I am pleased to announce that Paul Page recently joined AlphaTech Counsel, S.C. I am excited about this change and wanted to share a little about Paul.

Paul combines a science, business, and IT background with large law firm experience as a corporate lawyer. He is a great fit at AlphaTech as not only is he an excellent practitioner, he understands the needs of emerging companies and is well-versed in helping entrepreneurs to balance important legal and business issues.

Paul has quickly stepped in and is already actively working with clients and using a number of our automated systems. I am genuinely thrilled about Paul coming on board. Here is more information about Paul: http://alphatechcounsel.com/page-bio.html

As public companies are increasingly opting out of providing paper certificates to shareholders in favor of providing electronic registration (a movement known as “dematerialization”), most private companies and their shareholders have yet to follow suit.  Issuing uncertificated shares is allowed under most states’ laws, and, as many on the public company side can attest, numerous cost and time efficiencies can be gained by going paperless with shares.  As we accept electronic statements to represent our public company holdings and exhibits to Operating Agreements to note our LLC ownership interests, do we really still need as evidence of our private company ownership a hokey, bordered piece of paper with an eagle on it? 

Disadvantages of Issuing Paper Stock Certificates

Consider the inefficiency and chances for errors in the typical cumbersome process to issue paper stock certificates: 

1. Law firm staff orders special certificate paper
2. Attorney gives legal staff information needed to complete the certificates
3. Law firm staff keys in information on a blank Word document in calculated places on the page to line up with the paper form (or pulls out the old typewriter)
4. Law firm staff puts special certificate paper in the shared printer
5. Law firm staff reprints each certificate until the text lines up in the blanks
6. Law firm staff flips over the certificate (hopefully correct side up) and puts it back in the printer and prints the restrictive legend on the back side
7. Attorney reviews certificates for accuracy
8. Law firm staff sends or delivers the certificate to the company
9. The company obtains two busy officers’ signatures
10. The company sends the signed certificates back to the law firm to send out
11. Law firm staff prepares cover letters and overnight envelopes (or arranges for messenger service) to the investors
12. If the delivery was set for “do not release without signature,” the investor can be frustrated with having to be available for the package
13. The investor is then instructed to sign the stock receipt and return it in the envelope
14. Law firm staff follows up with investors who have failed to return the signed stock receipt, and sends another one

In addition to the inefficiency and error prone nature of issuing paper stock certificates, replacing lost stock certificates can be administratively burdensome for private companies.   Private companies typically require an affidavit of lost stock certificate and could (but usually do not) also require an indemnity bond to replace a lost certificate.  If a shareholder fails to replace a lost stock certificate while the company is private and it goes public, replacement can be quite expensive for the shareholder.  The transfer agent will pass through to the shareholder a fee charged by its indemnity carrier to insure replacement of the certificate, typically 2 – 3% of the fair market value on the date of replacement.  This could easily be tens of thousands of dollars!  What’s more, when delivering the certificates to the company or transfer agent for the IPO, most courier services will not insure a legal document delivery worth more than about $50,000.  I have seen a situation where a paralegal from the firm representing the selling shareholders in a follow-on offering, flew to the transfer agent’s office with shares worth millions in hand.

As rapidly growing emerging companies can go through one or more stock splits before an exit event, the disadvantages of issuing paper certificates multiply – more certificates for shareholders to safeguard, more chances for errors, and more costs associated with printing, proofing, and delivery.

Written Statement Instead of Paper Stock Certificates

The laws of Delaware, Wisconsin, Illinois and 42 other states/territories (all but Louisiana, Missouri, New Hampshire, New Jersey, North Dakota, Oklahoma, West Virginia and certain territories), with limited exceptions, provide that the board of directors of a company may approve the issuance of shares without certificates as long as the shareholder is provided with a written statement containing applicable information within a reasonable time after the issuance or transfer.  The written statement, which in most situations can be transmitted by email, typically must include the following: 

• Name of the corporation and what state organized under
• Name of the shareholder
• Number and class of shares and the designation of the series
• If a corporation is authorized to issue different classes or series of shares, include (i) a summary of the designations, relative rights, preferences and limitations applicable to each class and for each series, and the board’s authority to determine variations for future series and (ii) a conspicuous statement that the corporation will furnish the shareholder the information described in item (i) on request, in writing and without charge
• Transfer restrictions, if any

Usually, the board of directors can authorize the creation of uncertificated shares either by the first issuance or as replacement for shares previously represented by certificates.  The board also typically has the discretion to issue stock certificates for some classes and series of shares and not others.  Generally, there are no differences between certificated and uncertificated shares, except for the process to transfer them and to perfect security interests in them. 

