Anatomy of a Venture Financing

Emerging Companies & Venture Capital

Whether you’re a first-time founder or a serial entrepreneur, the process of obtaining venture funding can be complicated and confusing. Let’s look at the process of getting a venture financing to closing, and the primary deal documents you can expect to see along the way.

Process to Closing

Most venture financings start with a term sheet. Term sheets can vary widely in length and scope, from one-pagers that punt on many deal terms to multi-page documents that provide a definitive roadmap to the deal documents. Although term sheets are typically non-binding (other than confidentiality and no-shop provisions), we recommend that companies involve counsel at this stage to help negotiate the primary terms.

Once the term sheet is in place, the due diligence process begins. The amount and intensity of diligence can also vary widely but are often commensurate with the size of the financing. Investors focus on legal and intellectual property matters and may also investigate the target company’s market, financials, management and regulatory compliance.

Concurrently with diligence efforts, the company and the investors negotiate the deal documents, discussed below, and build the syndicate of participating investors. Once the financing documents are ready and diligence has been completed, the company obtains required board, stockholder and investor approvals, files the Charter (described below) and conducts the initial closing of the financing.

Principal Deal Documents

There are five primary documents in a typical venture financing. The financing terms are separated into different documents reflecting the expected signatories to those documents: terms applicable only to the investors go into the Investor Rights Agreement, for example, while terms applicable to all stockholders are in the Voting Agreement. Venture deals often use the model financing documents from the National Venture Capital Association (NVCA).

Here is a brief overview of the primary documents:

  • Stock Purchase Agreement: This agreement between the company and its investors documents the sale of shares of the company’s newly created preferred stock to the investors. It sets out the per-share price, number of shares sold and the closing process (i.e., one closing or “rolling” closings over a period of time). It also contains representations and warranties from both the company and the investors.
  • Charter:  The company must create, or authorize, the shares of stock being sold to investors in the financing. The Certificate of Incorporation (also known as the “Charter”) is a document filed publicly in the company’s state of incorporation. Among other things, it sets forth the number of authorized shares of each class of stock and the rights, preferences and privileges of the investors’ preferred stock, including things like dividends, liquidation preferences, conversion rights and obligations, anti-dilution adjustments and voting and protective provisions.
  • Investor Rights Agreement: This contract between the company and the investors sets out certain specific protections and rights given to investors in the financing. It covers registration rights, financial and information rights, preemptive rights to participate in future rounds and other covenants and provisions negotiated by investors in the financing.
  • Voting Agreement: This agreement is between the company and all (or almost all) of its stockholders, including the new investors. It details the size and composition of the board of directors. It also sets out the drag-along rights, which require all stockholders to vote in favor of a sale of the company if certain approval requirements are met.
  • Right of First Refusal and Co-Sale Agreement: This appropriately named contract is between the company, the investors and certain key common stockholders (the “Key Holders”). These Key Holders typically give the company first and the investors second a right of first refusal over sales of the Key Holders’ shares, subject to certain exceptions. It also includes a co-sale or “tag-along” right allowing the investors to participate (by also selling their shares) if a Key Holder sells their shares to a third party.

Although you’ll be sure to see other documents in your financing, like a legal opinion, management rights letter or indemnification agreement, these are the primary documents that you’ll use to close the financing.