Effective contract management can save a company time and money and mitigate risk. Even so, often after companies painstakingly negotiate agreements, they frequently file them away and move on to the next business negotiation without giving them much further thought. Getting control of contracts then can become a fire drill after deadlines are forgotten or when a potential strategic partner or acquirer wants to look at a company’s contracts.

Contract management is often ignored or relegated to the backburner due to more pressing daily demands or delegated to someone without the time or ability. Plus, for some companies without relevant expertise or time, it can be daunting to select a contract management solution and integrate the company’s contracts into the management tool. The earlier a company develops discipline in managing its contracts, the earlier it will reap the powerful rewards, including the ability to quickly and easily do the following:

• anticipate expiration and renewal dates
• manage its own deliverables
• monitor third party performance
• monitor and understand trends within recurring contracts
• produce custom reports based on unique search criteria

Having a good contract management system may also speed the due diligence process of a significant business transaction, as the contracts will have already been reviewed for completeness, summarized for searching and reporting purposes, and scanned for ready delivery. With more sophisticated contract management systems, not only are executed contracts managed better, but the contracting process on the front end can become more streamlined and efficient and yield higher quality and consistency among contract terms.

Variables to Consider when Selecting the Appropriate Contract Management System

When selecting a contract management system for an organization, it is important to consider both the complexity of the organization’s contracts as well as current and anticipated future needs of the organization. Here are some considerations:

• How many people are involved in contract administration, and how many people need to have read-only access?
• Do the users need to have electronic access to the agreements?
• Do the users need to have access to agreement summaries?
• Is it desirable for the agreement text to be searchable as well as the summary?
• Are there certain controls the organization would like to have in limiting access by some people to only certain types of contracts?
• How comfortable are the users with spreadsheets, databases and vendors’ applications?
• How many contracts, what types of contracts, and what variations in those contracts does the organization have?
• What key elements of a contract does the business want to monitor?
• Are email reminders of key dates needed?
• How important is it to have a turnkey solution that provides customer relationship management and full contract lifecycle management, including a contracting approval process?
• Is it desirable to use a hosted solution as a document repository to free up space on the company’s network?
• What is the budget?

Depending on the company’s current and anticipated needs and desires, the solution may be a simple spreadsheet, a homegrown database, a licensed software application, or a web-based hosted service. Ideally, the solution should be scalable so it can grow with the business, or at least the data should be easily exportable, in case a different contract management system is more appropriate as the business evolves.

Using Spreadsheets for Contract Management

A simple spreadsheet is better than nothing and may suffice if the business has relatively few contracts or many of a similar, simple standard form. The advantages of a spreadsheet are that it is inexpensive and easy to use. A spreadsheet can also be supplemented by scanning the agreements as text searchable PDFs. However, a spreadsheet has limited or no functionality to provide email reminders, tailored permissions by document or category, multiple non-standard contract elements, advanced searches, and various reports.

Using Databases for Contract Management

If the business has an employee or advisor experienced with creating databases, that person could create a tailored database for the business, with specialized contract clause fields, a user-friendly form interface, and customized searches and reports. Vendors’ database products frequently offer greater functionality, such as the following:

• email reminders
• tailored permissions
• customizable fields
• ability to upload agreements and make them searchable
• auto extraction of key data
• sophisticated searches and reports
• an unlimited hosted document repository
• customer support
• military-grade security

Pricing can be surprisingly reasonable. It depends on the sophistication of the software, the number of users, and whether it is a software license with one-time license fee and annual maintenance fees, or a hosted solution with ongoing subscription fees that include customer support.

Designating a Contract Administrator

Equally important as choosing an appropriate contract management tool is designating one or more qualified administrators to assume the contract administration function. The administrator(s) should (1) be able to interpret and summarize legalese, (2) be comfortable with the contract management system selected, and (3) have the time to dedicate to contract administration. Consistency of data entry wording is also important for helping retrieve data through searches of summaries. As the adage goes: Garbage In-Garbage Out! If the business does not have a qualified contract administrator in-house, a corporate paralegal at a law firm can fulfill that role or train someone within the organization to serve in that role.

While implementing effective contract management takes some planning and resources, for most businesses the benefits are well worth it. The earlier a business commits to contract management, the sooner it will begin reaping the rewards.