Resistance to Uncertificated Shares

Despite the legality of uncertificated shares in most states, most private companies still issue paper stock certificates and most shareholders still expect them.  Shareholders sometimes prefer to have tangible evidence of their company ownership even though they do not appear to have the same expectation for partnership or LLC interests.  Some people want stock certificates for historic preservation and pride.  That may make sense in the context of long-standing businesses, but makes less sense with emerging companies funded by angel and venture capital investors.  With most technology start-ups, the company sells, merges, dissolves, or goes public within several years, in which case the stock certificates typically must be tendered for replacement shares or cash; shareholders cannot keep them for historic sake, unless of course the certificates become worthless.  On the public company side, many brokers have been discouraging shareholders from requesting paper certificates in their name by passing through a $500 fee that the Depository Trust Company (DTC) started charging on July 1, 2009.

Changing the Tide from Paper Stock Certificates to Uncertificated Shares

DTC’s change in fees and procedures last year led to declining public company shareholder demand for physical stock certificates.  Just as stock certificates are becoming a thing of the past for public companies, it is time for privately held emerging companies to consider issuing uncertificated shares.

The recent $1 Billion Qualifying Therapeutic Discovery Project Credit program will be a real benefit to many area small life science and medical device companies. A surprise to many though when reading the requirements of the program is that limited liability companies (LLCs) that have as an owner a tax-exempt organization are not eligible for a grant under the program. Having a tax-exempt organization as an owner is more common than one might think. Many university technology transfer offices, such as the Wisconsin Alumni Research Foundation (WARF), are tax-exempt organizations and frequently hold an equity interest in the startups to which they license patents. As a result, those LLC biotech licensees are not eligible for a grant under the program. As the CEO of an LLC with which I work (but did not set up) said earlier this week about being excluded from eligibility, “Ouch! That stings! Another painful learning experience.”

LLCs are Typically Not the Best Choice of Entity for Emerging Technology Companies

The “LLC issue” for emerging companies extends well beyond this grant issue for therapeutic companies. I say this even though many attorneys recommend LLCs for virtually all contexts. Sure, LLCs have their place. I frequently advocate using them as holding companies, investment vehicles, and joint venture entities. Among other situations, it also can be appropriate to use them when there is a limited, small group of owners actively participating in the business or when the owners want to have a certain allocation of profits and losses that cannot be accomplished when using an S or C corporation. But for many emerging companies that have or plan to have outside investors, the LLC is often not the best choice of entity.

Most people have a general understanding of the potential benefits of LLCs: pass-through tax treatment, flexibility, few formalities, ease of setup, etc. I will leave it to others to summarize in detail the benefits of LLCs, as there are many.

The “I didn’t know” LLC Issues for Emerging Technology Companies

What I often encounter is that an “issue” arises after the founders either worked with a drumbeating LLC advocate when they were initially organized or the founders organized the entity themselves through an easy-to-use website. In either case, frequently, the founders do not have a good understanding of the common issues that arise through the life cycle of the entity. These “I didn’t know” issues come up often after the company has been operating as an LLC for a while. Below is a list of some of the LLC issues that I have witnessed:

• A 10% owner of an LLC becoming a less than 1% owner of a corporation after conversion to a corporation because his capital account in the LLC was propotionately less than that of the other owners.
• A venture capital firm refusing to look past the heading of an executive summary after it discovers the entity is set up as an LLC.
• Spending tens of thousands of dollars (not to mention management and investor time) implementing and maintaining “blocker corporations” to limit unrelated business taxable income (UBTI) to the VC firms’ limited partners, while trying to maintain economic parity between investors, through several rounds of venture capital financings.
• “What do you mean I can’t take advantage of the losses because I don’t actively participate in the business?!?”
• A small, dissident group of members refusing to consent to a conversion, which in many states requires a unanimous vote of LLC members.
• Inability to take advantage of the special tax benefits of incentive stock options available to corporations.
• Spending several dozens of hours more than it would take to administer a stock option or restricted stock program to administer a profits interest program.
• Two members of an LLC (with negative capital accounts) owing taxes as a result of converting to a corporation.
• Significantly higher investment transaction costs as law firms generally do not have “standard” LLC investment documents for sophisticated transactions.
• When a company started to make money, requiring the owners to choose between receiving “phantom income” or making distributions to members to cover individual taxes at high marginal rates, despite a desire to reinvest that cash and grow the company.
• Inability to do a tax-free reorganization as an exit strategy.
• An LLC taking 5 months to obtain the required residency certifications and tax information authorization forms from each of its 78 members in order to limit the international tax withholding requirements in connection with a transaction.
• An LLC obtaining the required written authorizations and powers of attorney of 90+ nonresident members in order to file consolidated state tax composite returns in 8 states (and the corresponding K-1′s from each state sent to each member).
• Spending tens of thousands of dollars (attorney and accountant fees) converting to a corporation

