A Guide To Angel Investing Documents: Preferred Stock Deals

This article is intended to provide a quick overview of the principal documents in a fundraising where the investors are purchasing stock. Unlike a convertible debt issuance, these stock transactions permanently alter the capitalization of the company by adding new stockholders, who are typically purchasing a brand new class of stock created for them, typically a series designated class of preferred stock with special rights and privileges they have negotiated.

Given this permanence and the associated complexity of these transactions, there are a great number of different types of deal documents used in stock transactions. For the purposes of clarity, we’ve divided them into Commonly Used and Occasionally Used. Readers should also keep in mind that this article talks in generalities in terms of where concepts are typically covered - every deal is different and a given issue may be addressed by counsel in a different way or in a different document in your deal.

Commonly Used Deal Documents in Stock Transactions

Term Sheet

Most deals start with or are accompanied by a term sheet or memorandum of understanding summarizing the terms of the deal. Unless a term sheet expressly states that some or all of its sections are legally binding, early stage investment term sheets generally are not legally binding agreements. Term sheets can be thought of as a set of notes outlining the principal elements of the deal as agreed by the negotiating parties. They serve as a basis for soliciting interest from prospective investors as well as a guide for use by counsel drafting up the definitive binding documents.

Stock Purchase Agreement

The SPA is the core document of any stock transaction. Its purpose is to document and transact the sale and issuance of the actual stock, as well as to specify key terms of the deal and allocate key risks between buyer and seller.

The main sections of an SPA typically include representations and warranties by the company and the founders as to the legal and financial status of the company and its shares, the seller’s right to enter into the transaction, and other important factual matters (see also Disclosure Schedules below). There is also a section where buyers of the stock make some representations and warranties back to the seller, and a section where the buyers impose conditions which must be met before they are obligated to buy - this section often reads like a laundry list of the other transaction documents which must be in place simultaneously. And the final section is typically a long “miscellaneous” or “other matters” section containing agreements on how the SPA will be interpreted and enforced, and documentation as to agreements on other legal matters.

Disclosure Schedule (or Schedule of Exceptions)

The disclosure schedules are technically part of the SPA and work in concert with the section on company representation and warranties. Notwithstanding that, the disclosure schedule is worth mentioning separately because (i) it is invariably prepared as a separate parallel document alongside the SPA (and is typically not finalized until the last minute) and (ii) it contains key factual data and reference information about the company which may be useful to you later.

The way disclosure schedules typically work is that the SPA says in section x.x: “the company has no material contracts except as listed in section x.x of the disclosure schedule” or in section y.y “the company has no shares outstanding except those listed in section y.y of the disclosure schedule” or in section z.z “the company is not party to any litigation other than that listed in section z.z of the disclosure schedule.” Often when looking for reference information about a company or tracking information for your Seraf account, you can find key bits and pieces in the disclosure schedule.

Investor Rights Agreement (also sometimes Registration Rights Agreement)

The IRA is where certain rights and privileges of the new stockholders are documented. The most common rights in an IRA are (i) the right to have your stock registered with the SEC as part of an IPO, so that they are freely tradable and liquid (typically after a lock-up period of 180 days or so) and note that these registration rights are sometimes handled in a separate Registration Rights Agreement (ii) the right to receive financial and management reports and information from the company and (iii) the right to participate (i.e. purchase stock in) future financings.

IRAs sometimes also contain agreements as to the establishment and composition of board and board committees and the right of the board/committees to approve corporate budgets and extra-budgetary expenditures. IRAs can spell out the stockholder’s rights with respect to dividends and sometimes IRAs contain rules for calculating share price in the event of a dilutive issuance, i.e. anti-dilution protection (though this provision is more typically found in the Certificate of Incorporation) or redemption rights which are the rights to force the company to redeem your shares for cash under certain circumstances. And finally, in some IRAs you will find language about the company’s obligation to pay directors expenses and indemnify directors in the event of liability in connection with board service.

