Series A Preferred Stock Financing
Best Practice Summary

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A "Series A Preferred Stock Financing" or "Series A Private Placement" is a private sale, usually by a privately-held company, of its first round of preferred stock, referred to as a "Series A Round" or "A Round". It usually represents the first equity financing of the company with professional, institutional investors (venture capital funds, insurance companies, corporations in the same industry, and the like) as opposed to company founders or individual "angel investors".

These institutional investors are generally in a position to demand convertible preferred stock rather than common stock. Convertible preferred stock carries a number of special features that make it attractive to investors in private companies, in particular a priority in liquidating distributions as well as participation in the company's growth. See LeapLaw's Preferred Stock overview and the Preferred Stock Best Practice Summary for a discussion of typical features of preferred stock. The first preferred stock offering by a company will usually be known as "Series A Preferred Stock", "Series A Convertible Preferred Stock", or something similar. See LeapLaw's Follow-on Preferred Stock Financing Best Practice Summary for a discussion of the additional issues raised in a second (or subsequent) preferred stock financing.

A preferred stock private placement usually includes the following steps:

1. Preparation of offering documents.
2. Business due diligence by the investors.
3. Preparation and negotiation of term sheet and capitalization table.
4. Securities law, tax and HSR analysis; pre-offer and pre-sale blue sky filings.
5. Legal due diligence by investors' counsel.
6. Preparation of closing agenda and distribution list.
7. Drafting of long-form agreements.
8. Negotiation of agreements.
9. Resolutions of the board and stockholders of the company approving the transaction.
10. Preparation of disclosure schedules by the company; review by investors.
11. Preparation of legal opinion by company counsel; negotiation of opinion.
12. Filing of charter amendment authorizing the new shares of preferred.
13. Completion of other closing conditions.
14. Delivery of closing certificates.
15. Delivery of executed documents.
16. Delivery of legal opinion.
17. Transfer of funds from investors to the company.
18. Post-closing securities law filings, if any, by company counsel.
19. Preparation of closing binders.

These steps are not always done in exactly the same order, and generally several of them will be in progress at the same time. As with all corporate transactions, the pace of activity gradually accelerates as the closing approaches and slacks off quickly once the closing occurs. See LeapLaw's model Private Placement Closing Agenda for a list of deliverables corresponding to the steps listed above.

What follows is an explanation of the purpose and overall procedure for each step listed above.

1. Preparation and Distribution of Offering Documents.

A company planning to offer securities may wish to prepare a formal Private Placement Memorandum (or "offering memo") describing the company's business, finances and personnel, which it will distribute to appropriate investors. Other companies may instead circulate a less formal business plan that describes the company and its plans but does not explicitly make a securities offering. In either case, care must be taken to ensure that the distribution of offering materials is done in a manner that will permit the sale of preferred stock to be exempt from the registration requirements of the Securities Act of 1933. Certain Regulation D offerings will require specific information to appear in the offering materials.

2. Business Due Diligence.

Business due diligence is the investigation of the company by the proposed investors. Generally this takes place without the involvement of counsel and may occur before counsel has even been engaged to represent the investors. It involves review and verification of the company's private placement memorandum, if any, and its business plan and financial information, and may involve background checks on senior company personnel.

3. Preparation and Negotiation of Term Sheet and Capitalization Table.

The Summary of Terms or "term sheet" is a summary of the major business and legal terms of the transaction. The various sections in LeapLaw's sample Series A Preferred Stock Financing Term Sheet are discussed in the following LeapLaw overviews:

Pre-Money Valuation
Preferred Stock
Dividends
Capitalization Table
Liquidation
Anti-Dilution
Registration Rights
Rights of First Refusal
Stock Restrictions
Key Person Insurance

The capitalization table or "cap table" is a chart detailing the entire capitalization of the company prior to the financing, and what it will look like after the financing. Most venture capitalists will require that the price of their preferred stock be calculated as if all options the company expects to issue have been both issued and exercised. In this way, they determine the percentage of the company that will ultimately be owned by investors and by management. If that percentage is too high, the investors may feel they are paying an excessive price for the preferred stock, while if it is too low, the investors may feel that there is insufficient motivation for management.

