Inside The Minds-Deal Strategies For Venture Capital and PE Lawyers (2006)

I N S I D E T H E M I N D S
Deal Strategies for

Venture Capital and
Private Equity Lawyers
Top Attorneys on Protecting IP Assets, Handling Fund-
Raising and Formation Issues, and Working with VC
Funds and Buyout Groups to Structure Transactions
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The Life Cycle of a
Venture-Backed Company
Frederic A. Rubinstein
Partner
Kelley Drye & Warren LLP
Audrey M. Roth
Partner
Convergent GC LLC
Inside the Minds – Published by Aspatore Books
Introduction
Throughout the life cycle of an emerging company, an experienced, well-

connected venture capital lawyer can provide invaluable assistance and help
the company avoid pitfalls and dead ends along the bumpy road to success.
From a company’s start-up, through friends and family/angel financing, into
building its sales and marketing strategy, to venture capital financing, to
finding and structuring the right strategic alliances and relationships, and to
maturity and exit, an experienced lawyer should be an integral part of the
company. Helping with organization, structuring, strategy, networking (the
non-technology kind), compensation, and capitalization, among many other
areas, is a critical part of the lawyer’s job. Being proactive is an important way
a lawyer can add value to a company. To be permitted to act proactively,
counsel must be seen as a trusted advisor to the client who is available,
responsive, and knowledgeable about the client’s industry, the venture capital
world, technology/life science companies, and the problems usually faced by
aggressive and rapidly growing companies.
A truly value-added lawyer is an active participant in all stages of the

company’s growth without draining the company’s coffers or increasing its
burn rate. This delicate balance is a difficult but not impossible feat, as we will
show in this chapter.
Start-Up Phase
The initial year of a company’s existence often sets the stage for its ultimate
success or failure. The company is at its most vulnerable stage. With little in
the way of finances and no significant track record—other than past
performance of the founders—the company must fend for itself.
Bootstrapping becomes a way of life, and lawyers are perceived as a luxury,
not a necessity. Nothing could be further from the truth. From the type of
entity chosen to intellectual property protection, among other critical issues,
founders need to make informed decisions based on reliable and time-tested
knowledge. All too often, entrepreneurs retain counsel without investigating
their relevant experience. This can have highly negative consequences, some
of which may not become apparent until well into the company’s life cycle.
The company’s valuation may be adversely affected, its intellectual property
The Life Cycle of a Venture-Backed Company
compromised irrevocably, and it may be faced with obligations that are

oppressive and unnecessary at best and overwhelming at worst.
Organization
One of the first decisions an entrepreneur must make is the form of entity
that will permit the venture to grow effectively. There are three meaningful
choices,1 each of which has advantages and disadvantages:
Form of Advantages Disadvantages

Entity
S Corporation • Taxable income and losses • With few exceptions,
of company flow through entities may not be
to shareholders shareholders
• No corporate income tax2 • Generally, company may

not issue more than one
• Limited liability for class of stock3
owners and management
1
We have included the three commonly used forms of entity. In extremely rare instances,
we have seen founders use the general partnership model, which subjects each owner of
the business to general liability and thus puts the owners’ personal assets at risk.
2
Although S corporations are not subject to income tax liability on a federal level, an
S corporation may be obligated to pay state or local income taxes. Examples of this are
(i) the 1.5 percent tax on income generally levied on S corporations in California and
(ii) the unincorporated business tax that is payable by companies doing business in New
York City.
3
S corporations may issue a separate series of common stock that is non-voting, but it
must be the same as the voting common stock in all other ways.
C Corporation • No restrictions on who • Company is subject to

may be a shareholder taxation at the entity level,
and shareholders then are
• Different classes and taxed on dividends/
series of stock permitted to distributions, resulting in
be sold with different rights double tax and lower benefit
and at different prices to shareholders
• Limited liability for • Each holder of a given

