By Will Bussiere

When a company’s founders agree to take on a sizable venture capital investment for the first time, they can be shocked by the volume of paper generated to memorialize the relationship between the company and its investors. A purchase agreement will set the monetary terms of the investment deal and establish closing conditions and representations and warranties. A company charter will spell out the relative rights and privileges of the preferred equity holders and dictate the procedures and distribution waterfall in an exit scenario. But among the other documents negotiated and executed by the parties, arguably none will impose so many burdensome obligations within the company’s governance and permission structure as the investors’ rights agreement, or the IRA.

Founders should understand and appreciate each of the new requirements to which they are subject by virtue of their company’s IRA, including the possible paths to waive or circumvent those requirements when expediency is preferable to letter-strict compliance. This article reviews two provisions of the IRA where a company’s management team might find itself stymied if it fails to appreciate the relevant deadlines and deliverables, many of which may not have applied to the company before it took on new investments. (The “usual”, “typical” or “standard” scenarios in this article refer to the terms found in the latest model version of the IRA adopted by the National Venture Capital Association, or NVCA, as of July 2020, available here.)

Financial Statements

The IRA typically provides that the company shall deliver its periodic financial statements to major investors, or those investors who have purchased and continue to hold an amount of equity that exceeds a negotiated threshold. The deliverables and delivery schedule usually include at least the following:

• A year-end balance sheet, statements of income and cash flows, and statement of stockholders equity (for which the company may need to retain an independent auditor depending on the parties’ agreement), due within 90 to 120 days after the end of the company’s fiscal year

• A quarterly unaudited balance sheet and unaudited statements of income and cash flows, due within 45 days after the end of each quarter of the company’s fiscal year

• A monthly unaudited balance sheet and unaudited statements of income and cash flows, due within 30 days after the end of each month

• A budget and business plan for the next fiscal year, broken down by month and including balance sheets and statements of income and cash flow, due 30 days before the end of the company’s fiscal year

When founders first enter into a term sheet that calls for entry into an IRA or delivery of financial statements, they should consider an appropriate scaling-up of their financial reporting resources to be a high priority. If the company is not adequately resourced to provide these financial statements on the timelines provided in the proposed IRA, then the founders likely cannot afford to treat this task as a post-closing item, especially since the deadlines start to take effect as early as 30 days after the initial closing of the financing.

The company’s management team may realize that a certain deadline or deliverable is not immediately feasible for the company. For example, a 30-day deadline might be difficult to achieve during tax season or some other administratively complex time frame. Another common conundrum is the company’s failure to hire an auditor to prepare financial statements, often for reasons outside the management team’s control. To avoid a breach of the IRA in such scenarios, management should communicate promptly with the company’s major investors about the reason for any anticipated delays and seek advance permission for any delinquency.

Instead of simply letting deadlines go by or letting deliverables go undelivered, a conscientious management team will call upon its legal counsel to prepare a written waiver that expresses agreement by all relevant parties that any delay is permissible and hopefully temporary. (A waiver can also be sought after the fact, but of course, a post-breach waiver does not prevent a breach from having existed in the first place.) The IRA’s “Amendments and Waivers” section will set forth the list of parties whose signatures are required on such a waiver. To waive any part of the delivery requirements for financial statements, a standard IRA will require the written consent of the Company, which in turn typically requires the approval of an appropriate resolution by the Board of Directors, and the holders of some percentage (at least a majority) of the registrable securities then outstanding and held by all the major investors. Putting this paper trail in place not only keeps the company in compliance with its commitments and out of breach, but it also promotes fruitful investor communications and helps the management team to avoid appearing either cavalier or uncertain about the company’s reporting obligations to its major investors.

The IRA may also impose similar deadlines and requirements on the company with respect to new insurance coverage or the implementation of new company-wide policies applying to employees or leadership practices. In any such case, founders should be aware of these upcoming deadlines as soon as they are negotiated and should plan accordingly – if they cannot simply negotiate a later deadline in the first instance – or plan to seek waivers if all diligent efforts are likely to fail.