One of the requirements in a private offering is that the issuer have a “pre-existing substantive relationship” with its investor. Once exhausting contacts with local or regional venture capital firms and angel investor groups, relatively few entrepreneurs seeking equity investments have adequate personal contacts with wealthy people who can provide sufficient money to meet the capital needs of the entrepreneur’s business. For those who don’t, one option is to engage an intermediary or “placement agent” to assist them in the process of finding potential investors. If a placement agent of an issuer has a pre-existing substantive relationship with an investor, that relationship generally extends to the issuer for purposes of avoiding the advertising restriction imposed on companies in private offerings. A placement agent usually refers to a person or firm that is a registered broker-dealer, but sometimes also includes “finders.”

Broker-Dealers vs. Finders

Broker-dealers are regulated professionals or firms that have passed a series of exams and have gone through a lengthy registration process that includes interviews. Finders, on the other hand, are not generally regulated. According to federal law, a broker-dealer is “any person engaged in the business of effecting transactions in securities for the account of others.”

For purposes of this article, the key language is “in the business of effecting transactions.” A finder is someone not in “the business of effecting transactions.” Rather, finders infrequently bring investors and companies together, but that’s all they can do. By law, a finder is not permitted to pitch for the company, develop deal terms, or negotiate for or represent the investor or the company.

There are likely many finders out there who actually perform the services of a broker-dealer, but have failed to register as one because of either ignorance or the time and cost that it takes to become registered. However, it is a violation of federal and most state securities laws to fail to register if a person or firm is engaging in conduct that constitutes broker-dealer activities. A violation of one of those laws can bring fines, investment rescission, penalties, headaches, and in egregious situations, imprisonment.

Some states place significant restrictions on performing any “finder-related” activities, and take away common blue sky transaction exemptions if an issuer compensates a finder as part of a sale of securities to the particular state’s residents. Moreover, there are regulatory issues of giving transaction-based compensation to finders (e.g., an 8% finder’s fee), which often times is exactly what the company and finder want to do.

Because of these and other regulatory issues and various limitations associated with using finders, it is usually better to work with a broker-dealer rather than a finder. However, there are many more finders that are willing to work with early-stage companies than there are broker-dealers willing to do so.

Selecting a Placement Agent

You may ask, “how does one find a placement agent?” Entrepreneurs can talk with their lawyers, accountants, or other entrepreneurs about their experiences with various placement agents in their area. Generally speaking, for smaller transactions (e.g., under $5 million), placement agents will typically operate on a regional basis (rather than national).

When selecting a placement agent, there are many things to consider. Probably the most important consideration is trust. By using a placement agent, you are putting a lot of faith in an individual or firm. The reverse is true as well from the placement agent’s perspective in that their reputation is affected by the companies with which they work. Below are some other considerations:

• Experience generally as a placement agent
• Experience and success with companies in similar industries raising comparable amounts of money.
• Reputation
• Knowledge and experience with securities laws
• For broker-dealers, good written policies and procedures
• For finders, the impact of using a finder on state Blue Sky exemptions, and potential legal issues with using the particular finder
• Pre-existing substantive relationships with prospective accredited investors

Placement Agent Contracts

Contracts with placement agents vary significantly. At the extremes, I have seen handshake deals, which I strongly advise against, and I have seen 25-page agreements. Below is a list of areas that are commonly negotiated in arrangements with placement agents:

• Exclusivity
• Duration
• Compensation amount and type (e.g., retainer/monthly fee versus a transaction-based fee)
• Events that give rise to compensation
• Ability to terminate and effect of termination
• The duration of the “tail” post-termination
• Additional services
• Indemnity
• Representations, warranties, and covenants
• Use of affiliates to assist in process

Once a company decides to engage a placement agent, finding the right one(s) under the right terms are essential. The placement agent may not only affect the success of your offering, but the placement agent may also affect (positively or negatively) the reputation of you and your company, expose you to securities law liability and sanctions, and bind you to a long-term, comprehensive, and expensive set of services.

So, if you decide to work with one or more placement agents, choose carefully.