Voting Agreement

The Voting Agreement is the document used to ensure that all the signing stockholders vote in concert for the good of all. Sometimes it is just the new stockholders of one class coming in with the new round who sign the voting agreement and sometimes it is all stockholders. A voting agreement typically has provisions requiring signatories to vote to create the board structure agreed upon in the term sheet. They also typically contain what is referred to as a “drag along right” or “change of control drag along” which is the right to make the minority follow (vote for) the “will of the majority,” as in approving the merger, acquisition or liquidation of the company. Often voting agreements require stockholders to vote to approve the issuance of all the new common stock necessary to convert preferred shares in the event a conversion is desirable. And typically they contain a provision stating that the stockholder automatically gives a proxy to a designate of the board to vote their shares in the event that they fail to vote them as required.

Right of First Refusal & Co-Sale Agreement

The Right of First Refusal & Co-Sale Agreement (ROFR & CSA) is a clean-up agreement used to document a couple important rights typically included term sheets, but not appropriate for the Stock Purchase Agreement. The first of two primary things a ROFR & CSA does is to ensure that no new shareholders are brought into the company without first giving the company the option to buy the shares proposed to be sold (instead of the proposed third party buyer) on the same terms as the proposed buyer. ROFR & CSAs also typically state that in the event that the company does not want to buy the shares, that right goes secondarily to the existing shareholders.

The second primary thing a ROFR & CSA does is to ensure that no existing shareholders are able to exit their shares by selling to a third party without giving other shareholders the right to participate in that sale on the same terms and on a pro rata basis.

This may sound odd and contradictory, but think of it like both a floor and a ceiling: the effect of a ROFR & CSA is to ensure that (i) if things are going well with the company, existing shareholders, who took all the early risk, have first dibs on the company’s shares and (ii) that if things are not going so great, nobody is allowed to find a buyer and get out unless everyone is allowed to participate in the partial liquidity event on a proportional basis.

The remainder of the ROFR & CSA is housekeeping to ensure that the mechanics of transfer are fair and smooth and any new shareholders are appropriately bound to the terms and conditions of the original shareholders.

Certificate of Incorporation or Certificate of Amendment (Articles of Incorporation in California)

It may seem odd to include a copy of state filing in a deal like this, but the reason this document is included in most early stage equity financings is fairly clever and sensible. Here’s why: for most early stage financings, a new class of preferred stock is created, and the preferences or privileges of that class of stock is recorded in the company’s Certificate or Articles of Incorporation. These key rights typically include liquidation preferences (getting paid before common stock or other classes of stock), dilution protection in the event of a down round, voting rights, election of directors, dividend rights, and rights relating to conversion into common stock.

What is sensible about that? Two things: (1) State law generally requires the affirmative vote of approval by the holders of a class of shares for a negative change to any of the rights of those shares, so preferred shareholders are going to have legal protection and the right to vote on any changes to their rights and privileges. For example, Delaware law says that the holders of a class must vote to approve any change which: “Increases or decreases the aggregate number of authorized shares of the affected class(es); or Adversely affects the powers, preferences, or special rights of the shares of such class.” (2) Because company Certificates of Incorporation are public state filings, anyone considering purchasing the stock of a company has the right to inspect the special privileges given out to the shareholders of preferred stock and know that they are getting themselves into.

Legal Opinion

Investors buying stock in a company generally require counsel for the company to stake their reputation “vouching” for the legal status of the company and the validity of the transaction. Legal opinions in this context generally start with a recitation of all of the items counsel has reviewed prior to giving the opinion (deal documents, corporate records) and then go on to say, with varying degrees of wiggle room reserved, (i) that the company is validly existing and in good standing in the state in which it is formed, (ii) that the signing of the transaction documents is legal and accompanied by the necessary approvals and consents, (iii) exactly what the outstanding capitalization of the company is, (iv) that the issuance of the stock is legal under the relevant SEC exemptions, and (v) that there is no material litigation pending. Some things may be added and some of the wording may vary, but these are the basic things investors look for in a legal opinion.

