Emerging growth companies commonly search for an influx of cash through funding provided by investors. Venture capital firms, angel investor groups, and high net-worth individuals (collectively, “Investors”) are common sources tapped for obtaining that much-needed cash. In these scenarios, the Investors provide cash to the corporation in exchange for shares of the corporation’s preferred stock. Each time a corporation offers its stock for cash, a new series of preferred stock is created. The name of the financing round generally corresponds to the name of the series stock. Typically, the initial rounds of financing are known as a “Series Seed” or “Series A” round, followed by a “Series B,” then “Series C,” and so on and so forth as further funding is taken in over the years. When going through these financing rounds, whether the very first Series Seed round to the last financing round before an exit, the same agreements are entered into and amended to memorialize the rights, privileges, and preferences of the various series of preferred stock offered.
This article is meant to serve as a primer for emerging growth companies and Investors, introducing the different documents and agreements that will need to be drafted and executed for each financing round.
The generally accepted standard of financing documents comes from the National Venture Capital Association (“NVCA”). The NVCA documents are regularly updated form documents that contain standardized language and various provision options to customize the documents based on the specifics of the deal terms that were negotiated. There are six documents that will need to be considered and drafted in a financing round:
- Term Sheet
- Certificate of Incorporation
- Stock Purchase Agreement
- Investors’ Rights Agreement
- Right of First Refusal/Co-Sale Agreement
- Voting Agreement
The Term Sheet
The Term Sheet provides an overview of the business and legal terms that will be flushed out in the other five documents. The Term Sheet is generally a non-binding agreement that is entered several weeks to months before the anticipated closing of the financing round when the funds are wired from the Investors to the corporation. The non-binding nature of the Term Sheet provides an effective and efficient deal process, as terms can be changed in the agreements and allow for flexibility and effective negotiation around finer points as the other documents are drafted. While the Term Sheet is non-binding, the terms for the proposed deal should be thought of as what the final deal is intended to look like, and for practical purposes, the terms contained should be drafted into the documents as closely as possible. The Term Sheet generally will have boilerplate binding terms that include confidentiality, choice of law, exclusivity, and costs and fees.
Certificate of Incorporation
The Certificate of Incorporation (the “COI”), also known as the “Charter”, is the main governing document for the corporation. The COI is filed with the Delaware Secretary of State (or whatever state the entity is organized (See Footnote 1)) and becomes effective when it is filed with the Secretary of State. The COI contains uniquely important sections such as:
- authorizing the number of shares that the corporation is allowed to issue;
- creating a separate series of preferred stock for the round;
- outlining the liquidation preferences (the multiple paid out for each share of preferred stock and order of payment amongst the shareholders) for each series of preferred stock in an exit event and
- providing for the protective provisions that give those holders of preferred stock blocking or approval rights for various corporate transactions or activities.
Careful attention must be paid to the provisions contained in the COI to ensure that the corporation accurately creates and authorizes the correct amount of new stock and grants the rights, privileges, and preferences that the Investors believe they will be receiving with their preferred stock.
Stock Purchase Agreement
The Stock Purchase Agreement (“SPA”) provides for the actual sale and purchase of the preferred stock from the corporation to the Investors. The SPA will cover things such as:
- establishing the price per share for the preferred stock;
- the number and price of securities to be sold;
- the closing date of the financing round (an initial closing and the amount of time that the round will be open for additional subsequent closings to occur) and
- representations and warranties for both the corporation and the Investors.
An integral part of the SPA is the disclosure schedule (sometimes referred to as the “schedule of exceptions”) that is provided to investors with the SPA. The disclosure schedule lays out the exceptions and qualifications to the representations and warranties made in the SPA. Providing a full and complete disclosure schedule to investors is essential to ensure that investors are fully informed of the health and dealings of the corporation and provides the corporation with assurance that it has not breached any of the representations and warranties made in the SPA.