With increasing frequency, companies are considering a change in their form of entity.  The reasons for the change vary considerably: sometimes companies are underwhelmed by the tax benefits of being a limited liability company and are overwhelmed by its complexities (international tax withholding issues, multi-state K-1’s, profits interests management, phantom income, and employee education regarding equity-based incentives), while other times companies are frustrated by the restrictions on S corporations and desire the flexibility that limited liability companies afford.  In other cases still, institutional investors may require a certain form of entity (e.g., a C corporation), while other investors (e.g., active angel investors) are looking to take advantage of pass through losses. 

Today, most states make it fairly easy to change the type of entity or even to change the state of organization of the entity.  It is important to keep in mind though that while the mechanics of converting to a new entity from a legal perspective are not typically too complex, the related tax issues can be incredibly intricate, especially for an organization with a long operating history and a complex capitalization structure.  While in many situations converting to a different type of entity will be tax-free, that will not always be the case.  Your tax advisor and accountants should be consulted early in the process when considering a change in entity form.  Assuming a change in structure is justified and the tax issues are manageable, this article focuses on the mechanics of converting from one type of entity to another.  

While there are variations among the states, there are generally two ways to change your type of entity from a legal perspective: merging with and into another entity of a different type and effectuating a conversion.  The method selected, as well as some of the finer details associated with the particular method selected, is often driven by tax considerations.

Change of Entity Form Through Merger

The more traditional way to change the form of an organization is through a merger.  Sometimes people refer to this as a cross-species merger.  A merger enables two or more entities to combine into a single entity.  The surviving entity can be recently created just to effectuate the change in entity form or it can have an operating history. The surviving entity typically files with the applicable state a plan of merger and a statement that the plan was approved in accordance with applicable law.  In most states, the plan of merger identifies the parties to the merger, the surviving entity, and the manner and basis of converting equity interests in each entity into interests in the surviving entity.  The plan of merger also includes any applicable amendments to governing documents (e.g., articles) for the surviving entity.  

After the merger, only the surviving entity continues to exist and it is responsible for all liabilities of each business entity that is a party to the merger.  Subject to certain exceptions and filing requirements, title to assets automatically vests with the surviving business entity.

Change of Entity Form Through Conversion

Within the last decade, most states have adopted statutes that allow organizations to convert their form of entity by just filing the applicable conversion documentation.  For example, in Wisconsin, a business that desires to convert to another type of legal entity must submit to the Department of Financial Institutions a certificate of conversion with a plan of conversion and a statement that the plan was approved in accordance with the laws applicable to the pre-converted entity. 

Similar to a plan of merger, most states require that a plan of conversion include the name, form of business entity and jurisdiction governing the entity both before and after the conversion.  In addition, the post-conversion articles of incorporation or other charter document is an attachment to the plan of conversion.  Some states however require a separate filing for the charter document.  Like with a plan of merger, the plan of conversion must also include the terms and conditions of the conversion and the manner and basis of converting the ownership interests in the old entity to the ownership interests in the new entity. 

Upon conversion, the new entity continues to be subject to the liabilities incurred prior to the conversion.  If a business owner had any personal liability by reason of the owner’s position in the entity (such as the general partner of a limited partnership), such liability will continue, but only to the extent accrued prior to the conversion.  The new entity continues to be vested with title to all its properties, subject to modest exceptions and certain filing requirements.  Any legal proceeding pending against the old entity will be continued against the new entity.  

Conducting Due Diligence When Changing Your Form of Entity

Despite the fact that the legal filing requirements for cross-species mergers and conversions are rather straight forward and mechanical, there are a number of due diligence issues that should be considered prior to making the change in entity form.  For example, in contracts, a merger is sometimes treated as an assignment of a contract from one entity to another and many contracts prohibit such assignments without prior consent.  Businesses should review all their material contracts and consider seeking consent for assignment where necessary.  Trademark and patent filings in the U.S. Patent and Trademark Office (USPTO) will need to be updated to reflect new company names in a conversion.  Mergers are treated as an assignment that also needs to be recorded with the USPTO.  Likewise, regulatory approvals, permits and licenses may need to be updated.  Because a conversion, rather than a merger, involves only a single entity, many consider that general contract anti-assignment provisions do not apply to conversions unless conversions are specifically addressed and prohibited.  In either case, however, there is frequently a company name change that may need to be reflected on a variety of documents. 

