Going Into a Series A Financing: Part One

November 6, 2016

It’s an important milestone in the life of a startup venture. You’ve built a product, perhaps been bringing in some revenue, and attracted some seed funding to get off the…

It’s an important milestone in the life of a startup venture. You’ve built a product, perhaps been bringing in some revenue, and attracted some seed funding to get off the ground. Now you’re ready for some serious financing to take your business to the next level. And you’re probably approaching meeting with VC’s with a mix of excitement and apprehension. They have millions of dollars in potential funding to help you, but they’ve been through this process countless times. This may be your first.

Thankfully, we’ve been through the Series A process many times and are ready to be your partner through it. In this two-part series, we will be looking at key considerations for founders before and when entering into a Series A financing round. In part one, the scene will be set several months before entering into discussions with VCs, when you should be thinking about making sure your company’s affairs are in order sufficiently to withstand the scrutiny that comes from a VC investment round. In part two, we will highlight issues that arise in negotiating the Series A term sheet.

PART ONE: Getting Your Company Ready For a Series A Financing Round

A Series A financing round is quite likely the first time your company’s affairs will come under intense outside scrutiny. Investor’s counsel will be examining your company’s books and records in detail to insure their client, the VC, knows what they are getting themselves into. What might seem like unnecessary legal formalities in the initial months and years of your venture – things that you didn’t think you had the time or money for – will suddenly come back to haunt you.

But you can mitigate your risks of scaring away investors or delaying a funding round, as well as minimize costs, by keeping in mind these key issues that we have seen arise in many financing rounds:

1) Getting IP Assignments From ALL Service Providers

Do you have properly drafted inventions assignment agreements from ALL of your company’s past and present service providers? If not, you may have a mere non-exclusive license to the work performed by such service providers. Just because you may have paid someone to do work for your company does not automatically transform the work into company property, particularly in the case of consultants and independent contractors.

Founders often mistakenly believe an NDA is sufficient and thus do not have inventions assignment agreements with their service providers. This can put your core technology at risk. It is important to ensure each and every one of your employees and consultants have signed proper inventions assignment agreements.

As part of the Series A due diligence process, investors’ counsel will likely require you to get signed inventions assignment agreements from all past contractors and employees, no matter how minor their contribution may have been. You will be put in the position of having to scramble to approach each and every contractor you may have ever engaged. This can cause serious funding delays, particularly if you have difficulty locating a former service provider or if your relationship with the service provider did not end well making such service provider less cooperative.

Don’t wait for a due diligence request to fix this problem. Now is the time to ensure that you have proper inventions assignments from all service providers, past or present, in order to avoid delays or complications during due diligence.

2) FF Preferred Stock

If you did not do so at incorporation, well-before a financing round you should consider setting up a special series of preferred stock for founders to facilitate enjoying founder liquidity before an exit (whether it be through M&A or an IPO). This will allow you to hedge some of the risk of having your equity interest tied up in a business that, no matter how promising, is still somewhat speculative.

At the same time, you need to be careful to avoid a situation in which your method of “cashing out” early either adversely impacts the pricing of common shares and/or results in an ordinary income tax hit for you.

A common way to achieve liquidity while avoiding the dangers above is through FF Preferred Stock. This is a class of stock which, when held by the founder, functions essentially like common stock until it is sold by mutual consent to an investor in connection with a preferred stock financing. Once sold to the investor, the FF Preferred Stock by its terms converts into the same series of preferred stock purchased by the investor in the financing. Thus the investor receives its desired preferred stock and the founder receives cash for the sale of FF Preferred Stock.

With FF Preferred Stock, the founder’s gain is subject to capital gains tax and because it is a sale of preferred stock, the price of the Company’s common stock for option purposes is not affected. If it is not sold, it can merely be converted into common stock at the option of the holder. FF Preferred Stock is desirable because Investors rarely want to purchase founder’s common stock. If, alternatively, your common stock is repurchased by the Company at the Series A price following the financing, your gain could be subject to income tax instead of the more favorable capital gain tax. There is very little downside to setting up this series of stock and having the foresight to do so at the outset can save you significant amounts of money in the future.

