Series A preferred stock entices venture capital investors to fund start-ups with the promise of substantial returns down the line. This kind of financing is often the first big move companies make to grow with outside support. The process is guided by the Series A Preferred Stock Agreement.
The Series A Agreement does more than secure preferential stock options; it also lays the groundwork for an important investment relationship. Functioning like the hub of a wheel, the purchase agreement is the place from which other contract terms flow. These include clauses that protect investors and companies alongside reps and warranties that encourage transparency between parties. There are also industry-specific provisions and other considerations that make this a complex document. Overall, the Series A Preferred Stock Agreement lays the groundwork for an economy increasingly dependent on venture capital investments.
Questions in this Episode
- What’s the purpose of a Series A Preferred Stock Agreement?
- Which are the ancillary documents that support a Series A agreement?
- What are the missing representations and warranties in this agreement?
- How is the language in a dispute resolution clause different in a simple vs complex scenario?
- What’s the best route to raising money as a company?
When Does a Series A Preferred Stock Agreement Enter the Picture?
Series A Preferred Stock Purchase Agreement (“SPA”), governed by Delaware law, is designed to memorialize venture money to the company. It usually comes into play after a startup company has been running for a couple of years and is looking to issue common stock.
Incorporating Ancillary Documents Into the Parties’ Intentions
When someone gives a company money, they need a lot of protection. This happens via different documents that support the main stock agreement.
1) Amended & Restated Certificate of Incorporation
This restates the classes of stock and their various rights. Frequently, this will also memorialize how many board seats a venture capital investor gets.
2) Indemnification Agreement
This agreement helps in indemnifying the officers and directors of the company. In some cases, a director will serve as a nominee of one or a group of directors. Frequently, Venture capital funds will request indemnification not only for the individual directors but for the funds themselves.
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(g) “Indemnification Agreement” means the agreement between the Company and the director designated by any Investor entitled to designate a member of the Board of Directors pursuant to the Voting Agreement, dated as of the date of the Closing, in the form of Exhibit E attached to this Agreement. |
3) Investors’ Rights Agreement
This defines the rights that investors have for information, registration, rights of first refusal, and preemptive rights. The more significant aspect of the investor rights agreement is registration. If the company decides to have a larger private capital raise under Reg D, investors would like to be involved. If it’s going public, investors want to be involved with the drafting of the registration statement and all the filings with the FCC. In other words, the investors want to have an active voice at the table.
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(h) “Investors’ Rights Agreement” means the agreement among the Company and the Investors and certain other stockholders of the Company dated as of the date of the Closing, in the form of Exhibit G attached to this Agreement. |
4) Management Rights Letter
The US Department of Labor, which is charged with administering an ERISA, has issued regulations that contain certain exemptions from the plan asset rules, and under one of those exemptions, an investor in a company needs to be qualified as a venture capital operating company. That means it needs to have 50% of its assets invested in venture capital investments. The management rights will be defined in the letter which can be shown as proof of qualifying as a venture capital operating company.
5) Right of First Refusal Agreement
The existing or new shareholders during an additional capital raise would want to avoid dilution. They would do that by being a party to a capital raise to maintain their percentage interest in the company.
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(n) “Right of First Refusal and Co-Sale Agreement” means the agreement among the Company, the Investors, and certain other stockholders of the Company, dated as of the date of the Closing, in the form of Exhibit H attached to this Agreement. |
6) Voting Rights Agreement
This agreement sets forth the board composition requirements for investors, giving them their rights and how the board is going to be operated. It also defines drag-along and tag-along rights. Drag-along rights are the rights that give the majority owners the right to force minority owners to join the sale of a company and tag-along rights are the mirror opposite which give co-sale rights. If a majority stakeholder sells the stake, the minority stakeholders wish for a voice at the table as well.
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(s) “Voting Agreement” means the agreement among the Company, the Investors and certain other stockholders of the Company, dated as of the date of the Closing, in the form of Exhibit J attached to this Agreement. |
Whether it be the purchase or the indemnification agreement, they are modeled after the National Venture Capital Association standard template documents that makes it useful as documents become predictable.
Achieving Transparency with Representations and Warranties
The purpose of the Company’s representations is primarily to create a mechanism to ensure full disclosure about the Company’s financial condition, litigation status, key employees, and business to the investors.
