Part one in a series of seven articles overviewing founders’ rights on a term sheet.
Raising institutional capital for a startup company is a full-time job for founders, especially those founders in chief executive officer and chief operating officer roles who will typically take on the bulk of the pitching, negotiations, and interfacing with legal counsel. The effort, time, and sacrifices that are made during the pitch phase of the process become worthwhile when the company receives a term sheet from a lead investor. It is a moment of validation and excitement that affirms the business and propels the company with traction to fill the round. It is also generally the point in time when the legal team becomes more hands-on in the financing process and things speed up quickly in anticipation of closing. From a legal standpoint, the term sheet is generally a non-binding agreement (with a few exceptions) but from a business standpoint, the term sheet creates an understanding on the key economic and control rights that is difficult to renegotiate under the definitive agreements.
Although the venture capital world has agreed on a set of template model documents prepared and updated by the National Venture Capital Association (NVCA), the terms and conditions of these documents are highly complex and customizable from deal to deal. An immense amount of education is required for first-time founders to understand the interworkings and nuances of the transaction documents. The document set encompasses the main corporate governance documents of the corporation, including the Certificate of Incorporation, Investors’ Rights Agreement, Right of First Refusal and Co-Sale Agreement, and Voting Agreement as well as the deal-specific documents.
Certificate of Incorporation
Delaware: It’s the Startup Founder’s First State Too
It’s important to note that institutional investors often require that the corporation is incorporated in Delaware. The NVCA summarizes the following reasons for this requirement, which include:
- “The Delaware General Corporation Law (“DGCL”) is a modern, current, and internationally recognized and copied corporation statute which is updated annually to take into account new business and court developments;
- Delaware offers a well-developed body of case law interpreting the DGCL, which facilitates certainty in business planning;
- The Delaware Court of Chancery is considered by many to be the nation’s leading business court, where judges expert in business law matters deal with business issues in an impartial setting; and
- Delaware offers an efficient and user-friendly Secretary of State’s office permitting, among other things, prompt certification of filings of corporate documents.”
As a result, this article focuses on Delaware corporations only and does not consider any alternative entity structures or states.
The Certificate of Incorporation
The Certificate of Incorporation is a key document prepared in connection with a venture capital investment, which among other items, establishes the rights, preferences, privileges, and restrictions of each class and series of the corporation’s stock. The Certificate of Incorporation is filed with the Delaware Secretary of State’s office to amend and restate the corporation’s Certificate of Incorporation immediately prior to the initial closing of the transaction. Under the standard long-form NVCA term sheet, the key terms for the Certificate of Incorporation are organized under the header “Charter” and include the control rights (voting rights and protective provisions) and the economic rights (dividend rights, liquidation preference, optional and mandatory conversion rights, anti-dilution provisions, and sometimes includes the company-favorable “pay-to-play” rights and/or investor-favorable redemption rights). This article narrows in on the control rights in the Certificate of Incorporation and the next article will focus on the economic rights.
Control Rights
Requisite Holders Threshold
The “Requisite Holders” threshold is a definition in the Certificate of Incorporation and sometimes referenced throughout the other transaction documents regarding voting requirements. The purpose of this threshold is to define the vote required by preferred stockholders in order for the company to take certain actions, e.g., sale of the company and license of the company’s assets. Often this threshold is set as the holders of greater than 50 percent of the outstanding shares of preferred stock; however, sometimes lead investors will try to require that this threshold must include their single vote even when they do not hold a majority of the preferred stock, which provides the lead investor with an essential veto right over any key company actions. Founders should cautiously review the Requisite Holder percentage in the term sheet and ensure that they understand the implications when multiple series of preferred stock, anti-dilution protections, and conversion rights are present.
Protective Provisions
The protective provisions section of the Certificate of Incorporation lists corporate actions that the company cannot take without first receiving the affirmative written consent of the preferred stockholders (generally the Requisite Holders threshold). The protective provisions are designed to protect the investors against the company making key decisions without the stockholders having a say. If the company takes an action without complying with the protective provisions, then that action would be deemed void ab initio (void from the beginning). In the company’s early capital raises, i.e., Series Seed and Series A, these protective provisions tend to be more limited as to not create administrative burdens and added legal expenses to the company’s post-closing operations. As the company raises additional capital, the list tends to expand and is sometimes divided among series of preferred stockholders to provide for tiered voting and give the more valuable preferred stock series isolated control.
Over time, the NVCA has expanded the list in the template Certificate of Incorporation to be comprehensive for investors, but founders should review these protections in detail to ensure alignment with the company’s post-closing operations. There are a few common ways to reduce the impact of the protective provisions, including:
- Removing the stockholder voting requirement if the board of directors approve an action;
- Adding qualifications so the voting right only applies if such action would adversely impact the preferred stock; and
- Setting value thresholds that trigger the voting right (e.g., indebtedness over $5,000,000).
Some investors state “customary protective provisions” in their form term sheets, which often results in the investor requiring the full suite of voting rights. If important to the founders, the exact protective provisions should be listed out in the term sheet to avoid intensive back and forth negotiations.
These two categories are part and parcel to the company’s post-closing operations. Founders should exercise care when agreeing to the Requisite Holders threshold and Protective Provisions at the term sheet phase to mitigate providing investors with an off-market and outsized amount of control.
Disclaimer: This material is intended for general information purposes only and does not constitute legal advice. For legal issues that arise, the reader should consult legal counsel. The NVCA model documents referenced in this article are the current documents as of the date of publication and do not include any updates that may occur thereafter.
