the senior executives.
4. Negotiated Provisions:
(a) Pay to Play.
(i) How we got there: With a difficult tech environment, down-rounds became not only more common, but a greater issue at the time of an initial VC round. The NVCA reported in 2004 that 23% of transactions were downrounds (17% being flat, 41% being up) and 47% of first rounds included ‘pay-to-play’. Investors, without an exit, had to determine which companies in the portfolio to continue to fund. Investors who are willing to risk additional capital, want all of the other investors in for the ride as well and ‘pay-to-play’ provisions are designed to encourage continued participation based on the ‘stick’ not the carrot. Even though markets appear to be stronger, pay-to-play in the US is: (i) increasing; and (ii) include more ‘convert to common’ results.
(ii) What the investors get to avoid: Without pay-to-play, so the theory goes, those who do not play and who continue to hold a preferential security, get to go along for the ride and get the benefit without the burden. There is a built-in motivator to avoid the awkward situation of a member of the ‘syndicate’ breaking ranks from a pro rata inside follow-on.
(iii) How they are structured.
A. Lose future rights to participate (see above)
B. Get a ‘lesser’ grade of preferreds (create preferreds in series to accommodate this)
C. Convert to common, and lose all of the preferential rights on original investment.
WatchMark Corp v. ARGO Global Capital, LLC (Delaware Chancery Court, November, 2004). WatchMark is a wireless networking software company based in Bellevue, Washington. WatchMark wanted to acquire Metrica Service Assurance Software Group. WatchMark’s board of six had 5 VC nominees, one of which was a nominee of ARGO. The board approved the merger in 2004. At the same time as the merger negotiations were going on, the board was also negotiating the issuance of a new series of preferred shares to finance the acquisition. All of the investors were invited to participate. A number of investors had agreed to the terms of the financing including the conversion of outstanding preferred shares of non-participants, to common stock. ARGO informed WatchMark that it would not participate in the financing.
The WatchMark charter provided protective provisions requiring consent of each series of preferred stock to any ‘adverse charter amendment’ as well as a ‘no-impairment’ clause. But, it did not contain words “whether by merger, consolidation or otherwise” which have been determined as necessary in order to clarify that adverse changes to preferred stock are intended to be blocked not only where the issuer’s charter is amended, but also if there are adverse changes effected through a merger.(9) As those words were not in the charter, WatchMark formed a wholly-owned subsidiary, merged with it and successfully eliminated ARGO’s ability to block the financing transaction.
ARGO then argued that the board breached its fiduciary duties by approving transactions that would result in the forced conversion of ARGO’s preferred stock into common stock. The court, however, concluded that, because all preferred shareholders were treated the same way with respect to ‘pay-to-play’, the board had not breached its fiduciary duties. In particular, all series of preferred shares lost their protective rights, not just the series held by ARGO. Also all preferred shareholders including ARGO could have participated in the financing and therefore it was only a preferred shareholder’s decision not to participate that ‘caused’ the conversion to common stock (ie the preferred shareholder shot itself in the foot). As a final comment, ARGO had indicated a willingness to participate, but only if the deal terms were sweetened.
Hints – allow all preferred shareholders to participate in pay-to-play and, if possible, have all preferred shareholders participate in negotiating its terms. Make sure protective provisions are comprehensive. The new provisions should only affect a party’s pre-existing investment to the extent of that party’s non-participation in the next round.
Dissenters rights? Section 238 Business Corporations Act (BC) and section 244, a dissenting shareholder may require the company to repurchase its shares.
(b) Retraction Rights. In addition to the terms outlined above for redemption rights (see paragraph 3(a)(ii)), investors may want retraction rights (likely will end up with redeemable on the same time-frame (eg. retractable after 5 years, if redeemable after 5 years, if can redeem a portion, can retract a portion). Consider timing of repayment (e.g. quarterly over two year period, or annually over 4 year period etc.). If payment over time, does the investor also secure against the assets of the company as a creditor entitled to collect the indebtedness of the company to the investor for repurchase of the shares? Are there other ‘note-holder’ types of provisions and covenants that the investor gets while waiting to get paid out in full. Note that retraction rights after a particular period will result in the preferred shares being classified as a debt instrument (see comment at 2(a)).
"Exhibit 1 - Term Sheet" may be seen as an appendix to this article at the link given below. |