The cap table is most often prepared on a spreadsheet so that various business proposals can be easily modeled. For a company with a simple capital structure, however, which is typical at the time of the Series A round, a separate cap table is sometimes dispensed with and the information is simply included in the term sheet. The expected capitalization is a critical issue, however, and should be agreed by the parties at a very early stage, however it is documented.

Company counsel will almost always be involved in the preparation of the term sheet. Some investors do not involve their own counsel at the term sheet stage, but an investor's counsel should insist on getting a chance to review the term sheet before it becomes final, to make sure that no significant issues are missed. It is very difficult to get a major business or legal term into the final documents if it does not appear in the term sheet.

4. Securities Law, Tax and HSR Analysis.

While there could be any number of legal obstacles to completing a private placement transaction, securities law and tax law are implicated in just about every private placement, and Hart-Scott-Rodino analysis must be done on every transaction with a dollar amount in excess of $50 million to determine whether it must be preceded by an HSR filing.

A "private placement" is an offering of securities intended to be exempt from the registration requirements of the Securities Act of 1933 by virtue of the private offering exemption set forth in Section 4(2) thereof. Regulation D provides a "safe harbor" from the registration requirements if the offering complies with certain rules. As certain sections of Regulation D require that investors be "Accredited Investors", it should be determined at an early stage whether any non-accredited investors intend to participate.

The "blue sky" laws of each state in which a proposed investor resides must also be checked to verify the applicable private placement exemption and determine any filings that need to be made. Under NSMIA, most filings may be made post-closing (see Step 16), but there are some cases in which filings must be made before the sale or even before the "offer" of securities. See LeapLaw's Blue Sky Filings Best Practice Summary for more details. In a transaction with a large number of investors in several states, a Blue Sky Compliance Chart may be helpful in organizing the information.

5. Legal Due Diligence.

Legal due diligence is the process through which the investors' attorneys attempt to help them answer the following principal questions:

• Does the company have any significant liabilities, such as pending or threatened lawsuits, debt, employment contracts or pension plans?
  
  
• Are there any legal obstacles to completing the transaction, such as required consents of lenders or landlords, change of control provisions in contracts with vendors or customers, or rights of first refusal, preemptive rights or anti-dilution rights held by existing stockholders?
  
  
• Are the investors buying the percentage of ownership of the company they think they are (that is, are there any undisclosed existing or potential stock, option or warrant holders)?
  
  
• Does the company have any undisclosed legal risks? Examples would include unsound environmental, accounting or labor practices.
  
  
• Do the investors have any legal requirements that will affect the terms of the transaction?
  

The first four questions are answered through a review of the company's documentation, while the last question is answered through a review of the investors' organizational documents and applicable laws. Examples of special investor requirements include:

• Company disclosure of all stockholders so that conflicts of interest can be identified.
  
  
• Investor "management rights" required for an exemption from Department of Labor regulations governing the investment of pension assets.
  
  
• For non-U.S. investments, a determination that the limited liability characteristics of the company and its investor entities will be respected by the local jurisdictions.
  
  
• Investors' counsel usually initiates the investigation of the company by providing the issuer with a due diligence checklist requesting copies of all the documents in the company's possession that are relevant to the above questions. This should be prepared and submitted by investor's counsel as soon as possible once she has been assigned to the transaction. The company may have already prepared a "due diligence package", and in such cases investors' counsel, while reviewing the package, should simply verify that all significant areas have been covered.
  
  
• Generally, each investor will have counsel who is aware of that investor's special requirements, but an attorney serving as "lead counsel" for a group of investors and is not familiar with each investor's requirements should contact each investor or its regular counsel to determine such requirements and make sure they are put on the closing agenda.

See LeapLaw's Due Diligence Best Practice Summary for more details on conducting due diligence.