Authorization in section 2.4 is frequently litigated. It’s a representation that the company has all the right authorizations to amend the certificate of incorporation, issue new stock, and include guardrails.
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2.7 Litigation. There is no claim, action, suit, proceeding, arbitration, complaint, charge or investigation pending or to the Company’s knowledge, currently threatened (i) against the Company or any officer, director or Key Employee of the Company; or (ii) that questions the validity of the Transaction Agreements or the right of the Company to enter into them, or to consummate the transactions contemplated by the Transaction Agreements; or (iii) that would reasonably be expected to have, either individually or in the aggregate, a Material Adverse Effect. Neither the Company nor, to the Company’s knowledge, any of its officers, directors or Key Employees is a party or is named as subject to the provisions of any order, writ, injunction, judgment or decree of any court or government agency or instrumentality (in the case of officers, directors or Key Employees, such as would affect the Company). There is no action, suit, proceeding or investigation by the Company pending or which the Company intends to initiate. The foregoing includes, without limitation, actions, suits, proceedings or investigations pending or threatened in writing (or any basis therefor known to the Company) involving the prior employment of any of the Company’s employees, their services provided in connection with the Company’s business, any information or techniques allegedly proprietary to any of their former employers or their obligations under any agreements with prior employers. |
The Company is required to list any deviations from the representations on a Disclosure Schedule, the preparation, and review of which drives the due diligence process on both sides of the deal.
Some lawyers prefer to deliver the Disclosure Schedule separately, instead of as an exhibit to the SPA so that the Disclosure Schedule will not have to be publicly filed in the event the Stock Purchase Agreement is filed as an exhibit to a public offering registration statement.
Missing Representations and Warranties
1) Real Estate
This applies to the Foreign Investment Real Property Tax Act of 1980 (FIRPTA). This particular real estate representation is appropriate in the case of foreign investors. For example, non-resident aliens. This representation will state that there is no firm, implying that the company does not have any real estate holdings outside the United States that would trigger a withholding tax situation.
2) Qualified Small Business Stock
Section 12 (02) of the Internal Revenue Code provides for a 100% exclusion from taxable income for gains recognized on the disposition of certain stock. This applies to start-up companies that have been in business for at least five years.
3) Representations for Foreign Companies or Investors Outside the United States:
1) Foreign Corrupt Practices ActThis is a representation that the company has not been actively involved overseas, and is not bribing people. This is a fairly easy one for most legitimate companies to make.
2) Export Control LawsThis means that the company has adhered to the Office of Foreign Assets Control or AFAC.
3) CFIUSThe Committee on Foreign Investment in the United States has a representation that none of the investment should be put into the defense industry.
Representations and warranties insert transparency into the document but these cannot replace the need for due diligence in any of these transactions. - Marc J. Halsema #ContractTeardown Click To Tweet
The Simple and Complex Sides of Dispute Resolution
The company raising capital will usually draft the documents as opposed to the company that has the money. On the simple side, parties will do everything under state law to resolve a dispute in the local courts. The language of the provision would include both sides waiving a jury trial and taking their dispute to court.
On the more complex side, there have been situations that require binding arbitration under the American Arbitration Rules or if it’s a Delaware company under the Delaware River Act. Each side gets to pick an arbitrator and they then pick a third arbitrator.
Companies Raising Money – What’s a Good Route?
Raising money via the private transaction route is a good idea. The U.S. securities laws are less onerous in terms of compliance for private transactions. If you go above $5 million, a certain additional layer of disclosure needs to be done. You would need accredited investors when you are doing a private transaction.
If it’s a public transaction, a SPAC, or a public offering, it would involve a whole other level of disclosure compliance. If it’s a public company, you would need a registration statement and filings with both the FCC and the state securities regulators. So, going private is a lot easier when it’s a smaller transaction.
Show Notes
In this episode of Contract Teardown, attorney and business advisor Marc Halsema talks venture capital as he tears down a Series A Preferred Stock Agreement. These contracts secure big investments by promising preferential stock incentives. They also contain ancillary clauses and reps and warranties that protect both parties and set a strong foundation for the investment relationship. Watch as Marc tells us about industry-specific contract variations–and stay to the end to get some insider advice on raising capital!
