Modeling the Market: The National Venture Capital Association Revises its Model Documents
The National Venture Capital Association (NVCA) published on July 28, 2020 an updated suite of model venture capital financing documents that reflect the current events shaping the investment climate, and for the first time, embedded analysis of market terms directly in the NVCA’s model term sheet. [1] Venture capital funds, professional investors, emerging companies and their respective advisors will benefit from the summary analysis contained in this article which highlights the most significant changes to the primary model financing documents.
The NVCA’s updates are timely because venture capital investing remains strong despite the challenges of 2020. Pitchbook reports 2,893 U.S. venture capital deals with an aggregate of $45.20B of capital raised as of the second quarter of 2020, representing approximately a 17% reduction in deal count and a 2% increase in aggregate dollars raised over the same period in 2019. Economic uncertainty looms in the market, as does the specter of increased governmental interest in foreign investments in certain emerging businesses. [2]
Efforts to revise the model documents clearly predate recent media fanfare regarding forced divestitures of popular mobile applications, yet a common theme flowing throughout the revised documents centers on the recently adopted regulations implementing the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA), which took effect on Feb. 13, 2020. While a full discussion of FIRRMA and the expanded powers of Committee on Foreign Investment in the United States (CFIUS) is outside the scope of this publication, the NVCA has established a framework through which investors and founders can negotiate compliant non-controlling foreign investments in U.S. businesses involved in certain critical technologies, infrastructure, or the personal data of U.S. nationals.
The following chart outlines the most significant changes to the primary model financing documents – the Term Sheet, Certificate of Incorporation, Stock Purchase Agreement (SPA), Investors’ Rights Agreement (IRA), Voting Agreement (VA), and Right of First Refusal Agreement (ROFR).
Summary of Significant Change |
TPHS Takeaway |
Term Sheet |
|
Market Analytics |
The market insights reflect 35,000 venture capital transactions, from over 17,000 unique investors. They provide increased transparency regarding Series Seed through Series D investment rounds that may ultimately frame negotiations and increase acceptance of market standards. |
Option Pool
|
The bracketed language impacts “promised” stock options, which are typically included in employment offer letters that are outstanding during the period of negotiation. If the bracketed language is included, the promised stock options would not come out of the post-money employee option pool, but would further dilute founders and existing stockholders. |
Amount Raised
|
This addition recognizes the frequency with which companies have raised capital using SAFEs, particularly in place of series seed investment rounds or convertible notes. |
Closing Condition
|
This change is consistent with the focus of other changes throughout the model legal documents, which collectively highlight the importance of being vigilant in navigating the CFIUS landscape. |
Certificate of Incorporation |
|
Alternative Dividends
|
This dividend formulation (or derivations of it) is commonly utilized in practice, and is a welcome addition to the form because it is consistent with giving the board discretion to issue dividends. |
Stockholder protections
|
The additional preferred stock protective provisions represent incremental changes that largely supplement and are consistent with the intent of existing protections for preferred stockholders, and are intended to ensure the company’s corporate governance obligations are consistent with state corporate governance laws. |
Specific Director Consent
|
The revision reflects the holding in Sinchareonkul v. Fahnemann, 2015 WL 292314 (Del. Ch. Jan. 22, 2015) that Section 141(d) of the DGCL requires that a provision requiring specific director approval for certain actions must be in the Certificate of Incorporation, and such a provision in an agreement (in that case a joint venture agreement) or the bylaws is not valid |
Stock Purchase Agreement |
|
Parties to SPA
|
The updated SPA reflects the market’s general acceptance that founders should not bear personal liability to investors after Series Seed, except where the founders are receiving liquidity from a transaction or where there are heightened due diligence concerns (e.g., ownership of intellectual property). |
Multiple Closings
|
The revision clarifies the section regarding multiple closing contemplates successive capital raising transactions with the same terms and a “tranched” closing where investments are made over time and/or upon the occurrence of certain milestones. [The NVCA publishes a separate SPA for life sciences transactions where tranched milestone closings are common.] [3] |
Definition of Knowledge
The definition of “to the Company’s knowledge” was expanded to include actual knowledge as determined under US patent law. |
The expansion of the defined term “Knowledge” is protective of investors, as it reasonably clarifies that a person’s actual knowledge after reasonable investigation assumes he or she has all requisite knowledge expected of someone in his or her role with the company. The reference to actual knowledge of a patent right does not expand the phrase of “to the Company’s knowledge”, but rather makes clear the definition is not intended to exclude the knowledge threshold established under patent law. |
Intellectual Property Representation
|
Although the representation is narrower than the prior iteration, it is consistent with the evolution of recent market standards and focuses on eliminating burdensome disclosure rather than shifting risk to the investors. Instead, the language is more precisely tailored to require disclosure of uses of open source software that could reasonably concern investors or could cause an investor to initiate a breach claim under the prior iteration of this representation. |
Data Privacy
