Since late 2002, a team of corporate lawyers from leading venture capital law firms and funds has been developing a model set of venture capital financing documents for use in the venture community. The project, sponsored by the National Venture Capital Association (NVCA), is the most ambitious effort to date to standardize private equity investment documentation. The initial set of model documents is in final drafting stages and is expected to be released on the NVCA’s Web site in the first quarter of 2004. This article offers a brief preview of the documents, which promise to be highly influential in future venture capital financings.
Even in lean years, thousands of venture financings of private companies are completed across a wide range of industries. They range from angel seed rounds and early stage VC rounds to mezzanine and late-stage financings. The NVCA conservatively estimates that the VC industry alone spends $200 million in direct legal fees just to close private financing rounds, a figure that does not include portfolio companies’ (greater) transaction costs. Investors, management teams and their attorneys spend countless hours preparing, negotiating and revising investment documentation.
Yet VC financings tend to be driven by form documents for many reasons. Investors take equity risks and structure investments similarly. There is typically a range of recurring issues commonly understood by investors and experienced attorneys. The portfolio companies are generally early stage, reducing the need for extensive due diligence or full-blown representations and warranties. Investors counsel fees are capped (through company reimbursement limits) at relatively low amounts that have not kept up with billing rate increases at law firms. And the unprecedented volume and velocity of deal making during the late 1990s led investors and lawyers to rely on simpler, off-the-shelf forms.
However, the surge in down rounds, washout financings, recapitalizations and venture portfolio consolidation over the last several years has pushed the limits of many form documents. Litigation among investors, and between investors and management, over “pay-to-play” penalties, heavy dilution and loss of rights in these types of financings has forced reexamination of former standard practices. These industry changes may also have coincided with the tendency every decade or so for venture funds and their lawyers to revisit and update form investment documentation.
Model Form Project
Beginning in mid-2002, largely through the efforts of Sarah Reed, the general counsel of Charles River Ventures, the NVCA agreed to sponsor the model form project. Experienced corporate lawyers and in-house attorneys at 38 leading venture capital law firms and venture funds in diverse geographic regions, including Silicon Valley, Boston, Dallas, Reston, Va., and New York, were recruited to participate and represent their institutions in the effort.
The stated goal was to create relatively down-the-middle documents that benefit both companies and investors by standardizing non-critical terms and conditions, providing a reasonable level of investor protection, maintaining company flexibility and, probably above all, streamlining the deal process. If successful, the form documents would reduce the time and cost of financings, allow parties to focus on high-level issues and trade-offs, and allocate limited legal budgets to key due diligence issues and higher value-add service from counsel. Moreover, principals would enjoy the most current set of best industry practices and be in a better position to avoid legal pitfalls.
The result of the work is a complete set of form investment documents consisting of a term sheet, a certificate of incorporation, a stock purchase agreement, an investors’ rights agreement, a right of first refusal and co-sale agreement, a voting agreement and assorted ancillary documents. Each of these documents is annotated with alternative formulations of critical provisions that require tailored advice for specific deals. The NVCA intends to make these documents publicly available, and working subgroups initially drawn from the drafting team will be responsible for maintaining and updating each document on an ongoing basis in an effort to ensure that each document reflects state-of-the-art thinking. The American Bar Association (ABA) has joined in the effort with the goal of adopting the model documentation.
The forms are structured as a standard investment in convertible preferred stock of an early stage private company. The company is a Delaware corporation (being the most common portfolio company domicile now), but the forms are annotated for California corporation differences. While the forms are set up as a first institutional round, they can be used for later rounds or by any investor.
In arriving at the current near-final drafts, the working group discussed and debated many provisions in extensive detail, and was able to examine (and sometimes reject) conventional wisdom on provisions that have been taken for granted in form documentation, in one form or another, for over a decade. Special attention was given to the changing venture environment, recent investment litigation, and recent developments in Delaware law.