6. Preparation of Closing Agenda and Distribution List.

A closing agenda, listing the documents to be completed and the parties responsible for each, will be prepared about this time. In addition to the transaction documents, closing certificates and other items on a standard private placement closing agenda, any additional closing conditions that have arisen from the due diligence process will be included. See LeapLaw's Closing Agenda Best Practice Summary for more details. It also may fall to an attorney or paralegal to prepare a "distribution list" containing contact information for all parties and distributing the list to everyone involved in the transaction. This should include name, organization, title, address, office phone, cell phone, fax and e-mail.

7. Drafting of Long-Form Agreements.

Traditionally, as the party with greater bargaining power, the investors insisted on preparing the first draft of the legal agreements effecting the transaction. The "drafter's advantage" is that small issues will generally be resolved in the drafter's favor. However, in recent years, the high volume of private placements caused documentation to become somewhat standardized, and many venture capitalists became willing to permit company counsel to draft. Since the company generally pays the legal fees for the investors in any case, the legal bill remains about the same if the company counsel drafts.

One important consideration is the relative availability of the counsel for the two sides. If the investors' counsel drafts and circulates the documents, the overall workload for the transaction will be approximately evenly divided between the two sides, but if the company counsel drafts, the company counsel will be doing the vast majority of the total work and, other things being equal, may need more attorneys assigned to avoid holding up the transaction.

8. Negotiation of Agreements.

Counsel for the side that did not draft the documents will comment on the documents, usually in consultation with their clients. An effort should be made to identify all issues on the first review, as it becomes more difficult to obtain concessions later in the transaction. Ideally, due diligence should be completed by this stage so that any new closing requirements needed to "cure" any deficiencies discovered in due diligence can be added to the documents. This is often not possible in practice, however.

As suggested above, if there are a number of investors, they will usually designate counsel to one of the investors (usually the group investing the most money) as the "lead counsel" to negotiate the documents with the company counsel. The lead counsel should determine early (1) if any other investor counsel or investors will review and comment on the documents and (2) if so, whether the lead counsel is to collect and combine comments from all the investors and their counsel or whether each investor counsel will transmit comments directly to the company counsel.

9. Board and Stockholder Resolutions.

Company counsel has the responsibility to ensure that the company has duly authorized the financing and any related actions such as adoption of a stock option plan. While the board can approve the transaction based on the term sheet and delegate negotiation of most of the documents to company officers, the proposed charter amendment setting forth the terms of the preferred stock must be approved in final form by the stockholders and directors before it can be filed with the secretary of state. In some states there is a significant delay between filing and approval, and accordingly, completion of the charter can easily become a "gating item" holding up the transaction. Therefore, when a number of documents are being negotiated, efforts should be made to complete the charter first so that the approval and filing process can proceed in parallel with the rest of the transaction.

10. Preparation and Review of Disclosure Schedules.

Disclosure schedules are generally presented as lists of "exceptions" to the representations and warranties made by the company in the stock purchase agreement. Items on the disclosure schedule typically represent risks and liabilities of the company that may be of significant interest to the investors. For a company with a material operating history, preparation of disclosure schedules requires significant labor on the part of one or more company officers and company counsel, and accordingly the schedules are often produced relatively late in the course of the transaction.

Ideally, the schedules will not include any information of which the investors are not already aware, either from their own business due diligence or from their counsel's legal due diligence. If a significant new issue arises late in the transaction, the closing can be delayed significantly if the investors are unwilling to proceed without the issue being resolved to their satisfaction. Accordingly, attorneys for the company should advise the company that disclosure schedules need to be completed in time for the investors to react to them prior to closing, not barely in time for the closing.