In addition to third party contracts and government filings and licenses, there are a number of organizational documents that may need to be created as a result of the merger or conversion.  For example, if an entity changes from a limited liability company to a corporation, many of the provisions from the organization’s operating agreement prior to the cross-species merger or conversion will be incorporated into a combination of the new corporation’s bylaws and perhaps a separate shareholders agreement, investor rights agreement or voting agreement.  Some of these organizational-related documents can be adopted wholesale with no or modest changes.  Others, however, will need considerable changes or even termination because of statutory requirements, efficiency, or custom.  

Conclusion

While it would be convenient to have all the facts up front prior to choosing an entity’s form when creating it, even the most diligent and seasoned entrepreneurs experience change in facts or laws that necessitate changing the organization’s form of entity.  With proper planning and involvement of your attorney and accountant, the process of converting your form of entity is usually manageable.  In the end, like with most things, the decision often becomes a cost-benefit analysis.

Below is a glossary for venture capital and merger and acquisition transactions. Users are encouraged to submit additional words for inclusion and suggestions for improved definitions. Once updating starts, the most up to date version of the glossary will be maintained at this link: Current Venture Capital and Merger and Acquisition Glossary.

Accredited investor

A person or entity that meets certain requirements under the federal securities laws for investment purposes. For example, a natural person is an accredited investor if he or she has a net worth (with spouse) that exceeds $1 million at the time of the purchase of securities, or has income either individually that exceeds $200,000 in each of the two most recent years or jointly with spouse that exceeds $300,000 for the two most recent years.

Angel investor

A wealthy individual (accredited investor) who provides seed or early-stage financing from his or her own funds in return for equity. Angel investors sometimes provide industry knowledge and contacts and sometimes play a direct role on the board, but infrequently participate in management. Angels invest either as individuals or in groups.

Anti-dilution provisions

An adjustment mechanism for preferred stock, options, or convertible securities that provides the holder the right to receive additional securities in the event of a future financing in which securities are sold at a lower price than originally paid by the holder of the right. Typically, anti-dilution provisions come in two types: full ratchet and weighted average. There are typically exceptions for the adjustment mechanism that carve out situations such as the issuance of certain employee options or existing convertible securities.

Assignment of inventions agreement

An agreement that states who owns the rights to intellectual property that is developed. An assignment of inventions agreement typically makes clear that an entity owns the relevant intellectual property developed by its employees, contractors, and agents.

Blank check preferred stock

Unissued class of preferred stock of a company, the terms and conditions of which (such as liquidation, voting, dividend, and conversion rights) may be expressly determined by the company’s board of directors without further shareholder approval. An issuer will typically use blank check preferred stock to simplify the process of creating new series of preferred stock to raise additional funds from sophisticated investors without obtaining additional shareholder approval.

Bridge financing

Interim financing used to meet a short-term, cash-flow need until more permanent financing (typically larger amounts) is secured. For example, bridge financing can be used to carry a firm to an initial public offering, a venture round of financing, or long-term debt.

Burn rate

The rate at which a company that is not profitable uses available cash to cover expenses that exceed revenues; the figure is usually expressed in monthly terms, as in a $100,000/month burn rate.

Business issue

An area that is traditionally negotiated between the clients, rather than attorneys (or in some cases, an area that one or both lawyers don’t want to negotiate for whatever reason).

Call right

A right that enables one person (or the issuer) to purchase securities held by another, usually at a fixed price and after a specified date or the occurrence of a certain event.

Capitalization

The combined sources of equity capital, consisting of convertible debt, common stock, and preferred stock.

Cap table

Short for capitalization table, it is a summary of a company’s issued and outstanding securities.

Common stock

A type of security representing the residual ownership rights of a corporation. Usually, company founders, management, employees, and some angel investors own common stock, while other investors own preferred stock. In the event of a liquidation of a corporation, the claims of secured and unsecured creditors, debt holders and holders of preferred stock take precedence over holders of common stock.

Convertible debt

A debt instrument (such as a promissory note) that can be converted to equity of the issuer (either as common stock or preferred stock).