THE CONTRACT: SERIES A PREFERRED STOCK PURCHASE AGREEMENT
THE GUEST: Marc J. Halsema serves as an outside counsel to family offices, successful entrepreneurs, and startup companies looking to raise capital.
THE HOST: Mike Whelan is the author of Lawyer Forward: Finding Your Place in the Future of Law and host of the Lawyer Forward community. Learn more about his work for attorneys at www.lawyerforward.com.
If you are interested in being a guest on Contract Teardown, please email us at community@lawinsider.com.
Interview Transcript
Mike Whelan [00:00:00] Mark Halsema, thanks for joining us on The Contract Teardown show. How are you today?
Marc Halsema [00:00:51] I’m doing terrific. Thanks, Mike.
Mike Whelan [00:00:53] I appreciate you being here. We’re talking about a document. I’m going to share the document with the folks at home real quick. This is a Series A Preferred Stock Purchase Agreement. And before we dig into it, Mark, why don’t you tell us what this thing is? When are we going to see this kind of a document? Why is it important for us to understand?
Marc Halsema [00:01:10] Well, that’s a great question, Mike. Series A Preferred Stock Agreement usually comes into play when a private company–and all of this is private–is looking to raise venture capital for its company. Usually, it comes after a startup company has been running for a couple of years, and they’ve issued common stock, maybe in different classes of common stock to the founders and the initial officers and directors. And now they’re looking for big money. And that’s where the Series A Preferred Stock comes in, because usually that’s some type of institutional venture capital investor.
Mike Whelan [00:01:44] Perfect. And there’s a lot to talk about there. Before we dig into it, Marc, tell us about your background. What brings you to documents like this?
Marc Halsema [00:01:53] I serve as an outside general counsel to families, family offices, successful entrepreneurs, start-up companies that are looking to raise capital, and I frequently get involved with drafting these types of agreements on behalf of companies that are looking to attract investment.
Mike Whelan [00:02:10] That’s great. That’s exactly the background that we need to talk about this Series A situation…we can talk about raising money for me later. My wife wants me to go do that, but we’ll talk about the ups and downs of that. But before we get there, let’s go through the agreement. There’s a lot to this. You know, when you’re raising money, there’s a lot of protection that needs to happen for the person giving money. So let’s talk about what some of those are. I wanted to start with ancillary agreements. As I’m looking through the definitions section, going down into page four and five, there are references to several other documents: Indemnification Agreement, Investors’ Rights Agreement, Co-Sale–Right of First Refusal and Co-Sale Agreement, Voting Agreement. Talk to us about these other ancillary documents, how they’re being referenced here, and how to make sure that they’re incorporated into the party’s intentions.
Marc Halsema [00:02:59] Right, exactly. The purchase agreement itself is sort of the hub of the wheel, as is the case with many types of legal agreements. There are other agreements that sit side by side and a Series A Stock, you know, Preferred Purchase Agreement has a number of agreements side by side. In addition to the ones that you’ve mentioned, Mike, there’s an amended and restated Certificate of Incorporation. And I’ll preface my comments by saying everything I’m going to refer to in this conversation is going to be based on Delaware law. People can choose different laws, of course, but this particular agreement is governed by Delaware law. And so are some of the ancillary agreements. Starting with the amended and restated Certificate of Incorporation, it’s going to restate the classes of stock and their various rights. Frequently that will also memorialize how many board seats a venture capital investor will get. The Indemnification Agreement, that’s really about indemnifying officers and directors of the company. In some cases, a director will serve as a nominee of one or a group of directors. But because venture capital funds with director nominees may be named as parties or otherwise incur expenses in connection with litigation against their director nominees, frequently, those venture capital funds will want to have indemnification not only for the individual directors, but for the funds themselves. The Investor Rights Agreement is really just as it says: it defines the rights that investors have for information, registration rights, rights of first refusal, preemptive rights. And I think the more significant aspect of the Investor Rights Agreement is really around registration. Should the company decide it’s going to have a much larger private transaction–a private capital raise under Reg D, they want to have a seat at the table. Or if it’s going to go public, they want to be involved with the drafting of the registration statement and all of the filings with the FCC. In other words, the investors want to have an active voice at the table. The Management Rights Letter, that’s very specific to ERISA. The US Department of Labor, which is charged with administering ERISA, has issued regulations that contain certain exemptions from the plan asset rules. And under one of those exemptions, an investor in a company needs to be qualified as a venture capital operating company, and that means it has to have 50 percent of its assets invested