Accredited Investor Questionnaire/Certification

The vast majority of early stage equity financings are done pursuant to an exemption from the registration and disclosure requirements normally imposed by the US Securities and Exchange Commission on the sale of securities to the public. The scope of the exemption is rather narrow, and among other things, it requires that shares in exempt deals be sold only to accredited investors who are presumed to be sophisticated enough to evaluate a deal without public disclosure and wealthy enough to withstand a total loss stemming from an exempt deal. The accredited investor questionnaire is the document which investors fill out and sign to certify that they are accredited investors eligible to participate in an exempt offering. This questionnaire is not always a separate document - its concepts and certification are sometimes incorporated in the Stock Purchase Agreement or other deal document instead.

Signature Pages

Technically these are not a separate document in any sense of the word - typically this term merely refers to a separate electronic or paper file containing all the signature pages of all the deal documents collected together in one single document for the convenience of a signing party. Once signed, they are attached on your behalf to the relevant documents, counter-signed by the company and returned to you as part of the final closing documents package or “closing binder.” Sometimes when looking for key numerical information about your shareholdings or other tracking information for your Seraf account, you can find key bits right next to your signature in the signature pages.


Occasionally Used Deal Documents in Stock Transactions

This section covers documents which turn up from time to time. It is not a problem or concern if they are not used in a given deal; it may just mean: (i) the issues to which they relate are covered in other agreements (ii) the issues to which they relate are not present or relevant in this particular deal or (iii) the lawyers drafting the deal documents have a different drafting style.

Capitalization Table

Early stage equity financings will often, but not always, include a detailed chart or table laying out all of the ownership positions of the different stockholders of the company including common stockholders, preferred stockholders and option and warrant holders (technically these last two are security holders not stockholders.) The capitalization table may either document the various positions before the close of the new round, after the close, or preferably both in one document. Often the Capitalization Table, or at least a high level summary of it, will be included in the Disclosure Schedule (above), but sometimes it is distributed as a stand-alone document. Often when looking for key numerical information about your shareholdings or other tracking information for your Seraf account, you can find key bits in the capitalization table. Capitalization tables often prove useful down the road (for example, when trying to double-check proper payouts in an exit), so it is not a bad idea to ask for a copy of the current cap table every time you invest in a company or sign deal documents. Then just upload them to Seraf with the round and you will always have them for reference.

Board Consent

A company must generally have the approval of its board to be authorized to partake in an equity financing. This approval is typically recorded in board minutes of a live meeting but sometimes permission is sought and recorded in writing by means of a unanimous written consent; in those cases, a copy of that written consent is sometimes included in the deal document package.

Stockholder Consent & Waiver

Similar to the board consent, under the Certificate of Incorporation or bylaws of a company an equity financing can require shareholder approval as well as board approval, so a stockholder consent is often included in as part of the deal. Sometimes it is part of one of the principal deal documents, and sometimes it is a stand-alone document. If the rights of shareholders are being changed or cut back by the terms of the new deal, an explicit waiver of the abridged rights may be included to make it abundantly clear that everyone is onboard with the deal.

Irrevocable Proxy

In a typical equity deal, voting matters are left to the individual shareholders. The assumption is that it is relatively easy for a major investor to put together a majority block in favor of a proposal the major investor would like to see passed. Or a voting agreement is used. But in some deals, nothing is left to chance and investors are asked to assign their voting rights to an investor delegate (this assignment is called giving a proxy to a proxy holder) who can then vote the rights. This is a way of ensuring that shares get voted, blocks get neatly formed and no one has to spend effort or incur delay chasing votes for desirable outcomes. These proxy assignments are generally permanent and irreversible (hence the name irrevocable) transfers of voting rights, so if you see one in a deal package, read it carefully and make sure you are comfortable that the proxy holder’s interests fully align with yours.