A representation was added that the company has not experienced any unauthorized use or access of personal information requiring disclosure to a government authority or affected persons, or unauthorized access of the company’s confidential information and trade secrets. |
The data privacy representation revisions regarding non-compliance with law do not expand the disclosure obligations of the company, but rather clarify what the representation should include. For instance, the prior iteration required disclosure of non-compliant uses of personal information, which would have included uses that did not comply with state and federal prohibitions on unfair and deceptive trade practices, and the new language explicitly covers this type of situation. The revisions also address new considerations and risks stemming from privacy laws, such as the General Data Protection Regulation and the California Consumer Privacy Act. This language will shed light on the reliability of the company’s data protection and monitoring programs, which is, and should be, an ever-increasing focus of investors. |
CFIUS
|
This representation is intended to address whether CFIUS’ mandatory filing regimes apply to the transaction, although CFIUS may nonetheless intervene if the transaction will result in a foreign party holding greater than a 9.9% ownership interest of the company. If the company cannot make the full representation, it should consider whether any of the representations are accurate, which by themselves may reduce the filing obligations. From a practical perspective, if the company cannot make the full representation, careful consideration should be given to how CFIUS’ review may impact the transaction timeline and overall deal cost, and prompt additional diligence to understand the operational constraints under the Defense Production Act. |
Consent to Electronic Notice
|
This provision is not technically required, as electronic notice is the default standard under the Delaware General Corporation Law as of August 2019. However, it provides investors protection by automatically revoking the efficacy of notice provided to an incorrect or undeliverable address, while also protecting the company by causing purchasers to covenant to notify the company of any change in his or her email address. |
Investors’ Rights Agreement (IRA) |
|
CFIUS and Foreign Investor Updates
|
The potential outcome of these revisions, which relate to CFIUS’ authority with respect to a transaction, remains to be seen. In practical terms, sophisticated foreign persons may negotiate around the triggering threshold in spite of the balancing test of control rights. Alternatively, even if a foreign person is implicated, a national security issue may not be present. |
Qualified Small Business Stock (QSBS)
|
These updates are intended to simplify the QSBS provision, which previously allowed the company to elect to either provide a similar certificate to investors or to provide investors the necessary information for determining the applicability of QSBS to the company’s stock (even though the nature of such information was not specified). Now, the company is obligated to deliver the certificate, but is not exposed to significant liability absent gross negligence or fraud. |
Board Observers
|
This modification is intended to reflect the reality that board observers do not have the right to participate in board decisions. This modification places the burden to monitor information flows on the board of directors, and reduces the imposition on board observers, particularly those who sit on multiple boards. |
Real Property Holding Company
|
This change flows from recent revisions to the tax code, which require a venture capital fund to report to a transferring limited partner the extent to which a transfer of interest would generate U.S. tax obligations. |
Definition Of “Immediate Family Member”
|
This change reflects the increasing recognition of the diversity of domestic partnership types. |
Termination of Information and Observer Rights
|
This revision is intended to protect investors and provide them with compensation upon the occurrence of certain events. |
Waiver of Statutory Information Rights
|
A Delaware court may still hold this provision enforceable, given the trend to enforce private agreements between sophisticated investors. |
Voting Rights Agreement (VA) |
|
Size of Board
|
This revision reflects the reality that the size of the board is most often fixed in a company’s bylaws rather than contractually agreed upon by investors. |
“Bad actor” disqualifications
|
This revision focuses on determining if investors are bad actors to prevent the issuer from being precluded from relying on Rule 506 for future offerings or future sales in the same offering if the applicable investor is or becomes a 20 percent beneficial owner of the issuer’s voting securities. |
Right of First Refusal |
|
CFIUS
|
As echoed in the IRA, the potential outcome of these CFIUS revisions remains to be seen, as sophisticated foreign persons may negotiate around the triggering threshold, in spite of the balancing test of control rights, or even if a foreign person is implicated, a national security issue may not be present. |
Lock-up
|
This exemption for the establishment of a 10b5-1 plan is equitable as it is consistent with the intent of the lock-up - to reduce the likelihood of a stock price being depressed by large sales form company insiders - while providing such sellers with access to pre-planned liquidity. |
In addition to the primary financing documents discussed above, the NVCA also updated its model
Management Rights Letter,
Indemnification Agreement, and
Limited Partnership Agreement and a few other ancillary documents. For more information regarding the NVCA’s model legal documents and the impact of the recent revisions, please contact:
Matthew Greenberg,
James Jumper, or
Christopher Miller.
[1] In August and September 2020, the NVCA made additional minor editorial revisions to the model Term Sheet, Certificate of Incorporation, Stock Purchase Agreement, Investors’ Rights Agreement, and Right of First Refusal Agreement.
[2] PITCHBOOK DATA; Retrieved from Pitchbook database, August 19, 2020 (Criteria: All VC deal types for US and Globally (including the US) from January 2019-2020 YTD).
[3] Note to Draft: The NVCA indicates a model Stock Purchase Agreement for life science transactions with tranched closings is available.