in venture capital investments. And so the venture capital fund is looking to invest several million dollars into a private company will ask the management of the company to issue a letter that the management rights are defined in the letter and that should there be a question from the Department of Labor regarding ERISA plan assets, they have a management rights letter that shows that they do qualify as a venture capital operating company. The right of first refusal agreement is just as it sounds. People who are existing or new shareholders, if there’s going to be an additional capital raise, they want to avoid dilution. And by that, they want to be able to be party to a capital raise in order to maintain their percentage interest in the company. And lastly, the Voting Agreement, and again, I’ve seen most of these agreements in connection with Series A preferred stock transactions. The National Venture Capital Association has been good enough over the years to promulgate standard template documents around all these so frequently, I see either in reviewing documents, any of these particular agreements, whether it be the purchase agreement or the indemnification agreement, et cetera, modeled after the National Venture Capital Association templates. And so that makes it very useful because it becomes predictable. But lastly, the Voting Agreement. The Voting Agreement sets forth board composition requirements for investors, giving them their rights and in terms of how the board is going to be operated. But also defines drag along and tag along rights. Drag along rights being the rights that give the majority owners the right to force minority owners to join in the sale of a company, and a tag along right, which is the mirror opposite which gives co-sale rights if a majority stakeholder sells the stake, the minority stake holders, they want a voice at the table as well. So in addition to the agreement that we’re talking about today, Mike, frequently in these kinds of transactions, you’ll see any or all of these ancillary agreements that I just described.
Mike Whelan [00:07:51] Well, and I wonder, maybe this is a basic question, but as a drafting exercise is, is this the way to do that: to incorporate these other documents through the definitions section? Do you like this approach or is there a more transparent way or maybe a more efficient way to do that? What do you think about them being plugged into the definitions section like this?
Marc Halsema [00:08:08] Well, I think it’s important to have them front and center because not only are they in the definitions section, they are also frequently exhibits to the main agreement. As I mentioned earlier, the purchase agreement itself is really the hub of the wheel, and you have all these various agreements that are side by side and all of which fit together like a puzzle, if you will–
Mike Whelan [00:08:30] –so you’re kind of identifying what all the spokes are, and so you gotta make sure–the nice thing about a definitions section, to your point, is it’s up at the top! And so if you sale out those spokes early, that makes a lot of sense. Well, let’s jump down to section two. It is the representations and warranties section, which I assume is a big part of this because that transparency is the really the value that the money-giver depends on. We’ll start with the 2.4 authorization. There are some limits here. Talk to me about the reps and warranties section and 2.4 specifically.
Marc Halsema [00:09:02] Well reps and warranties generally are a long laundry list of statements that a company will make about its financial condition, its business operations, its current status of litigation, its key employees, etc. I mean, it is a list that will go on several dozen sections. I chose authorization and litigation simply because those are the ones that have frequently–can be litigated. If something goes haywire in one of these transactions, the authorization is simply a representation that the company has all of the right authorizations to amend the certificate incorporation issue, the new stock, and it will also set up some guardrails within the authorization section, that indemnifications can come only through the indemnification agreement or the investors’ rights agreement. So I chose authorization because there’s a textbook example as to how these ancillary agreements, the hub and spoke documents in this transaction, come into play. The litigation section 2.7, rep and warranty is…it’s an unqualified litigation representation, meaning there’s no litigation, you know, flat out full center in a Series A offering is rather typical, but it may be different in a later financing because transactions become much more complicated.
Mike Whelan [00:10:39] Mm-hmm, yeah, I’m wondering about the “pending” or “to the company’s knowledge” or “currently threatened.” You know, I assume that that sort of knowledge goes to those key employees as well so that the representation is coming from the chiefs, you know, that are signing this document.. through the lawyers. But to the point here that it also can’t be against any director or key employee of the company, their knowledge, I assume, is imputed in that as well. Well, you know, representations and warranties get long, presumably in a document like this, because that transparency again, is really important to the company giving money. But I know that you are seeing some stuff missing from this section that we might put in here to protect that transaction. What kind of sections might you also see in the reps and warranties?