I could go on and perhaps dedicate a post to each of these situations. And, of course, there are expensive and complicated solutions to some of these issues. But as some of my former colleagues at Michael Best said in a recent article, choosing an LLC can be a mistake for many companies and the decision should not be made without a full understanding of the ramifications.

Converting an LLC to a Corporation

A frequent comment I hear from executives of companies that are set up as LLCs is that they can convert to a corporation at any time. This is generally true. With the exception of some of the issues I described above, it often just involves an analysis of the benefits of being a corporation versus the time and expense involved to convert to one. I have handled a number of conversions and co-authored a brief post on the topic: Changing Your Choice of Entity: Cross-Species Mergers and Conversions. The difficulty is that the longer a company waits and the more complex the company’s capitalization structure, the more expensive it is and the longer it takes to do.

As with most important decisions, it is wise to talk with your trusted advisors about choice of entity issues. Take the time to understand the potential (and likelihood) of the benefits and costs long term, especially if you are considering using an LLC as the entity for your emerging growth company. Sometimes an LLC is the best entity choice, but more often for emerging technology companies, it is not.

Because of the frequency of which they are used, one of the first forms that we automated at AlphaTech was the Confidentiality Agreement.  Sometimes they are called Nondisclosure Agreements (NDAs), Confidential Disclosure Agreements (CDAs), Proprietary Information Agreements (PIAs) or Secrecy Agreements, but for the most part, they each are the same thing trying to accomplish virtually the same objective: limit the disclosure and use of one’s confidential information. 

So, if they are all trying to do the same thing, why are there so many forms out there?  The answer is that it often comes down to legal limitations, the one-way versus two-way (or mutual) nature of the agreement, and exceptions or limitations to the disclosure and use limitations.  For example, many states consider when employees sign a Confidentiality Agreement it is a restrictive covenant (or noncompete).  As such, to be enforceable in most states, the agreement must have “reasonable” limitations on variables such as duration.  These legal restrictions are not typically the same for two businesses entering into an NDA.

The balance of this post examines the details of an NDA.

Definition of Confidential Information

Most NDAs define “Confidential Information” very broadly.  There are commonly carve-outs for things like information that ends up in the public domain, information already in the possession of the recipient, and information conveyed to the recipient from someone else who was not under an obligation to keep it confidential.  It is also common to see trade secrets carved out of the confidential information definition if the NDA imposes more strict obligations on use and disclosure of trade secrets.  Sometimes one sees a carve-out for information that is “independently developed” by the recipient without the use or benefit of the confidential information provided by the discloser.  This last carve-out is appropriate in some contexts, but not in others.  Regardless, if the “independently developed” provision is incorporated, be sure that it does not permit “reverse engineering” of confidential information.

A controversial provision that one sometimes sees in NDAs is a requirement that in order to be considered within the definition of confidential information, the information must be marked “confidential” or confirmed in writing as confidential if communicated orally.  This limitation is fine for arrangements that are very limited in scope and have a specific set of documents that are considered confidential.  However, companies should be wary of such a limitation for continuing relationships or arrangements in which many people are exchanging a lot of confidential information.  The process of marking and communicating what is confidential (consistently) can get unwieldy very quickly.  A failure to follow just once this “simple” procedure of marking something confidential, can lead to disastrous results.

Use and Disclosure of Confidential Information

An important but sometimes overlooked provision is the scope of the permitted use of confidential information.  The scope of use should be broad enough to accomplish the intended purpose of the disclosure (e.g., to enable the consultant to perform under a consulting agreement or explore the possibility of entering into a strategic partnership with another company), but not overly broad to enable shenanigans.  The use provision should be tailored to the specific context of the intended use.  Also, it is common to see a provision that enables disclosure if the recipient is legally compelled to do so (e.g., under a court order or subpoena). 