owners and management series of stock must have
exactly the same rights and
pay the same amount per
share for shares issued
concurrently
Limited • Same flow-through tax • Venture capitalists are
Liability treatment as an reluctant to invest in LLCs
Company S corporation
(LLC) • More complex to grant the
• No restriction on who equivalent of corporate
may own securities in the stock options, which are an
company important component of an
emerging company’s
• No restriction on classes compensation structure
or series of securities
• Purchasers of securities
may pay different amounts
for their ownership
interests in the company
• Limited liability for

owners and management
Many start-ups choose the LLC as their form of entity without being aware
of its disadvantages. Once an LLC is selected, it can subsequently be
merged into a corporation, but it may be difficult to retain any options or
similar future equity rights granted to employees or consultants that were
granted prior to the date of the merger. Many experienced venture capital
lawyers will advise entrepreneurs to organize initially as an S corporation in

order for the shareholders/founders to avail themselves of the tax benefits
of losses that will flow through to them individually, as they would in a
limited liability company. The advantage of using an S corporation instead
of a limited liability company is that at the time the company obtains
institutional financing, it can revoke the S corporation election and become
a C corporation at no extra cost and without modifying its essential form.
An inappropriate choice of entity is not an insoluble problem for start-ups.

However, it can be costly to fix and can have adverse tax consequences at
precisely the time the company has few funds and is focusing on other,
more critical parts of its business. It is always an advantage for
entrepreneurs to limit distractions from their core mission: growing their
companies.
Intellectual Property Protection
There is no more important issue to a technology or life science company

than the protection of its intellectual property. Unfortunately, many
entrepreneurs are not fully aware of the perils of failing to take adequate
steps to secure their rights to their proprietary information. Protection
can take many forms: patent, copyright, trademark, and trade secret, to
name a few. Therefore, it is critical that the entrepreneurs establish a
relationship with a knowledgeable, experienced intellectual property
attorney early in the company’s life cycle.
An experienced attorney will encourage a prospective client to focus on

intellectual property protection before almost anything else. While
corporate, real estate, employment, and other problems can almost always
be fixed, once unprotected intellectual property is disclosed to others,
even the best lawyer may not be able to secure its protection. At the very
least, entrepreneurs should obtain a preliminary online patent search on
the U.S. Patent and Trademark Office Web site
(www.uspto.gov/patft/index.html) to ascertain whether any issued patent
or published application covers their ideas, products, or services. The
search is not a substitute for intellectual property counsel, but it can
provide some basic information about whether infringement issues may

arise. Good patent counsel can steer the entrepreneur toward an
alternative strategy if need be, may point out vulnerabilities in existing
patents and applications, and may be able to suggest broader claims and
protections for a prospective patent.
We have seen start-ups lose intellectual property protection by publishing

proprietary information on their Web sites or otherwise disseminating it
publicly, or having their intellectual property misappropriated by larger
companies that refused to signed non-disclosure agreements while taking
advantage of unsophisticated entrepreneurs. Even relatively sophisticated
founders will often be so eager to engage in discussions with large
companies that they will deliver proprietary information before obtaining
patent protection and without an adequate non-disclosure agreement or
with one that is so diluted that it becomes meaningless.4 An experienced
attorney can intercede on the client’s behalf and seek meaningful
protection.
Even something as seemingly uncomplicated as choosing a corporate name

can present the start-up with a challenge. It is relatively simple to set up a
corporate entity in most states, although the selection of the state of
incorporation is an important choice. The founder can check the availability
of a given name on most states’ Web sites and then incorporate the
company immediately. What the founder may not consider is that a name
that is clear in one state does not mean it is available in others. Moreover,
corporate names are only the beginning. There are trademarks, trade names,
URLs, and foreign translations of names, among other issues, to consider.
The company’s counsel can help a start-up choose a name it should be able
to grow with through its life cycle. Furthermore, a decision should be made
as to whether the name of the company will be the same as the name of its
4
A recent example of how more sophisticated companies are attempting to lessen non-
disclosure agreement protections is the use of an “unaided residual information” clause.
This clause provides that even if information is confidential, to the extent a recipient can
retain the information in his or her memory unaided, the information can be used by the
recipient party. Clearly, this has potentially damaging ramifications for the disclosing
party. We try to strike the clause or significantly narrow its application.
initial product or service. Having to change a company’s name after it has