Marc Halsema [00:11:29] Any number of them, particularly if an investor is a foreign company, but even if the company is not a foreign company–I’m sorry, if one of the investors is not a foreign company, you’ll see certain reps and warranties. None of the reps and warranties I’m about to mention exist in the current document that we’re tearing down, but I’ve seen them in many others, and they’re going to be important for a drafter considering this type of agreement. One is around real estate, and this is applicable to FIRPTA, FIRPTA being the Foreign Investment Real Property Tax Act of 1980. This particular real estate representation is appropriate if there are going to be foreign investors–nonresident aliens, for instance–involved in the transaction. And usually this representation will state that there is no FIRPTA, meaning we mean that the company does not have any real estate holdings outside the United States, which would trigger a withholding tax situation. Another area that–and again, this is not necessarily for foreign investors at all–is a Section 1202 qualified business stock representation. Section 1202 of the Internal Revenue Code provides for a 100 percent exclusion from taxable income for gains recognized on the disposition of certain stock held for at least five years. And certain companies–and again, this is applicable to start-up companies that have been in business for a short period of time, but at least five years–that they may be able to qualify for a Section 1202 qualified business stock deduction. And perhaps in this particular transaction, it didn’t didn’t qualify, it wasn’t applicable. But for start-up companies that have been in business for at least five years, I have seen that quite frequently. With respect to foreign companies or investors that are outside the United States, they’re usually at least three other representations and warranties that I see in these kinds of transactions. One is the Foreign Corrupt Practices Act, representation that the company has not been actively involved overseas, has not been bribing people, has not been making payments, is a fairly easy one for most legitimate companies to make. There’s also representation for around export control laws and a representation that the company has adhered to the Office of Foreign Assets Control, or OFAC. And finally, there is a representation that I’ve seen quite frequently that under CFIUS, which stands for the Committee on Foreign Investment in the United States, that none of the investment is, to put it simply, related to the defense industry. Back in the 1950s, there was legislation passed that made it clear that investment in the United States couldn’t touch the U.S. defense industry for all sorts of obvious reasons. You know, my last comment on reps and warranties and I’ve seen this countless times, is that depending on the particular rep or warranty, there will be an exhibit or a deliverable or disclosure schedule for each of these different reps and warranties. And so you may have pages and pages of disclosure reps for the issuing company, and of course, for the investor as an addendum to the agreement itself.
Mike Whelan [00:15:06] I’m curious, and again, this is probably a basic question, but I’m thinking about the nature of these transactions and the power relationship between the two sides, the person who’s got–the company who’s got the money and the company who wants the money. It–I’m assuming in these kinds of transactions, there’s a lot of due diligence to be done, that the company who’s giving the money wants to know and good practice would say, go dig, you know, send investigators and find out about everybody’s background or whatever. It sort of sounds like they’re using the reps and warranties in this kind of document to shift that burden a little bit and say, “You know what, I’m not going to do due diligence. I’m just going to make you promise me that you gave me the equivalent of due diligence. Is this, you know, sort of being used as a way to shift responsibility for the digging? Or is this just good practice?
Marc Halsema [00:15:58] In the realm of good practice, you’re absolutely right that giving a rep or warranty that we have no litigation, we have no environmental concerns, we could be complied with CFIUS and Foreign Corrupt Practices Act, et cetera. And where the reps and warranties come into play, of course, is if there’s a breach or if there is a misrepresentation that obviously can unwind the deal or cause litigation down the road. So the due diligence–there’s no replacing the need for due diligence in any of these transactions. And that’s usually done these days, done virtually, and you get reams and reams of documents that you have to review. But to cut to the chase, then you have a rep or warranty that you can hang your hat on. If you’re the investor, you can hang your hat on. And if there’s some screw up or some misrepresentation, it gives you a right to pursue litigation.
Mike Whelan [00:16:53] Got it! Yeah, that makes a lot of sense and relevant to that as we jump down to 8.13 and dispute resolution, you know, the power structure often comes out in these relationships in the dispute resolution section and who’s giving up what. And so I wanted to ask you in these kinds of contracts, in these kinds of documents, as a background question, who’s usually drafting these? I assume that the starting drafter is the company with the money because they’re–in a Series A anyway–they’re able to pick and choose. Is that accurate? And as we jump to the dispute resolution section, does that reflect the power structure or are you seeing arbitration-like language, which is common when you know there’s one party in power is the one that’s drafting? What’s the power relationship between these two sides in this document and how does that impact this dispute resolution section?