No License or Warranty

It is common to have a provision in an NDA that disclaims any license or warranty being conveyed when delivering the confidential information.  Sometimes, when something is delivered, there can be an implied warranty or license associated with the item being delivered (that the information is accurate, that it works, that it doesn’t infringe on the rights of others, that the recipient can use it, etc.).  This type of provision typically disclaims those.

Duration of the NDA

NDAs typically have two elements of duration.  The first element is the period during which disclosures can be made that are covered under the NDA.  For example, for employees or consultants, this is typically the period during which the employee or consultant is engaged by the company.  The second element is the period during which confidentiality and use restrictions apply after the agreement comes to an end.  A common restriction one sees for employees is that the duration lasts for a period of two years following the end of the employment. 

Governing Law, Jurisdiction, Forum/Venue

Most NDAs address which state’s (or country’s) law applies when interpreting the NDA.  Many NDAs also address where a dispute will be resolved.  The provision is less important when the two parties are located in the same area.  It becomes more important (and often negotiated) when the parties are not located near one another or are located in different countries.  Common compromises are to (i) choose one party’s state’s law (or country’s law) to govern the contract and the other party’s location as the forum/venue, (ii) delete the provision altogether, making it unclear which state’s law applies and where disputes are to be settled, or (iii) in a two-way NDA, choose a neutral but relevant state’s law to govern the agreement (e.g., Delaware, if both companies are incorporated there) and require the discloser (the company enforcing) to use the recipient’s location in the event the discloser would like to sue the recipient.

Right to Equitable Remedy

Many NDAs will include a provision that states if the recipient breaches the agreement, the discloser will be entitled to equitable or injunctive relief.  In the NDA context, equitable or injunctive relief refers to getting a court order to stop the recipient from using or disclosing the confidential information.  Sometimes, this type of relief can be more difficult to obtain than monetary damages.  However, in most contexts involving an NDA dispute, the discloser’s top priority is to prevent the recipient from continuing to use or disclose the confidential information.  As a result, the purpose of the provision is to attempt to stipulate that the requirements to get an equitable or injunctive remedy have been met.

Entitlement to Attorneys Fees in the NDA

Many NDAs contain a provision covering attorneys’ fees.  Sometimes they are structured as a prevailing party obligation—the winner gets the loser to pay the winner’s attorneys’ fees.  Other times, especially in one-way NDAs, the attorneys’ fees provision requires the recipient to pay the discloser’s attorneys’ fees in enforcing the terms of the NDA. 

Return of Confidential Information and Materials

Most NDAs address the situation of what happens at the end of the term of the NDA with regard to materials that contain confidential information.  Most NDAs require that materials containing confidential information either be returned or destroyed.  Some NDAs require that if the recipient destroys the materials, the recipient is required to certify that the materials have been destroyed. 

Sometimes NDAs contain a provision that entitle the recipient to retain a copy of all confidential information for record keeping purposes.  Query whether maintaining a single copy for recordkeeping purposes on a server that everyone has access to is consistent with the expectations of most companies disclosing confidential information.  If retaining a copy for recordkeeping purposes is included, be sure that type of issue is addressed.  Similarly, sometimes the NDA will contain a provision that enables people within the recipient organization to retain the “residual” information in their memory.  Of course, regardless of the presence of this particular provision, people cannot readily “delete or destroy” information in their mind without collateral grave implications.  However, be sure to understand what people can do with that residual confidential information under the terms of the agreement.

Other Provisions in the NDA

Depending on the industry or substance of the disclosure, there can be additional provisions included within the NDA.  For example, there can be some export limitations for certain types of information.  The NDA can address those limitations.  The NDA can also cover certain disclosures and limitations that are applicable to insider trading restrictions under federal securities laws.  These and other issues should be considered when developing an organization’s NDA forms and when reviewing those received from another company.

As a follow up on the angel investor and venture capital term sheet post, I want to elaborate on some efforts to streamline angel investor transactions and reduce related transactional legal costs. In the last year or so, there has been considerable effort to create standardized open source angel financing documents. The first of these recent efforts was from Y Combinator. With the assistance of the law firm of Wilson Sonsini, Y Combinator published the Series AA Equity Financing Documents. Another organization focused on seed stage companies, TechStars, subsequently released its Model Seed Funding Documents, which were prepared by the Cooley Godward law firm. And, most recently, attorney Ted Wang from Fenwick & West led an effort to put together the Series Seed documents. There are others as well, especially form term sheets, such as the one investor Basil Peters advocates: One Page Term Sheet. In coming months, a Midwest group of attorneys and law firms plan to publish a set of documents that will add to the mix, with a Midwest flavor of default terms.