Investors’ Rights Agreement
The Investors’ Rights Agreement (“IRA”) can cover a variety of different subjects that provide the Investors with additional rights and privileges outside of those established in the COI. Generally, the IRA will cover the following three main topics:
- registration rights of the securities (i.e. an Initial Public Offering or “IPO”);
- information and observer rights on the board of directors and
- rights of first offers (colloquially known as “preemptive rights”).
Some of the provisions of the IRA, such as the information and observer rights, may only be applicable to a “major investor.” Who qualifies as a major investor is negotiated amongst the corporation and the Investors, and usually will either contain a threshold of shares needed or list individual Investors (a key venture capital firm or private equity investor).
Rights of first offer (preemptive rights) grant Investors the right to purchase securities in subsequent equity financings conducted by the corporation.
Right of First Refusal/Co-Sale Agreement
The Right of First Refusal/Co-Sale Agreement (“ROFR”) is an agreement amongst the Investors, the corporation, and certain “Key Holders” that governs the transfer of shares. “Key Holders” is a defined term in the ROFR that is generally applied to founders, important equity-owning management, and stockholders that hold significant quantities of common stock. The underlying parts of the ROFR include:
- right of first refusal giving the corporation first, and the Investors second, the right to buy shares from Key Holders or Investors when they propose to sell them;
- right of co-sale giving the Investors the right to participate pro rata in any sale to a third party;
- exempt transfers which list out the types of transfers and transferees that do not trigger the Right of First Refusal or Right of Co-Sale; and
- lock-up restrictions on transfers before or after an IPO.
The exempt transfer provisions are an essential negotiated section for the corporation, Key Holders, and Investors alike. The exemptions provided in this section are used to allow transfers to certain affiliates (such as subsidiaries or sister companies) and family members, and can name specific individuals or entities that the Investors agree the Key Holders can freely transfer their shares.
Another decision to the exempt transfers provisions is whether or not to allow the transfers to be made in exchange for consideration (payment). Restrictions on the transfer of shares for consideration can be undesirable for Key Holders that are acting as warehouse entities that subsequently transfer shares to their affiliates for cash.
The Voting Agreement governs the shares of stock and how and when the holders of such shares must cast them in certain fundamental transactions or operations of the corporation. Like the ROFR, the Voting Agreement contains the Key Holders concept, and generally, the same Key Holders are uniform across the documents. The Voting Agreement contains two key concepts:
- voting provisions regarding the Board of Directors, including which shares have the authority to appoint and vote for which board members and the threshold that must be met for such shares all to vote a certain way; and
- drag-along rights providing that if a certain percentage of shares of common stock, preferred stock, and the Board of Directors approve a Sale of the Company (defined in the Voting Agreement), then all of the stockholders must also vote in favor of the Sale of the Company and not inhibit it.
These provisions in the Voting Agreement provide important leverage for both Investors and Founders. The approval thresholds, requirements for electing board members and drag-along rights can be tailored to give Key Holders or new Investors enough say to make them feel comfortable in the governance and decision-making of the corporation.
 For purposes of this article, it is assumed that the emerging growth company is organized as a Delaware corporation. While the same financing rounds and financing documents can also apply to a non-Delaware corporation or even a limited liability company (“LLC”) (in the form of “Units” of the LLC instead of stock and the concepts contained in each separate agreement described in this article will likely be incorporated in the LLC’s company agreement), the most common (and Investor favored) form of entity is a Delaware corporation.
 Note that a financing round is not bound to have only these six documents. Other common agreements can include side letters, management rights letters, and indemnification agreements. Alternatively, a company could elect to have an omnibus stockholders’ agreement in lieu of some of the various individual ancillary agreements.
 In the case of an LLC, the company agreement that generally contains all of the concepts in this article, including those important provisions contained in the COI, is not filed with any secretary of state.
 Proper tax counsel should be consulted when authorizing shares in the COI. In Delaware, as in many states, the franchise taxes that a corporation must pay could be determined based on a matrix of the number of authorized shares and their par value. Authorizing too many shares or not having a low enough par value can create an unexpected tax bill.