achieved brand recognition can be costly and damaging.
Finally, experienced counsel can assist in the crucial step of hiring new
employees, many of whom will have worked for other and possibly
competitive technology or life science companies. Many prospective
employees have signed proprietary information agreements with their
previous employers, which prohibit their using any of the company’s
proprietary information other than on behalf of the company. Those
agreements usually provide that the employer owns any inventions created
by the employee while employed by the employer.5 Some agreements also
contain enforceable prohibitions against competition with the employer.
Counsel to the start-up can usually determine whether hiring a particular
employee is likely to cause problems. Many large companies are extremely
aggressive in protecting their intellectual property and may allege that the
departed employee is using the former employer’s intellectual property for
the benefit of its new employer. They may even sue the start-up, timing the
suit and its announcement when the start-up introduces a competitive
product. The start-up, in order to protect its intellectual property, should
require each of its employees and consultants to sign its own form of
proprietary information agreement. Experienced counsel will draft a form
of agreement to address issues that may arise with prospective employees,
and will review with management any disclosures by the employee of
intellectual property he or she may claim to own, to ascertain whether any
problems are likely to ensue.
Intra-Founder Arrangements
Entrepreneurs are well known for “hitting the ground running.” Upon the
formation of their business entity—and frequently before—they work long
days, nights, and weekends, moving at a rapid and aggressive pace to
5
The scope of the agreement varies. Most often, it states that the employer owns any
invention created by the employee that is related to the employer’s business and that the
employee has worked on during business hours or while on the employer’s premises.
Some provisions are much more broad, stating that anything created by the employee
during the course of employment is owned by the employer, to the extent it relates to the
business.
develop their products or services, hone their business models, and try to
raise funds. One important matter that tends to be deferred is determining
how the founders will interact with each other. This is another area in
which an experienced venture capital lawyer can be valuable. Founders need
to have an agreed-upon set of expectations about their ownership of the
business, their respective roles, how the board of directors and management
will be structured, and how their ownership interests will be treated if they
leave the company, if they die or are permanently disabled, and even if they
get divorced. Counsel can aid in this process, sharing their experience with
the founders and helping defuse any emotional discussions that may occur.
Once the founders have made key decisions on these and other issues,
counsel can draft an agreement between or among them that will manage
expectations and reassure potential investors that the founders have already
addressed issues that might otherwise have caused delays and distractions in
the course of and after a financing.
Initial Stock Plan
One of the principal methods for young companies to attract quality

employees—from engineers or scientists to salespeople, marketing experts,
and operations staff—is to incentivize them with an ownership interest in
the company. The rationale for this approach is several-fold. First, these
companies are unable to compete with the salaries more mature companies
can afford to pay. By giving employees a “piece of the company,” they are
using the “capital” they have available—their stock—to offer the employees
a chance to share in the company’s future successes, either through a stock
option plan or the purchase of restricted stock.
Stock option plans are somewhat complex and need to be structured

carefully and thoughtfully so as not to trigger adverse tax consequences to
the employee or the company, or hinder later venture capital financings,
among other reasons. Counsel should be familiar with the issues that are
important to institutional investors, and can engage the founders in
discussions about these issues. Two of the more important concerns of
venture capitalists with respect to employee stock ownership are:
• Vesting. Typically, options should vest over four years, with no

equity being earned until twelve months after the employee’s start
date. Vesting thereafter may be monthly, quarterly, or annually,
although monthly vesting is used predominantly.
• Acceleration upon change of control of the company. Prior to arranging a

venture capital round of financing, management often includes an
acceleration provision in the event of a sale or merger of the
company so all options at that time become immediately
exercisable. Venture capital lawyers know unrestricted acceleration
of vesting can cause serious concern to institutional investors and
can adversely affect the company’s valuation.6 We advise
companies to be flexible in their acceleration clauses or to provide
a “double trigger” for acceleration upon a change of control.7
An alternative mechanism for stock issuance to consider, particularly early