Marc Halsema [00:17:45] Well, you know, common practice is for the company that’s looking to raise the capital will draft the documents as opposed to the company that has the money. So for instance, in this context, I’m guessing that it was Comstock Mining or the lawyers for Comstock Mining that drafted all the documents. And that’s rather typical, you know, either a buyer or an issuer, in this case, of the security, will draft the documents. And then the other side gets to pick and choose. As it relates specifically to dispute resolution, I’ve seen it on the simple side, which means they’ll do everything they can under a particular state law to resolve a dispute and they’ll take it to the local courts and typically there is–there’s language that, you know, both sides waive a jury trial and they’ll simply take their dispute to court. That’s on the simple side. On the more complex side, I’ve seen situations that require binding arbitration under the American arbitration rules or if it’s a Delaware company under the Delaware R-[muffled] Act. And there you have, each side gets to pick an arbitrator and then the arbitrators pick a third arbitrator and it becomes actually quite complex. But, you know, usually the common practice is for the issuing company or the buyer in an M&A transaction to be responsible for drafting the documents.
Mike Whelan [00:19:24] Awesome. Well, as we wrap up, I’m thinking about money raises. I read a book recently that talked about VC world and basically argued that VC world is going to take the American economy down because it creates these sort of perverse incentives and who’s in charge and how they get to dictate. But I read, as I occasionally do, I was surfing around the Social Science Research Network and reading academic articles because I was bored this morning and there was a study done of a group of companies that received money versus a group of companies that didn’t, and there was an 85 percent increase in sales for the companies who received the money. So stepping back from this kind of stock purchase agreement and just the idea of raising money for companies that are in this position, that they’ve got enough success, that they can raise money. Talk to us about the context of choosing this as a path versus bootstrapping versus some other path and how you advise companies on making that choice.
Marc Halsema [00:20:22] I like to go through the private transaction route. Depending on the amount of capital being raised, if it’s a relatively small amount, less than $5 million, the U.S. securities laws are less onerous in terms of compliance, in terms of a private Reg D transaction. If you go above $5 million and it becomes this, you know, certain additional layer of disclosure that needs to be done. And of course, you have to have accredited investors when you are doing it in a private transaction. But it becomes a public transaction, a SPAC or a public offering, that’s a whole other level of disclosure, compliance, certainly, in terms of the complexity of documents, legal documents that need to be provided. If it’s a public company, of course, you have to have a registration statement and you have to have filings with both the FCC and the state securities regulators. So the private is a lot easier, so long as it’s a smaller transaction. I mean, but whether it’s public or it’s private, the overwhelming challenge for a company that’s looking to raise capital is not only to identify people who are interested in investing in your company, but what kind of control are you going to give up? OK. You know, when we talk about some of these ancillary agreements, particularly around a voting agreement and management rights agreement, we’re talking about giving up a certain amount of control of your company to an outside investor. And for a start-up company, that’s a really important river to cross. So bottom line, private transactions, particularly if it’s sub $10 million, but there’s always going to be the issue or concern about investor control and that’s really where the negotiation and the horse swapping comes with an outside investor in terms of control.
Mike Whelan [00:22:27] Well, if my wife finally persuades me to raise money for our YouTube slash cat and bird home that we have business, I’ll be sure to keep it under $5 million for simplicity’s sake. Mark, I appreciate you joining us, and this breakdown: If my wife does persuade me to raise money, where do I call you? What’s the best way to reach out to you if people want to learn more about your background and transactions like this?
Marc Halsema [00:22:50] Absolutely. The name is Marc Halsema. The best email address is j-a-c-l-i-s-e, jaclise (which is a contraction of my two children’s names, Jacob and Elise), at live dot com.
Mike Whelan [00:23:06] Awesome. Well, I appreciate it, Mark. We’ll have that information as well as links to this document and maybe even my random SSRN article that I read this morning over at Law Insider dot com slash resources. And if any of you watching wants to be a guest on The Contract Teardown show and beat up a contract like Mark just did, just email us. We’re at community at Law Insider dot com. We will see you all next time. Thank you again, Marc.
Marc Halsema [00:23:29] Thank you, Mike.