Co-sale or tag-along rights

These rights enable the holder to participate in a sale of stock from another shareholder to a third party, typically in proportion to the number of shares the holder holds in the company. Co-sale rights are usually designed and intended to protect the holder if a founder or a majority shareholder decides to sell his, her, or its interest in the company. The co-sale rights holder can participate in the sale, usually on the same terms and conditions as the founder or majority shareholder.

Covenant

A contractual obligation to do or not do something in the future. For example, an affirmative covenant could be to provide quarterly reports to investors and a negative covenant could be to not enter into another financing without enabling existing investors to participate.

Cram-down financing

A financing that results in significant dilution of non-participating existing shareholders, usually reducing the value of the inon-participating existing shareholders’ original investments or the rights held by such non-participating existing shareholders.

Cumulative dividends

Dividends that accrue when unpaid and must be paid out before dividends are paid to subordinate classes of stock.

Deal flow

The amount of potential investments that an investor reviews in a given period of time.

Demand registration rights

Rights that enable a holder to demand that the company register the stock held by such holder under the Securities Act of 1933 in order to enable the holder to sell the stock in the public market without restriction.

Dilution

The reduction in the ownership percentage of shareholders caused by the issuance of new securities or the conversion of convertible securities of the issuer, typically with the connotation that the new securities are issued at a lower price than that paid in the previous round of financing.

Discounted cash flow

A valuation method in which the present value is calculated of anticipated future company cash flows.

Dividend

Payment made by a company to the owners of one or more of its types of securities.

Down round

A financing in which the new securities are issued at a lower price than the previous round of financing.

Drag-along rights

Rights that enable a shareholder or group of shareholders (usually those who own a controlling interest in the company) to compel other shareholders to sell their stock in the event a purchaser desires to purchase more than what the controlling shareholder(s) own(s).

Due diligence

A prudent and proper investigatory process to assess a company and the viability of a potential transaction.

Earn out

An arrangement in which sellers of a business may receive additional future payments if certain financial performance metrics are met.

Exit strategy

The method or plan for enabling shareholders to sell their shares and earn a return on investment. Typically, it refers to either the sale of the company or a public offering.

Founder

A person who participates in the creation of a company.

Founders’ stock

Nominally priced common stock issued to founders, officers, employees, directors, and consultants at or around the time a company is formed.

Full-ratchet, anti-dilution protection

Rights that enable investors to reduce the share price at which they can convert their earlier investment or debt to the lower price per share that the company subsequently sells or issues its securities.

Fully diluted basis

The total number of shares of common stock issued by a company, assuming all warrants, options and other rights are exercised and all preferred stock and other convertible securities are converted to common stock.

Initial Public Offering (or IPO)

The first registered offering of securities to the public that is in compliance with the Securities and Exchange Commission requirements.

Inside round

A round of financing in which the investors are the same or a subset of investors that invested in a previous round.

Institutional investor

Large, licensed entities that invest capital on behalf of companies or individuals.

Investment banker

A firm that raises capital, trades in securities, or facilities or brokers mergers and acquisitions (or a combination of some or all of the above).

Issuer

Refers to the company that issued or sold its securities.

Joint venture

An agreement or understanding between two or more companies in which the companies work together for a particular business undertaking.

Lead investor

The investor who manages the negotiation, documentation, and closing of a round of financing, and typically makes the largest investment in such round.

Liquidation preference

The amount of assets holders of preferred stock are entitled to prior to any distribution of assets to holders of common stock upon a liquidation event, such as the dissolution or sale of the company. The preference amount is often based on the original purchase price paid by the holders of preferred stock, or a multiple thereof (e.g., a 2x liquidation preference).

Living dead

Refers to investors who go through a few down rounds of financing, are unwilling or unable to invest any more, and for whose interests in the company there is no liquidation event on the horizon. When the term is applied to a company, it means that the company continues to operate, even though the company is insolvent or has little chance of thriving.

Lock-up provision

A contractual requirement that for a period of time (such as 180 days) a shareholder is restricted from selling such shareholder’s securities following a public offering.

Mezzanine financing

Typically a hybrid of debt and equity financing that is used to finance the expansion of an existing company. It is generally subordinated to debt provided by senior lenders, such as banks

No-shop requirement

A contractual requirement that prevents a company from soliciting or negotiating other deals for a specified period of time, while it is exclusively negotiating with a potential investor, group of investors, or acquiror.