in a company’s life cycle, is a sale of “restricted stock” to management
and key employees at a low price that can be justified because of the
questionable value of the company at that early stage.8 Restricted stock
grants are popular among founders because they can be very tax-
advantageous. Within thirty days after purchasing such shares, the grantee
needs to file an election under Section 83(b) of the Internal Revenue
Code of 1986, as amended, electing to pay tax on the difference, if any,
between the purchase price and the fair market value of the stock at the
6
Venture capitalists are concerned that if all the options vest, key employees will have no
incentive to stay with the company after it is sold. This may cause the acquiror either to
lower the purchase price in the sale or, in cases where continuity of management is
important, to cause the acquiror to walk away from the deal.
7
A double trigger is commonly structured so vesting of options is accelerated if (i) the
company is sold (whether by stock sale, asset sale, or merger) and (ii) the employee is
terminated by the acquiror within some period of time thereafter—usually ranging from
six to eighteen months.
8
Restricted stock is stock that is sold by the company at its then-fair market value. It
generally contains similar vesting provisions to those provided in stock options. The
unvested shares are generally subject to buy-back by the company at their original
purchase price.
time of the purchase (the difference frequently being zero). The election,
if properly made, can protect employees from being required to pay taxes
on the gain between the purchase price and the fair market value at the
time the restriction is eliminated even if the underlying stock is not sold
(or cannot be sold because of securities law restrictions). This is especially
important for holders of more than 10 percent of a company’s stock, who
are not eligible under present law to receive “incentive” stock options
(options that are not subject to taxation on their exercise). The recipients
of non-incentive stock options, on the other hand, have the disadvantage
of having taxable income upon the exercise of their options, in an amount
equal to the difference between the exercise price of the options and the
fair market value of the underlying shares at the time of exercise.
Furthermore, it is possible that the employees may have to exercise their
options at a time when the underlying shares have securities law
restrictions against their sale. Such a situation would render the employees
subject to taxation without the ability to sell shares to cover their tax
liabilities. If the employees had instead been permitted to purchase
restricted stock at its fair market value, typically very low in an early-stage
company, they would have been taxed on the difference, if any, in the
amount they paid and the fair market value at the time the restricted
shares were purchased by them. Thereafter, they would not have any
taxable income until they sold the shares.
Other Value-Added Early Input by Venture Capital Lawyers
Experienced counsel can add value in numerous other ways at the early
stages of a company’s life cycle. In addition to the advice outlined elsewhere
in this chapter, we are including some of the other major areas below where
their input can have significant positive effect.
Employment Matters
The earlier a company standardizes its employment policies and practices,

the more likely it is to avoid problems with its employees. Many start-ups
hire people without checking references, doing adequate background checks
(in the case of key employees), verifying immigration status, or using a
standard and carefully drafted form of offer letter. We have seen companies
enter into employment agreements with long terms of employment and
even with severance provisions for all levels of employees. This type of
agreement can be damaging for the company if it needs to terminate
employment for any reason. Investors generally dislike companies using
employment agreements with a guaranteed duration of employment and
prefer instead that almost all employees be “at will,” thus giving
management the right to terminate them without the requirement that
severance be paid. Venture capitalists advocate the use of stock options or
restricted stock as a more effective and appropriate tool to give employees
an incentive to stay with the company.
Experienced counsel can draft employee manuals and put standardized

practices into place, such as conducting regular performance reviews and
creating a written record for each employee, which are highly useful when
seeking to terminate employment. In addition, it is invaluable to have
counsel conduct periodic trainings with managers and staff about
employment practices, intellectual property protection, and other issues.
Management and counsel should be a team, working together to protect the
company in all matters relating to employees.
Business Modeling
Over the course of its life, a company’s basic business model is likely to
evolve significantly. At its earliest stages, a defensible and well thought out
model is a crucial part of a company’s ability to grow and move toward a
financing event. Venture capital counsel can again be an invaluable part of
the management team, giving input into the business modeling process.
While this area does not usually involve legal issues, good venture capital
counsel are more than mere lawyers. They should be advisors, giving start-
ups the benefit of their experience representing young companies. These
counsel are likely to have seen numerous mistakes made by other
entrepreneurs, can point to specific examples of what tends to work and
what doesn’t, and focus the company on the following practical issues.
What is the market for the product or service? Is it a large enough target
market to be of interest to future investors? What is the strategy for
capturing a significant share of the market? Is the company going to be first