Charter. The form certificate of incorporation, or charter, contains the terms of the security itself. It has familiar preferences based on deemed “liquidity events,” a menu of recommended protective provisions, and alternative formulations of price-based antidilution adjustments. Custom alternatives to the basic structure are provided for change of control liquidation event triggers, the addition of cumulative dividends to the liquidation preference amount, redemption privileges, participating preferred stock, and other custom terms back in favor.
One feature that may create some initial confusion is the method for implementing “pay-to-play” provisions. Instead of automatically converting the preferred stock of investors who fail to invest pro rata in later rounds into a “shadow” series of preferred stock resembling the original series but lacking the eliminated right, or into common stock, the form employs undesignated “blank check” preferred stock. While typically excluded from the charter of venture-backed companies, blank check preferred allows the board of directors to create terms for a new series of preferred stock without stockholder approval. By being able to set up the “pay-to-play” penalty at the time of investment, the board is in a better position to negotiate and secure financings, avoid stockholder vetos of needed financings, and adapt to changing litigation precedent providing grounds for attacking potentially coercive financing strategies.
Stock Purchase Agreement. The form stock purchase agreement contains a complete package of representations and warranties for investors to rely upon in making investments. The consensus view was that representations and warranties are primarily a due diligence tool, and less useful as a liability insurance policy in venture investments. Considerable time was spent picking and choosing the “right” set of representations and warranties, and scrubbing the language of each in detail.
Although much has been said about the supposed difference between “East Coast” and “West Coast” terms, the group found mostly common ground. The most notable departures were the level of investor control, and founders’ representations and warranties, found in Eastern terms. The form contains, but does not necessarily recommend, the inclusion of representations to investors by founders in their personal capacities. Early stage Northeast investors in pure startups, in particular, feel that it is fair and essential for due diligence purposes to look through the corporate veil and hold founders personally liable for misrepresentations. Entrepreneurs in most regions outside the Northeast are not accustomed to this, and are not inclined (putting it politely) to accept unlimited personal liability in connection with a risky investment. Limiting liability to the value of the founders’ stock in the company is a possible middle ground, but the consensus was that the issue fades in later rounds when investors no longer demand that founders be on the hook.
Stockholder Agreements. While consideration was given to consolidating the investors’ rights agreement, the right of first refusal and co-sale agreement and the voting agreement into a single document, they were left as separate, stand-alone agreements. That was the customary practice in order to provide flexibility to grant rights (and exclude some stockholders) selectively, limit availability of sensitive rights, and insulate agreements from unenforceable provisions in another.
Careful thought was given to balancing investor control and protection against company flexibility. The type and regularity of financial reporting, different formulations for preemptive rights, corporate governance (such as board, investor board designee, and stockholder class votes for various matters), and potential fiduciary duty and conflict of interest concerns were addressed in the form.
Ancillary Documents. Standard forms of management rights letters, indemnification agreements, legal opinions and closing documentation appear in the forms. While it was recognized that these types of documents vary the most among different firms, it was felt that the package would not be complete without a concerted effort to set a standard for them.
The ultimate success of the NVCA model form project will depend on the extent of adoption. A core group of participating venture funds are poised to adopt. The forms will likely be picked apart and provoke commentary. Individual firms will customize the forms for their own use. Future legal or industry developments, even a new investment cycle, will lead users to view terms and issues in different lights.
These are all healthy developments for the forms. Like so many technology companies that will be funded through them, they depend for their sustained usefulness upon constant field testing, competition and upgrading. Unlike past form reform movements, an unprecedented industry infrastructure has been established to maintain and improve these forms. With the right amount of continued leadership and buy-in, the venture industry can institutionalize the forms and significantly improve the quality of deal documentation.
Curtis Mo is a corporate partner in the Silicon Valley office of Weil, Gotshal & Manges LLP. His practice focuses on public offerings, venture capital, private equity, mergers and acquisitions, and restructurings. Associate Peter S. Buckland assisted in the preparation of this article. Mo and Buckland have been active participants in the NVCA Model Venture Financing Documents Project since inception. The views expressed herein are those of the author and do not necessarily represent the views of Weil, Gotshal.