When the founders of a company first take on a large venture capital investment, they may be shocked at the volume of paper generated to commemorate the relationship between the company and its investors. A purchase contract will set the monetary conditions of the investment agreement and establish the closing conditions as well as the representations and warranties. A corporate charter will set out the relative rights and privileges of preferred stock holders and dictate the procedures and the distribution cascade in an exit scenario. But of the other documents negotiated and executed by the parties, none is likely to impose as many onerous obligations within the corporate governance and licensing structure as the investor rights agreement or the IRA.
Founders should understand and appreciate each of the new requirements to which they are subject under their company’s IRA, including possible avenues for waiving or circumventing those requirements when the opportunity is preferable to strict compliance. This article reviews two provisions of the IRA where a company’s management team could find themselves stuck if they fail to appreciate relevant deadlines and deliverables, many of which may not have applied to the company before it undertakes new investments. (The “usual”, “typical” or “standard” scenarios in this article refer to terms found in the latest version of the IRA model adopted by the National Venture Capital Association, or NVCA, from July 2020, available here.)
The IRA typically requires the company to deliver its periodic financial statements to major investors, or to investors who have purchased and continue to hold an amount of equity above a negotiated threshold. The deliverables and the delivery schedule generally include at least the following:
A year-end balance sheet, income and cash flow statements, and a statement of shareholders’ equity (for which the company may need to retain the services of an independent auditor as agreed by the parties), due within 90 to 120 days after the end of the fiscal year of the company
An unaudited quarterly balance sheet and unaudited income and cash flow statements, due within 45 days of the end of each quarter in the company’s fiscal year
An unaudited monthly balance sheet and unaudited income and cash flow statements, due within 30 days of the end of each month
A budget and a business plan for the following financial year, broken down by month and including balance sheets and statements of operations and cash flows, due 30 days before the end of the financial year of the company
When founders first enter a condition sheet that calls for entry into an IRA or submission of financial statements, they should consider appropriate scaling of their financial reporting resources. as a high priority. If the company does not have sufficient resources to provide these financial statements within the timeframe specified in the proposed IRA, the founders probably cannot afford to treat this task as a post-closing item, especially since the deadlines begin to take effect on the 30 days after the initial closing of the financing.
The management team of the company may find that a certain deadline or deliverable is not immediately achievable for the company. For example, a 30-day deadline can be difficult to meet during tax season or any other administratively complex deadline. Another common conundrum is the inability of the business to hire an auditor to prepare the financial statements, often for reasons beyond the control of the management team. To avoid an IRA violation in such scenarios, management should promptly communicate with the company’s major investors about the reason for any early delay and seek prior authorization for any default.
Instead of just passing deadlines or leaving deliverables undelivered, a conscientious management team will call upon their legal counsel to prepare a written waiver that expresses the agreement of all parties involved that any delay is permissible and hopefully. -the, temporary. (A waiver can also be requested after the fact, but of course a post-violation waiver does not prevent a violation from having existed in the first place.) The “Amendments and Waivers” section of the IRA will set out the list of parties whose signatures are required on such waiver. To waive any part of the financial statement delivery requirements, a Standard IRA will require the written consent of the Company, which in turn generally requires the approval of an appropriate resolution by the Board of Directors, and holders of the Company. a certain percentage (at least a majority) of the registered securities then in circulation and held by all the main investors. The implementation of this paper trail not only keeps the company in compliance with its commitments and out of the question, but it also promotes fruitful communication with investors and helps the management team to avoid appearing cavalier or uncertain about the company’s reporting obligations towards its main investors.
The IRA may also impose similar timelines and requirements on the company with respect to new insurance coverage or the implementation of new company-wide policies that apply to employees or practices. leadership. In such a case, the founders should be made aware of these upcoming deadlines as soon as they are negotiated and should plan accordingly – if they simply cannot negotiate a later deadline in the first place – or plan to seek waivers if all diligent efforts may fail. .