to market, or is the space already crowded, making it difficult to
differentiate the product or service? How is the product or service
distinguishable, and what and how difficult are the barriers to entry for
others? How will the company evolve? Is the business scalable? What
hurdles are there, and how does the company plan to conquer them? What
is the ultimate exit strategy for the investors—sale to a company or the
public market? These are among the issues venture capitalists will be
looking at in making an investment decision. Experienced counsel knows
how companies have struggled with these issues in the past and should be
familiar with the industry in which the company operates. The earlier a
company has a solid business model from which to operate, the more
readily it will be able to achieve its goals.
Securities Laws
One of the early mistakes young companies make is offering or selling

securities without complying with federal and state securities laws. This can
cause significant problems later in the company’s life, because offers and
sales of securities that are not in compliance with securities laws can subject
the company to rescission rights in the purchasers and/or penalties. When
experienced counsel gets involved with a company at a later stage, much
time and energy may be required to correct these problems. If experienced
counsel enters the picture at a sufficiently early stage, it is likely that offers
and sales of securities will be undertaken in compliance with laws, and the
company will save money and avoid later distractions. Experienced counsel
can also guide the company regarding terms of sale of securities and make
sure it does not consent to provisions that may cause problems with later
financings.
Readying the Company for Financing
After the start-up is organized and operating, one of its continuing tasks is
raising sufficient funds to finance its business in each of its stages of
development. The venture capital lawyer’s familiarity with this process, and
all that must be done in preparation, can help the company in numerous
ways.
Business Plan and Executive Summary
The first contact a potential investor usually has with an emerging company
is with an executive summary describing its contemplated business and
addressing issues expected to be of concern to the investor. Assuming the
investor desires to learn more about the company, the summary will be
followed by its detailed business plan. These, then, are critical documents
that can make or break a financing. Investors receive scores of executive
summaries every month and at best give them a quick read-through. If the
executive summary does not thoroughly and compellingly lay out a brief
summary of the business and persuasive reasons justifying the sought-after
investment, the company will lose the attention of the investor. The general
rule of thumb is that an executive summary should be no longer than three
pages and should capture certain critical information. It is the written
equivalent of an “elevator pitch.”
Experienced lawyers will participate in the creation or thorough review and

critique of the company’s business plan, particularly the executive summary.
Lawyers who have worked with young companies understand the way
executive summaries and business plans should be structured.
Entrepreneurs are often too close to their product or service to give an
objective view of the market, the competition, the business model, or the
amount of financing it will take for their company to succeed. Experienced
counsel focus their clients on presenting a persuasive and thorough plan
that addresses the concerns and interests of venture capitalists, making sure
the business model is credible, addresses and captures a significant portion
of a large enough market, and fulfills a meaningful need that has not
previously been adequately met. Lawyers should also make sure their
clients update the business plan frequently. In a rapid-paced industry,
important elements can change extremely quickly, and nothing can
damage a company’s prospects more than outdated information.
There are numerous Web sites with advice on the elements of a good
business plan and what an investor will look for. Here are examples of a
few:
• newyorkangels.com/entrepreneurs/criteria.html
• sbir.gsfc.nasa.gov/SBIR/BusPlan.html
• techventures.org/resources/docs/Outline_for_a_Business_Plan.pdf
Many venture capital Web sites will also give valuable information about
their criteria for investment as well as their primary areas of interest.
Once the company’s business plan and executive summary are complete,
the founders face the prospect of selecting appropriate candidates to
approach for investment. Venture capitalists and angel investors are
inundated with unsolicited business plans and rarely have the time or
inclination to give those a careful review. Although many venture
capitalist and angel Web sites provide for a mechanism for entrepreneurs
to send their business plans, without the right personal introduction to the
prospective investor, the company faces an uphill battle to garner any
meaningful attention. One of the ways counsel can be most value-added is
by providing these introductions. Entrepreneurs can learn much in an
initial meeting with prospective counsel by asking about their approach to
providing introductions. Good lawyers will suggest a targeted approach to
venture capitalists with particular attention paid to their prior history, the
industry of the company, and the stage of financing. It doesn’t help the
early-stage company to solicit venture capitalists who normally invest in
mid- or late-stage companies. The converse is also true. Investors often
look to the lawyers with whom they have worked and whom they trust for
deal flow. Experienced lawyers value their reputations and do not
inundate investors with unwanted and inappropriate deals.
Managing Expectations
Valuation
Entrepreneurs are understandably enthusiastic about their product or