Outstanding stock

Shares of stock that have been issued and are not held by the issuer

Participation right

A right that enables the holder to purchase the holder’s pro-rata percentage of the company’s equity securities in future rounds, enabling the holder to maintain his, her or its percentage ownership in the company.

Participating preferred stock

Preferred stock that entitles the holder not only to holder’s stated liquidation preference, but also allows the holder to participate in liquidating distributions to holders of common stock after the initial liquidation preference is distributed to the holders of preferred stock.

Payment in-kind dividends

A dividend paid in equity rather than cash.

Pari passu

A Latin term referring to the equal treatment of two or more parties in an agreement. For example, an investor may want to have a certain right that is pari passu with investors in a previous financing round.

Pay-to-play

A requirement that in order retain a right, the holder must do or pay something in the future. In the venture capital context, if a holder of preferred stock desires to maintain certain rights as a preferred stockholder, he, she, or it must participate and invest pro rata in future financings or lose those rights.

Piggyback registration right

A right that enables an investor to force an issuer to register the investor’s previously issued, but unregistered shares of the issuer in the event the issuer decides to register some of its other securities.

Placement agent

An individual or firm that assists with identifying investors to purchase securities.

Portfolio company

A company that has received an investment from a venture capital fund is said to be a portfolio company of that venture capital fund.

Post-money valuation

The value of a company after investors invest in a given round of financing.

Pre-emptive right

The right of an existing shareholder to purchase such shareholder’s pro rata share of any new stock that is being issued by the company prior to that stock being offered to new investors. Pre-emptive rights are similar to participation rights.

Pre-money valuation

The value of a company before investors invest in a given round of financing.

Preferred stock

Stock that gives its holders certain rights, preferences, and privileges over holders of common stock and other securities.

Private placement memorandum (PPM) or offering memorandum

A document explaining the details of an investment opportunity related to the sale of unregistered securities to potential investors.

Put right

A right that enables the holder to force the company or another investor to purchase the holder’s securities, usually for a prior agreed upon price, after a specified date or the occurrence of a specified event.

Qualified public offering (QPO)

A public offering that meets certain requirements, as agreed between investors and an issuer, such as a minimum amount or a specified return for holders of preferred stock.

Reg D or Regulation D

Refers to certain alternative rules promulgated by the Securities and Exchange Commission that enable an issuer to sell its securities with certain restrictions, without registering them, to a limited number of people, most or all of whom must meet certain standards of sophistication or wealth (see “accredited investor”). Each rule under Reg D has different requirements, such as those relating to the size of the offering, the number of investors, and the types of required disclosures.

Redeemable preferred

Preferred stock that can be redeemed by its holder in exchange for a prior agreed upon price.

Rights offering

An offering of securities only to current shareholders of an issuer.

Road Show

A series of presentations made in several cities to potential investors.

Securities and Exchange Commission (or SEC)

The federal agency that is in charge of enforcing the federal securities laws and regulating the securities industry (including the stock exchanges).

Stripped down preferred

A type of preferred stock that carries only the very basic rights of preferred stock (e.g., a liquidation preference), but does not carry the variety of other rights (contractual or otherwise) frequently associated with the issuance of preferred stock.

Syndicate

A group of investors that participate in a round of financing or a group of investment banks that participate in a public offering.

Term sheet

A document that outlines the key terms of a proposed transaction. The term sheet is typically non-binding, except for certain provisions.

Underwater option

An option is underwater when the current fair market value of the underlying shares is less than the option exercise price to purchase those shares.

Veto rights

Negotiated rights that enable the holder to prevent a company from taking certain actions or cause it to take certain actions.

Warrants

A derivative security that gives the holder the right to purchase securities (usually common stock) from the issuer at a specific price within a certain time frame.

Weighted average anti-dilution protection

Adjusts the investor’s conversion price downward based on a weighted average formula reflecting the number of new shares sold and the new price per share at which the additional shares were issued. It can be a narrow-based, weighted average or a broad-based, weighted average. Compare to full-ratchet anti-dilution protection.