Indemnification Agreement

Although companies generally carry Directors’ and Officers’ insurance to protect directors from the damages and expenses of shareholder lawsuits alleging that they did something wrong as a director, many highly skilled and sought-after directors want additional protection if they are going to be convinced to serve. What companies do in that situation is offer to, in effect, re-insure the directors by indemnifying them (agreeing to reimburse them or “hold them harmless”) for any expenses or damages they incur while doing their job competently and in good faith. The way this is recorded is in an indemnification clause in one of the principal deal documents, or as a stand-alone indemnification agreement. They are long and jargon-laden documents, but what they basically say is that if the director is doing a good job and acting in good faith, and they get sued by shareholders, the company will make them whole. There are a lot of details about the precise conditions in which such reimbursement will occur and the limits on that reimbursement, but if you see one of these, the concept is pretty simple - the company will cover the directors’ costs.

Secretary’s Certificate

The Secretary’s Certificate is essentially a small cover sheet attesting to the authenticity and accuracy of the copies of the various deal approvals and governance documents. They are typically worded as a series of paragraphs each starting out with “attached is a true and correct copy of the…” and going on to list the bylaws, the board and stockholder resolutions approving the transaction, the names and titles of the current list of officers of the company and the certificates of good standing and legal existence from the state of incorporation. And they are signed by the secretary of the corporation (who often is the CEO in small companies.)

Compliance Certificate

The compliance certificate is a belt-and-suspenders document intended to give investors extra protection by requiring the company’s CEO to personally take responsibility for the transaction. Compliance certificates typically include statements that (i) all the representations and warranties the company has made in the deal documents are true, (ii) that the company has obtained all the consents, approvals, permits and waivers it needed to obtain, (iii) the shares being issued are duly authorized, and (iv) newly revised Certificate of Incorporation has been filed and is in effect. And they conclude with a simple signature from the CEO.

Joinder Agreement

Joinder agreements are sometimes used as an easy way to make new investors a party to existing agreements - they literally join you in with the other signatories. They typically list the specific agreements and their dates and make it clear that by signing the joinder agreement, the new investor is signing, and means to be bound by, all the other agreements listed.

Founder Stock Agreement (aka Vesting Agreement or Restricted Share Agreement)

Term sheets in early-stage equity deals often require that the founders stock be subject to forfeit in the event they leave the company. This concept is sometimes inaccurately nicknamed “founder vesting” but in fact what going on is that founders are agreeing to put a layer of contractual claw-back on top of stock they already own. Given this, “restrictions lapsing” is technically more correct language than “stock vesting,” but the economics are equivalent. The claw-backs amount to an agreement that they will forfeit the stock (at a typically very low price so as to not cause a cash crunch for the company) if they leave. The vesting nickname stems from the fact that these restrictions lapse as time goes by. These arrangements are usually documented in agreements variously named things like Founder Stock Agreement or Vesting Agreement or Restricted Share Agreement. Investors are typically not a party to these, but a copy is sometimes furnished to them as proof of their existence because of the importance of the issue.

Risk Factors Statement

A list of risk factors is sometimes furnished to the investors as a way of limiting various types of liability for the company in the event that things do not go as planned or shareholders become unhappy. They literally serve as a “can’t say we didn’t warn you” device and work by disclosing a variety of risks associated with the investment. Example risks you might see include: the stock being offered is not registered and not liquid, the terms of your deal might be renegotiated in a later financing, the company has a limited operating history and may not be successful, the company has limited operating capital and might run out of money and either fail or need to raise more money on less attractive terms, competitors may out-compete the company, customers may not like the product, the company may not get sufficient intellectual property protection, the company may not be able to attract and retain enough good talent, etc. At most you will be required to acknowledge that you got your copy.

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