3) Share Allocation

Founders often delay documenting share allocations between each other and even issuances to others in the hope of saving legal fees. In fact, this is a mistake that can significantly increase fees later on, create unnecessary tax risks and even delay or hold-up an equity financing round. No VC will invest in your company without certainty as to the allcation of the company’s capitalization.

First, while legal fees to document initial share allocations between partners and restricted stock or option issuances to employees, contractors or advisors are relatively low, the cost of retroactively documenting these transactions months or years later can be much higher. Memories may differ as to what was agreed to by handshake early on. Or you might have difficulty finding a former employee or contractor to sign the necessary purchase agreements. These will make the process of documenting issuances much more time consuming and expensive.

Second, you may create unnecessary tax risk by failing to document share allocations. If you wait until right before a financing to document allocations and issue shares at a significantly lower price than the share price in the financing, the IRS could determine that the issuances were made at less than fair market value. This would subject the founders to recognize ordinary income for the spread between the purchase price paid by the founders for their shares and the fair market value as set in the financing. This tax risk is obviated if share issuances are documented early on, well-before a financing is consummated.

Third, by waiting until right before a financing to document share allocations and issuances, you create the risk that there may be disagreements as to what each founder, employee or contractor was entitled to in terms of equity. At the consummation of the relationship between the company and its founders, employees and/or contractors, everyone is generally on good terms. That is the time to get any agreement on compensation (including equity compensation) in writing, for the avoidance of doubt. But the longer you wait, the more likely that there could be a falling out with a founder or service provider. The disgruntled founder, employee or contractor may be unwilling to simply sign a document before the financing, which could delay investment or scare away an investor.

Do not assume that because all parties are in agreement for the correct share allocation, doing the paperwork is a mere formality that can be handled at the time of the financing. Avoid delays and undue tax burdens by cleaning up and documenting the proper share allocation.

4) Due Diligence

Founders are often surprised by the formal due diligence request memo they receive from investor’s counsel in the financing. Although the term sheet and definitive agreements are a significant part of the Series A, the bulk of the time consuming process and resulting delay is due to the diligence requests made by counsel. As discussed above, your company will need to have documented all share issuances, inventions assignment agreements and option grants. But the diligence process goes much further. Investor’s counsel will be looking to make sure, for example, that there has been proper corporate governance and record-keeping. In that vein, not only do you need to make sure your share allocations are documented with founders/service providers, but the company should also have recorded board of director authorization (either via a written consent or board meeting minutes) authorizing every share or option grant and note issuance. It is prudent and legally necessary to keep such accurate corporate documents, including all board and shareholder consents. If you are unsure of whether a particular action requires board approval or shareholder approval, your attorney can be of assistance.

5) Being Careful about Interim Funding

Startups often follow a similar trajectory – incorporation, followed by a bridge financing using convertible notes or SAFEs, and then a Series A financing with a lead institutional investor. Sometimes, however, companies need to raise funding outside of the standard convertible note or SAFE and due to the bargaining power, will beforced to accept less than ideal terms. Or the company’s founders may not be aware of what terms are typical of the market or what the implication are of various deal provisions. Such companies may enter into a convertible note under unusual or onerous terms and will fail to consult with a lawyer for fear of legal fees or under the assumption that a lawyer will cause unnecessary delay or simply add “legalese”.

A trusted lawyer will know the issues to be aware of and will efficiently guide you to avoid pitfalls. We have seen many clients be “brought down” by contracts they entered into without consulting a lawyer. For example, companies sometimes issue convertible notes or enter into other early investment arrangements that perhaps inadvertently give early investors rights that allow them to veto financing or exit opportunities. You need to ensure that, however you raise money early on, your company has the maximum possible flexibility in terms of future financing and exit options.

Don’t be a cautionary tale. Remember to consult your attorney to ensure your early and interim funding terms make sense for your company.

Please keep an eye out for Part Two of the “Going Into a Series A Financing” series.

If you have any questions about any of the information in this article or wish for assistance in considering your next funding round, please do not hesistate to contact us.

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