Rights of First Offer for New Securities

Major investors typically bargain for more than just the right to purchase an interest in the company on one single occasion. The IRA’s “right of first offer” or preemptive rights provision will give major investors the opportunity to participate pro rata in the company’s future offerings of “new securities,” which covers a broad range of debt, equity and convertible security offerings, subject to any exclusions carved out in the company’s charter or set forth in the IRA. Major investors usually also have the right to oversubscribe, or to purchase any allocated securities that their fellow major investors do not elect to purchase. Founders are usually well aware of these rights, but they are often less familiar with the mechanics with which the company must comply if it wishes to offer new securities. A standard set of procedures for the offering of new securities generally looks like the following:

• Before selling any new securities, the company provides an “offer notice” to each major investor that sets forth the terms of the offering, including the price per security and the overall round size.

• Within 20 days after the offer notice is given (as calculated by the notice provision in the IRA), the major investors may respond to the offer notice with an election to purchase a pro rata amount of securities.

• At the end of that 20-day period, if any of the major investors elect to purchase none or less than the full amount of securities offered to them, the company promptly notifies each major investor who elected to purchase all of the securities offered to it, so that each such major investor can further elect to purchase any of the remaining securities available for purchase.

• Each major investor must supply its oversubscription election within 10 days after the company’s oversubscription notice is given.

• At the end of that 10-day period, the company may then sell the offered securities up until the later of (i), if the major investors fully subscribe, 90 to 120 days (depending on what the parties negotiate) after the initial offer notice is given, or (ii) if the major investors decline to purchase any of the offered securities, typically 90 days after the expiration of the major investors’ election periods described above.

The above procedure is noteworthy both for the rigidity required in communications with major investors and for the sheer length of time required to complete the offering process. A major preferred equity financing might occasionally follow such a deliberate pace, but most flavors of financing – especially in a venture-backed climate of innovation and growth – do not lend themselves to such a timeline.  In practice, major investors often expect that the timing of the right of first offer will be greatly condensed, and perhaps even that their ongoing discussions with the company about upcoming financing needs will help them to arrive at their committed amounts without the need for a formal offer process. If the major investors are on board, a financing can be consummated in weeks and not months – but only if a waiver to the right of first offer is included in the transaction approvals.

The IRA’s waiver provision for the right of first offer can be heavily negotiated. The most typical provision tracks the requirements of the financial deliverables discussed above: the company’s board must approve any waiver of the process, and a percentage (at least a majority) of the registrable securities then outstanding and held by the major investors must also agree. The existence of a percentage threshold for 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 denying pro rata rights to the smaller major investors. But some IRAs are negotiated (often by existing earlier investors) to bar this outcome, providing that if a major investor votes to waive any provision of the right of first offer and nonetheless participates, then all major investors are entitled to participate on at least the same pro rata basis as the major investor(s) who approved the waiver.

Whatever the threshold for approval and whatever participation rights are ultimately provided in a waiver scenario, the waiver itself is typically covered not in a standalone waiver document but in the board and stockholder resolutions authorizing the financing transaction.  These resolutions will also provide for any requisite approvals under the protective provisions of the company charter or, if applicable, under the section of the IRA that sets forth transactions requiring the approval of one or more investor-appointed members of the board of directors. In any negotiation of a new financing round where time is of the essence, the company’s management team or board deal committee will need to be confident in its ability to deliver the requisite waiver votes, or else risk delaying the financing by subjecting the company to the full timeline set forth in the IRA. To successfully navigate these negotiations and avoid these pitfalls, the company’s leadership should ideally engage in upfront and frank communication with key existing investors about the right of first offer, and should maintain an accurate and up-to-date picture of the company’s outstanding voting securities in collaboration with company counsel.