This post provides a brief summary of each publisher of the open source form documents as well as a brief overview of the standardized terms for each set.

The Reasons for Using Standardized Forms in Angel Financings

As mentioned in an earlier post in connection with the National Venture Capital Association‘s (NVCA) efforts in adopting form venture capital investment documents (More Terms for Venture Capital Term Sheets), industry standardization would be helpful to achieve these and other goals:

• Reduce transaction costs
• Reduce time to closing
• Reflect industry norms
• Promote consistency among transactions
• Establish certain industry standards
• Provide basic explanations as to the reason for particular provisions or the context in which certain provisions should be included

While achieving these goals would be laudable, creating a standard set of angel financing documents that are used by various groups presents challenges. I will cover these issues in a later post. But first, here is a summary of the current open source documents:

Y Combinator Series AA Equity Financing Documents

Toward the end of 2008, Y Combinator was the first of the groups to release an open source set of angel financing documents. Y Combinator provides small investments (typically less than $20,000) to computer, Internet, and software startups. Along with the investment, they provide initial consulting and networking opportunities for startups, including a three-month training program in the San Francisco Bay Area. According to Y Combinator, they take a 2-10% equity stake in participating companies. To date, they have worked with over 140 companies.

The Y Combinator documents were originally created for Y Combinator’s portfolio companies to use for their angel financing rounds. Among other provisions, the documents contain a 1x nonparticipating liquidation preference, no springing future rights from subsequent issuances, participation rights, a basic set of representations and covenants from the issuer, and a board seat.

TechStars Model Seed Funding Documents

In early 2009, TechStars released its set of model seed funding documents. TechStars provides up to $18,000 in seed funding to emerging companies, primarily in Internet and software industries. In addition, they provide educational programs and mentoring for three months in Boston, Boulder, and Seattle, with the chance to pitch angel investors and venture capitalists at the end of the program. In exchange for the funding and services, TechStars takes a 6% stake in companies.

TechStars provides its model documents to founders and lead investors as a starting point in seed and angel financing rounds in the $250,000 to $2 million range. The TechStars documents contain, among other provisions, a 1x nonparticipating liquidation preference, broad-based weighted average anti-dilution protection, springing future rights from subsequent issuances, participation rights, a basic set of representations and covenants from the issuer, and a limited right to a board seat that remains in place until the holders drop below 5% ownership of the company on a fully diluted basis.

Ted Wang’s Series Seed Financing Documents

The Series Seed Financing Documents were released last month (March 2010). An important characteristic of these documents is that they are, for the most part, slimmed down versions of the NVCA forms. As a result, investors who use the NVCA documents will generally be familiar with the terms of these documents. According to Ted Wang, the documents are intended for typical angel financing rounds in the $500,000 to $1.5 million range.

Although the documents are intended to be neutral, they generally contain the most investor-friendly terms of the three sets. Among them are assignment of the company’s right of first refusal to investors, drag-along rights, reimbursement of investor legal fees (up to $10k), and protective provisions typical for a company-friendly venture capital financing. Still, some investors have commented that the terms in the Series Seed documents are not aggressive enough.

The Series Seed documents are also intended to be used “as-is” without further negotiation (just fill in the blanks). The philosophy behind this approach is that the value of standardization outweighs the costs of customization: a controversial concept for many companies and investors. Ted Wang has invited comments and is planning to publish a revised set of documents after one quarter, including regular updates thereafter.

Comparison of Angel Investment Form Documents

All three sets of model documents anticipate that the security issued is preferred stock. Last month, attorney Yokum Taku of Wilson Sonsini put together a nice summary that compares the three sets of documents in tabular format: Yokum Post. Generally speaking, the Y Combinator and TechStars documents are more company-friendly than the Series Seed documents, although the TechStars documents contain anti-dilution protection and the other two do not.

While it may sound like only a self-serving comment, the open source forms should not be a substitute for involving an attorney experienced in angel and venture capital financing transactions. Selecting and negotiating terms (and alternatives), addressing the inevitable deal-specific terms not encompassed within the forms, providing a check as to what current “market” is, and securities law compliance are some of the reasons to involve an experienced attorney in the process. That said, industry or at least regional adoption of a standard set of angel investment documents (with common variations) should significantly reduce transaction legal costs, especially if both sides are represented by experienced counsel familiar with the forms.

