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The Handbook of Financing Growth: The Stock Purchase Agreement

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al


The Stock Purchase Agreement

The stock purchase agreement frames the parameters of the economics of the investment transaction; provides specific baselines for the representations and warranties of the company, the founders, and the investors; and designates the ancillary agreements that must be obtained and the actions that must be taken by the company in order to close the transaction.

Basic Investment Transaction

The stock purchase agreement opens with a section describing the basic structure of the securities acquisition. It is in this section that the parties establish the obligation of the purchasers to purchase and the company to issue the securities that have been designated in the company's term sheet. The amount and price of the securities designated in the purchase agreement have been determined based on the premoney valuation of the company negotiated in the term sheet.

In staged or phased stock purchases, the opening section will describe the timing of subsequent stock purchases and any milestones that must be achieved as conditions to the obligation of the purchasers to make the additional purchases.

Representations and Warranties

While investors will have completed a substantial amount of due diligence prior to negotiation of the stock purchase agreement, in most investment cases, the representations and warranties section provides investors with supplemental information either confirming the investor's prior due diligence or identifying issues that need further examination. The due diligence is confirmed either by the company making an absolute and unqualified representation and warranty about a specific area, or where the company cannot make an unqualified statement, detailed information regarding the qualification is chronicled on the company's disclosure schedule and compared by the investor to information the investor was provided in connection with initial due diligence.

In addition, where an investor intends to negotiate definitive documentation first and finalize due diligence after signing the purchase agreement, the representations and warranties section serves to provide an opportunity to decline to make an investment to the extent that the investor determines in the follow-on due diligence that the representations and warranties are inaccurate or untrue. In some transactions, investors will include indemnification provisions in the stock purchase agreement, and in these instances, the representations and warranties serve as a baseline of information used by an investor to determine whether information supplied by the company in connection with the investment was inaccurate. If information is in fact inaccurate, investors look to the false representation or warranty as the basis for indemnification to the extent that the false or inaccurate information can be tied to damages suffered by the investor.

Stock purchase agreements negotiated in connection with early stage investments may dedicate a separate section of warranties and representations relating to the founders of the company. This section is not normally found in later stage investments. In a founder's representation and warranty section, the investor attempts to determine whether the founder is subject to any contracts that could conflict with the business plan presented to the investors. The potential conflicts that concern investors generally arise in connection with noncompetition agreements, nonsolicitation agreements, or confidentiality agreements. The examination extends to determine whether the founder is involved in any litigation. Also of concern to investors is the question of whether the founder has any other arrangements with other investors to sell founder stock or to vote in a predetermined manner.

Investors are asked to make representations and warranties in a stock purchase agreement that relate to their authority to make the purchase, as well as the circumstances surrounding their investment. Investors will confirm their financial status and whether they meet the minimum requirements for accredited investor status under Rule 501 of Regulation D. In this regard, the company will rely on the investor's representations and warranties to ensure compliance with the applicable private placement exemption claimed by the company. Importantly, the investors will in this section confirm their understanding the stock is being purchased in a private placement, and that there is no public market for the company's securities. Coupled with this affirmation is a representation and warranty by the investor that the shares are being purchased for investment, with no view toward distributing the shares, and that the shares must be held for an indefinite period of time in the absence of a public offering.

In order to evaluate the list of representations and warranties made by the company, it simplifies the analysis if the long list of representations and warranties is organized into three broad categories. The categories are corporate organization, financial statement presentation, and company operations.

Corporate Organization

An investor pays close attention to the corporate organization section. It is in this section that the company confirms that it has the right, power, and authority to issue the securities. In addition, the company confirms that the board of directors has authorized the securities to be issued and all other required actions in connection with the issuance have been taken. Where a company has issued securities to a large group of shareholders, the investor will require assurances that the company has complied with all securities laws for each sale of securities undertaken by the company. If the company has not complied with securities laws, there may be a significant repurchase obligation on the part of the company for any shares issued outside of compliance with these laws.

A significant representation and warranty made by the company relates to the capitalization of the company. The number of shares of stock issuable to an investor is based on an accurate understanding of all securities issued by a company, including all warrants, rights to purchase, options, and instruments that may be convertible into the company's securities. If the capitalization section is inaccurate or incomplete, an investor will have a basis for demanding an adjustment in the number of shares issued in connection with the stock purchase agreement.

