Seed funding documentation
February 20, 2022
Once in a while we’ll be approached by a foreign investor planning to invest in the seed round of a U.S. start-up. By the time they come to us, they’ll have read the financials, feel positive about the deal and are ready to invest. The last stage of the process is execution of the legal documentation. They have counsel in their home jurisdiction (e.g. France) who may have a general understanding of how U.S. investor documentation looks, but cannot substantively advise.
The investor is reasonably sophisticated and know their way around deal documentation, but needs a local pair of eyes to review and to advise them if anything is out of the ordinary with reference to the type of deal in question. In essence, they’re looking for a sense check rather than a deep dive.
The first issue that often needs explaining is why there are so many documents. While in their home jurisdiction they may be used to a Subscription Agreement and a Shareholder Agreement, in the U.S. they are provided with separate agreements for voting, voting rights and ROFR/Co-sale, in addition to being provided with a lengthy Cert of Incorporation and Share Purchase Agreement. The reason we generally cite is because this is how it’s generally done in the U.S. together with a brief explanation of severability – if one agreement is void, it doesn’t impact connected, but separate agreements.
Getting down to basics, what we’re looking at in a “sense check” is a) anything obviously out of the ordinary and b) rights/protections. An example of the former could be the agreement using the law of an obscure jurisdiction. For the latter, we’re looking at the following:
1. Pro-rata rights. If the company really takes off, the seed investor needs to be able to go along for the ride, by having the right to invest in future rounds. The investor may be granted pro-rata rights, but then be asked to waive them in certain situations – e.g. if a high-quality investor decides to invest that would significantly increase the company’s value. This new investor may be less likely to want to invest if their desired ownership percentage is diluted down by existing investors electing to participate in the same investment. So where is the balance? Generally the agreement should grant pro-rata rights but have a waiver mechanism where the majority of investors can waive the pro-rata rights of all investors provided that no existing investors are permitted to invest in the round (i.e. equal treatment)
2. Rights of first refusal. Seed investors should generally be given a right of first refusal pro rata with similarly situated existing investors. While a sale of shares to a third party in this situation is quite rare (the ROFR tends to be a big impediment – who wants to go through the process of arranging a purchase of shares only to have the other shareholders swoop in and purchase most (or all) of the shares that were for sale?), if it does occur, it can upset the balance in a company if an existing shareholder is given priority rights. For this reason its best to include.
3. Tag-a-long rights. If the founders/other early investors cash out, the seed investor needs to have the ability to participate in the same sale and on the same terms.
4. Drag-a-long rights. This is a mechanism that ensures that reluctant shareholders are obligated to sell all of their shares where a majority of shareholders votes to sell the company and/or a stake in the company to a purchaser. Drag-a-long rights are important to ensure smaller shareholders don’t have undue leverage over a sale, but it’s also important that the terms foisted upon them are reasonable.
5. Liquidation preference. Ideally waterfalls should be avoided (subsequent investors take priority over prior-round investors), though for seed investors its rarely a deal breaker and is something that oversized attention is paid.