11. Negotiation of Legal Opinion.

In most preferred stock financings, the investors will require the company's legal counsel to provide them with an opinion letter assuring them that certain legal issues have been resolved. Generally, most or all of the following topics will be covered, although there are variations:

• The company is duly incorporated and in good standing in its state of organization and is
  authorized to do business in all states in which such authorization is necessary
  
  
• The company has the corporate power and proper authorization to enter into the financing
  
  
• The financing agreements are binding on the company
  
  
• The execution and performance of the financing agreements do not violate any existing
  agreements or applicable law
  
  
• Some kind of statement as to the capitalization and charter of the company
  
  
• The shares of preferred stock will be validly issued and not subject to preemptive rights
  
  
• There is no outstanding litigation against the company
  
  
• No governmental approvals or filings are required for the transaction (this implies an exemption from registration of the preferred stock under the Securities Act)
  
  
• All existing outstanding stock was validly issued

Since a legal opinion creates liability for the issuing law firm if it is incorrect, all the statements in the opinion must be supported by due diligence on the part of the company's counsel. In addition, most firms have a standard form of opinion for each type of transaction as well as an administrative process that must be followed before an opinion may be issued; this typically will involve attorneys other than those on the transaction team (such other attorneys often called the "opinion committee"). Since all changes to an opinion must be approved by the opinion committee, negotiating the text of an opinion can be a cumbersome process. Accordingly, to prevent the opinion process from holding up a closing, the first draft of the proposed opinion should be produced as early in the process as possible, whether by investors' counsel or company counsel.

12. Filing of Terms of the Preferred Stock. Before the company can close the financing and issue the preferred stock, it must make a filing with the secretary of state in the state of the company's incorporation, authorizing the preferred stock and setting out the features of the preferred stock as negotiated with the investors. Once the final form of the preferred stock terms has been agreed upon, appropriate stockholder and director resolutions must be approved, and the charter amendment or certificate of designation filed with the secretary of state's office. Pre-clearance may be appropriate, particularly in states which have a long turnaround time to approve a filing. As noted above under "Board and Stockholder Resolutions", the process at the secretary of state's office in some states can cause several days delay in the closing of the transaction unless done well in advance. It is good practice to check with the secretary of state's office early in the transaction to find out their expected turnaround time for a charter filing. See LeapLaw's Filing Mechanics Best Practice Summary for further details.

13. Completion of other Closing Conditions. The basic closing conditions for a preferred stock private placement include:

• Filing of the charter amendment authorizing the preferred stock, as discussed above.
  
  
• Execution of any ancillary agreements such as a registration rights agreement, stock restriction agreement or co-sale agreement.
  
  
• Execution of any required third-party consents from landlords, lenders, vendors or customers.
  
  
• Delivery of a legal opinion (see below).
  
  
• Certain business "milestones" that the investors require to be completed prior to closing, such as the hiring of key personnel or the execution of specific agreements with vendors or customers.

14. Delivery of Closing Certificates. The closing conditions will typically require the delivery to the investors of the following closing certificates:

• An officer's certificate or "bringdown certificate" stating that the representations and warranties remain true as of the closing (although in many cases there is no delay between signing and closing, so this becomes purely a formality).
  
  
• An officer's certification that the closing conditions have been met (usually included in the brigndown certificate).
  
  
• A certificate of the secretary or other officer as to the current bylaws and charter of the company, the effectiveness of stockholder and director resolutions authorizing the transaction, and the identity of certain officers (an "incumbency certificate").
  
  
• Stock Certificates. See LeapLaw's Stock Issuance and Record Keeping Best Practice Summary for details on preparing stock certificates.
  
  
• See LeapLaw's Closing Certificates Best Practice Summary for more details on the other closing certificates.

15. Delivery of Executed Documents. Typically these transactions do not involve a face-to-face closing in a closing room, but close based on an exchange of faxed signature pages to the principal documents, combined with satisfactory evidence that the other closing conditions have been met. Quite often, if the parties expect to be unavailable on the day of the closing, they will send executed signature pages in advance to either the lead investor counsel or the attorney handling the closing (who may be the same person) to be "held in escrow" and not treated as actually delivered until a final telephone or e-mail confirmation is received from the signer.

Prior to collecting signatures, the attorney or paralegal responsible for preparing the closing binders should ascertain how many parties to the transaction require original signatures for their records. That information will help determine how many signatures should be requested for each document. It is also good practice to keep track of the expected whereabouts of the parties, so that an opportunity to obtain signatures is not missed.

If conducting an in-person closing, please refer to LeapLaw's Closing Room Management Best Practice Summary.