First offer rights for new titles
Large investors usually negotiate more than the right to buy a stake in the company at one time. The IRA’s âright of first offerâ or pre-emptive rights provision will give major investors the opportunity to participate pro rata in the company’s future offerings of ânew securitiesâ, which cover a wide range of equity offerings. debt, equity and convertible securities, subject to any exclusions provided for in the corporate charter or set out in the IRA. Large investors also generally have the right to oversubscribe or purchase any assigned security that their fellow large investors do not choose to purchase. Founders are generally familiar with these rights, but they are often less familiar with the mechanisms the company must comply with if it wishes to offer new titles. A standard set of procedures for offering new securities generally looks like the following:
Before selling new securities, the company provides an âoffer noticeâ to each major investor that sets out the terms of the offer, including the price per security and the overall size of the round.
Within 20 days of delivery of the offer notice (as calculated by the notice provision in the IRA), major investors may respond to the offer notice by choosing to purchase a proportional amount of securities.
At the end of this 20-day period, if a major investor chooses to purchase at least all of the securities offered to it, the company promptly notifies each major investor who has chosen to purchase all of the securities that are offered to it. are offered, so that each of these large investors can additionally choose to purchase any of the remaining securities available for purchase.
Each major investor must provide their choice of oversubscription within 10 days of notification of the company’s oversubscription.
At the end of this 10-day period, the company may then sell the securities offered until the last of (i), if the main investors subscribe in full, 90 to 120 days (depending on what the parties are negotiating) after the initial offer notice is given, or (ii) if the principal investors refuse to purchase any of the offered securities, generally 90 days after the expiration of the principal investor election periods described above.
The above procedure is notable both for the rigidity required in communications with major investors and for the time required to complete the bidding process. Major preferred stock financing can sometimes follow such a deliberate pace, but most types of financing – especially in a climate of innovation and growth backed by venture capital – do not lend themselves to such a timeline. . In practice, large investors often expect the right of first offer timeline to be drastically condensed, and perhaps even their ongoing discussions with the company about future funding needs will help them achieve. their amounts committed without the need for a formal agreement. bidding process. If the major investors are on board, funding can be consumed in weeks, not months – but only if a waiver of the right of first offer is included in the deal approvals.
The IRA’s waiver provision for the right of first offer can be heavily negotiated. The most typical arrangement follows the requirements of the financial deliverables discussed above: the board of directors of the company must approve any waiver of the process, and a percentage (at least a majority) of the recordable securities then outstanding and held by the companies. major investors must also agree. The existence of a percentage threshold for the approval of such a waiver means that the major investors who control the vote are often able to participate in a financing while also voting to waive the right of first offer, thereby depriving the pro rata rights of the smallest large investors. . But some IRAs are negotiated (often by previous existing investors) to prevent this outcome, provided that if a major investor votes to waive any provision of the right of first offer and participates nonetheless, then all major investors are eligible to participate. on at least the same pro rata as the principal investor (s) who approved the waiver.
Regardless of the approval threshold and the participation rights ultimately granted in a waiver scenario, the waiver itself is typically covered not in a stand-alone waiver document, but in board and shareholder resolutions authorizing the transaction. funding. These resolutions will also provide for all approvals required under the protective provisions of the Company’s Charter or, where applicable, the section of the IRA that sets out transactions requiring the approval of one or more members of the Board of directors appointed by investors. In any negotiation of a new round of financing where time is of the essence, the management team of the company or the operations committee of the board of directors will have to be confident in its ability to deliver the required waiver votes, on pain of risk delaying funding by subjecting the company to the full schedule set out in the IRA. To successfully navigate these negotiations and avoid these pitfalls, company management should ideally engage in direct and frank communication with existing major investors on the right of first offer, and should maintain an accurate and up-to-date picture. outstanding voting securities of the company. in collaboration with the company council.