Typically, the capitalization section will contain not only an analysis of the company's capital structure immediately before the investment is made, but also a capitalization table for the company on a pro forma basis assuming the investment has been consummated. In the pro forma capitalization table, investors will confirm their due diligence relating to any outstanding securities that have been granted antidilution protection. If the price paid in the current round triggers the antidilution protection, the impact of the protection must be illustrated in the pro forma capitalization table.

Financial Statement Presentation

The importance of the company's financial statements increases as the maturity of the company increases. That is not to say that early stage financials are disregarded by investors. To the contrary, the statements are scoured for outstanding liabilities that must be paid or satisfied out of the proceeds of an investor's investment. But in early stage deals, many companies have little or no revenues, so the emphasis is on historical costs and outstanding liabilities. Where early stage founders have accumulated salaries during the start-up phase of a company, it is common for investors to force the forgiveness or conversion of these debts to equity prior to closing the investment.

The financial statements also contain provisions relating to contingent liabilities of a company. Investors focus on these disclosures, particularly where the contingency relates to litigation or where the financial statement reflects significant future obligations owed in connection with material contracts, particularly real property leases. Financial statement presentation required in connection with private placements is typically an audit for the two most recently completed fiscal years, and unaudited statements for the months lapsing between the last audit and the closing date. The financial statements required include a balance sheet, income statement, and statement of cash flows for each of the periods. All financial statements must be presented in a form that has been prepared in accordance with generally accepted accounting principles (GAAP), applied on a consistent basis throughout the periods covered.

The financial statements will be coupled with a narrative representation and warranty that the company has no liabilities or obligations, contingent or otherwise, except for those set forth in the financial statements or disclosed in the company's disclosure schedule. In addition, the company will indicate whether any of its assets are encumbered by mortgages, deeds of trust, liens, loans, or other encumbrances.

Where there is a gap between the date of the last financial statements and the date of closing, investors require financial representations and warranties from a company that bring down the financial statements to the date of closing. This bring-down representation and warranty contains a variety of separate statements, all relating to the financial performance and incurrence of obligations between the most recent financial statements and the date of closing.

Company Operations

The examination of company operations by a potential investor focuses on discrete segments of the operations of the company depending on the stage and maturity of the company. For later stage companies, the focus is on existing material contracts, recurring revenue sources, proprietary assets, outstanding obligations, and contingent liabilities that could significantly alter the forecasted performance of the company. In earlier stage companies, an investor will perform significant due diligence on the proprietary assets of the company, including analysis of patent filings and intellectual property controlled by the company. In addition, material contracts that either grant or in-license (obtain rights to intellectual property from a third party) intellectual property are examined under the microscope as part of the examination of operations by an investor. The issues of importance to investors include an understanding of whether the company has exclusive control over the intellectual property, whether the company has long-term commitments requiring significant cash obligations, and whether the company has the ability to terminate contracts that may have been entered into when thecompany needed cash flow to survive.

Most investors prefer to examine all exceptions to any warranty or representation in lieu of permitting a company to modify representations and warranties with materiality or knowledge. The disclosures made by a company are of significant importance to the investor and under normal circumstances, the investor prefers to decide what disclosures are material. As a result, in connection with early stage investments, it is rare to find materiality modifiers in the purchase documentation, because investors want to investigate all obligations of the company. As the maturity of a target company increases, the ability to list all exceptions to a warranty or representation becomes a burden to the disclosing company and investors become more willing to establish materiality limits to the disclosure schedule, unless the disclosure relates to a core asset or intellectual property.

Conditions to Closing

In connection with the finalization of documentation relating to a stock purchase agreement, the parties will describe all deliveries and actions that must be provided or taken by the company and by the investors in order for the closing to be consummated. All ancillary agreements required of shareholders or required to be filed by the company will be described, and these action items and agreements must be fulfilled prior to closing. Where an investor negotiates a definitive agreement prior to completion of all due diligence, the investor's due diligence must be completed prior to closing in addition to completion of the designated action items and execution of designated agreements.

Although most investors will negotiate conditions to closing as part of the stock purchase agreement, the primary route to closing involves a signing and simultaneous closing. In this case, the conditions to closing constitute a closing checklist for the company and the investor. As a checklist for closing, the investor is entitled to receive ongoing assurances that the representations and warranties made by the company are in fact accurate as of the date of closing. Because the stock purchase agreement may have been negotiated over 30 to 90 days, the company will continue to update its disclosure schedule until the actual date of closing and an investor will be diligent in evaluating the disclosures up until the actual moment of closing.

(Editor's Note: VC Experts has assembled a variety of expert commentary on the Stock Purchase Agreement, including model forms, with hideable commentary, and associated documentation.)