16. Delivery of Legal Opinion. This is typically the final step prior to closing. Once the company counsel has confirmed all the facts supporting the legal opinion (including the presence of all signatures, certificates, etc.), other closing conditions have been met, and the firm's opinion committee has approved the opinion, the signed opinion is generally faxed to the investors' counsel. The legal opinion is generally supported by one or more good standing certificates that need to be ordered in advance.

Note: Because the good standing certificates, if ordered in advance, may arrive prior to the closing, and the legal opinion must be valid as of the actual date of the closing, there may be a "gap" of several days during which, in theory, the company could have ceased to be in good standing. Some company counsels will recite that their opinion that the company is in good standing is based on a certificate dated "as of a recent date," while others will call the secretary of state or their service company on the day of the closing to confirm that the company is still in good standing. Others will insist on not releasing the opinion until a good standing dated as of the closing date is in hand. It is important to know what procedure the company's counsel prefers, so that the closing is not held up because the legal opinion cannot be released until an updated certificate arrives.

See LeapLaw's Good Standing and Legal Existence Certificates Best Practice Summary for more details.

17. Transfer of Funds to the Company. Funds transfer is typically handled in one of two ways. One procedure involves the attorney for the investors collecting the funds in his or her firm's escrow account, and sending it to the company once the closing conditions have been met. In the other method, the investors' counsel simply notifies each investor that the transaction has closed, and each investor sends its money to the company directly.

The advantage of the "escrow" method is that the funds are transferred quickly and efficiently to the company as soon as the closing is done. The disadvantage is the additional time and expense involved in accounting personnel, junior attorneys and/or paralegals tracking the flow of funds. In addition, interest on the collected funds must be accounted for and paid to the appropriate party following the closing. This involves obtaining the Tax ID number for each party receiving interest so it can be properly reported to the IRS.

The preferred method of funds transfer is via wire transfer in almost all cases. If using wire transfer, the responsible attorney or paralegal should make sure to obtain the company's wire instructions and, if each investor is wiring separately, verify that each investor has the instructions.

If an investor sends a check to the attorney handling the closing, the attorney should verify in advance if the check is to be made out to the company directly and forwarded to the company by courier, or whether his firm is willing to accept the check as "good funds" and deposit it in the firm's escrow account for later wire transfer to the company.

18. Post-closing Securities Law Filings. If the transaction qualifies for an exemption from registration under Regulation D, a Form D filing must be made within 15 days following the closing. Under NSMIA, in most cases any "blue sky" filing requirements can be fulfilled by filing the "state version" of Form D with the appropriate state.

19. Preparation and Distribution of Closing Binders. A "closing binder", "closing book" or "closing bible" is a permanent volume containing a complete set of the legal documents created in the course of the transaction. It is usually based on the closing agenda for the transaction, but may not match it exactly, depending on style. The firm that initially drafted the transaction documents will usually, but not always, take responsibility for preparing and distributing the binders; it pays to make sure all parties have the same understanding.

Generally, at least one binder contains original signatures, but that is not a requirement as long as one of the law firms involved retains a set of originals. The binder may be formally bound in cloth or leather in some major transactions, but more typically the documents are either collected in a loose-leaf binder or "velo-bound" in plastic using a machine available at the law firm. The person preparing the binders should contact all parties after the closing to determine how many closing binders will be needed.

Collecting the final documents for a closing binder can be a lengthy process, stretching over several weeks even with diligent effort on the part of the preparer. If the parties closed via fax, original signatures for most documents should be sent to the preparer by mail, although parties who sent faxed signatures may be lax about following up with originals. Formal confirmations from government agencies may take some time to arrive as well. If receipts for funds and stock certificates are desired, these too may take time to obtain, as the motivation of the parties to the transaction to attend to such details is often lacking. The person preparing the binder needs to be persistent in collecting the missing documentation in order to make sure the transaction is completed in a timely and professional manner.

LeapLaw's
Related Best Practice Summaries

Blue Sky Filings
Closing Agenda
Follow-on Financings
Hart-Scott-Rodino
Preferred Stock
Stock Issuance and Record Keeping
Understanding Capital