If and when the Midwest-based angel financing documents are published, I will provide another update.

When raising funds from angel investors or venture capital firms (VCs), the offering terms are often summarized in a term sheet prior to consummating the deal.  Term sheets negotiated with angel investors are typically less complex than those proposed by VCs, but there can be considerable overlap between the two.

Negotiating with Angel Investors

When dealing with angel investors, it is typical for the company to produce the initial draft of the term sheet.  There are variations by region and it is not uncommon to see an angel investor or angel group prepare the initial draft of the term sheet, especially if the company has not already prepared one.  If an angel investor or angel group has taken on the role of lead investor, it is common to see the term sheet negotiated. In such cases when a term sheet has been negotiated, it is important that the company communicate that fact with subsequent prospective investors to avoid further negotiations and different terms.

Elements of an Angel Investment Term Sheet

In an equity financing with angel investors, the terms of the deal are often rather straightforward.  Typically, the security being offered is either common stock or a stripped down preferred stock. The angel investor term sheet will typically contain at least the following:

• A description of the security being sold
• The price for the security
• The company pre-money valuation
• The minimum (if any) and maximum amount to be raised
• Basic information about the issuer (e.g., whether it is a corporation or limited liability company, the state of incorporation/organization)
• The current capitalization table
• Any applicable security transfer restrictions

The term sheet may also contain other provisions that address issues such as board representation, veto rights over certain types of transactions or conduct, co-sale or tag-along rights, drag-along rights, dividends, put rights, piggyback registration rights, and anti-dilution provisions.

Once the term sheet is “finalized” for the equity financing with angel investors, it often becomes an important element of the issuing company’s private placement memorandum, if one is used.

Negotiating with VCs

When dealing with VCs, in almost every case, it is the VC who prepares the initial draft of the term sheet. Unless the deal is very small, VCs commonly invest in small groups or syndicates (e.g., two or three firms), with one VC acting as the lead. The lead VC will typically present the term sheet, and the company will have a relatively short time period to accept it or negotiate its terms (in an attempt to prevent the company from “shopping” the deal).

Elements of a Venture Capital Term Sheet

Venture Capital term sheets are usually complex. Below is a list of issues that are often included or addressed in a VC term sheet. This list is in addition to the items listed above for an angel investment term sheet.

• Conditions to closing the investment
• Closing date
• Identity of investors.
• Dividends (the percentage and whether cumulatve or not)
• Liquidation preference (e.g., amount (multiple) and whether the security is participating preferred stock or not)
• Board representation (e.g., single board member or control of the board)
• Protective provisions (veto rights over certain types of transactions or conduct)
• Conversion rights
• Anti-dilution provisions (weighted average or full ratchet)
• Pay-to-play provisions (assuming more than one VC is participating)
• Redemption/put rights (requiring the company to buy back the investors’ shares on a given date)
• VC’s attorneys’ fees (shifting costs over to the company)
• Demand registration, S-3 registration, and piggyback registration rights
• Management and information rights
• Participation or preemptive rights
• Employee stock or equity incentive requirements and limitations
• Tag-along (co-sale) and drag-along rights
• Confidentiality and no shop requirements

There can be a variety of other provisions and requirements included, such as a tranche or milestone funding process.

Upon acceptance of the term sheet, the VC’s attorney steps into the process (if he or she had not already done so at the initial due diligence stage). The VC’s attorney typically produces the initial drafts of the investment documents.

Term Sheet Forms

There are many good resources on the Internet with sample venture capital term sheets. Likely the best known is the one published by the National Venture Capital Association (NVCA). The NVCA form term sheet contains many good explanations of the various provisions in a VC term sheet. However, as you might have guessed with the authors of the form (VCs and their lawyers), the NVCA term sheet is generally drafted in favor of the VCs.

A version of the NVCA term sheet form that contains more company-friendly terms and more detailed discussions of the various negotiating points was prepared by those of us on the American Bar Association (ABA) Private Equity and Venture Capital  Committee. The ABA Comments to the NVCA term sheet form is intended to do the following:

• Generate more options and alternative provisions, including many that are more company-friendly
• Provide more detailed explanations concerning key provisions and negotiating points
• Elaborate on current case law and the implications of various provisions
• Identify which of the alternative provisions are more frequently used

Using resources such as the NVCA term sheet and the ABA Comments can help prepare companies to negotiate effectively (and more efficiently) with angels and VCs.

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.