service. Their passion is critical in moving the company forward and
attracting financing and customers. However, a byproduct of their passion
for their enterprise is that they often have unrealistic expectations about it
and, in particular, its potential valuation. An important part of a venture
capital lawyer’s role is to help create realistic expectations for the

management team. Experienced counsel generally has an understanding of a
reasonable range of valuation venture capitalists are likely to suggest and
how much room there may be for negotiation.
Lawyers must walk a fine line in working with clients on this issue.
Entrepreneurs like to feel their advisors believe in the company, and any
suggestion of a lower valuation for the company can meet resistance. Our
experience is that it is best to have this discussion with young companies
before they actively seek financing. We have had clients who have lost
financing because they were so insistent on a particular minimum valuation
that all investors walked away. Ultimately, those companies did not succeed,
because they were unable to obtain funds. One way for lawyers to approach
this sensitive topic is to share illustrative anecdotes about other clients who
have struggled and ultimately succeeded in growing their companies to a
point where, based on performance, they received a much higher valuation
in subsequent rounds. Pushing for a high initial valuation may haunt start-
ups later, because on subsequent investment rounds, with added investors,
which are invariably necessary, investors generally expect a ramp-up in
valuation as confirmation that the company is improving. It is often better
to start with measured expectations and increase them as the company has
positive developments.
It is also important to try to assess the amount of money a client requires in

any particular stage of financing. It may be preferable to seek less money at
an early stage when the investor is likely to place a low valuation on the
company, with the realization that the company will seek another round of
financing after it has made sufficient progress to warrant a greater valuation.
There are also proposals an experienced attorney can suggest to negotiate a

higher valuation, although these are becoming less acceptable. Lawyers may
propose milestones and staged investments, even volunteer possible
downside protection in case the company fails to meet agreed-upon
milestones. Some of these concessions to propose to the investor to use in
the event the company fails to perform include granting warrants on the
stock or an automatic downward change to the conversion ratio (increasing
the number of shares the investor is entitled to so the valuation is implicitly
reduced), increased protective provisions (using some of the typical debt-

like negative covenants), and even permitting a takeover of the board of
directors by the investors of the company. Venture capitalists, however,
generally prefer less complex deals with lower valuations for the company
while providing potential upsides to management via stock options or
restricted stock.
Board Composition
Before a financing occurs, many founders underestimate the importance of

their company’s board of directors. They view the board as a mere
formality with no practical importance. Nothing could be further from the
truth. From the earliest stages of a company’s development, it is important
that the board be structured so it helps the company more easily
accomplish its goals. Usually at the initial stage, the founders are the only
board members. Once the company starts to grow and the founders seek
financing, they should consider how to assemble a value-added board.
Many entrepreneurs place friends or family on the board either in an effort

to ensure that they will retain control of the company after a financing or as
placeholders for likely venture capitalist representatives to the board. This
tactic creates an unnecessary and unavoidable extra step to the financing
process: a board restructuring. Leaving people off an early-stage board
eliminates the embarrassment of subsequently asking them to resign.
Counsel can help the founders structure a board that will reassure venture
capitalists that the company is already operating professionally and in a
manner likely to promote its growth. We generally advocate a three-person
board at early stages of a company’s life cycle, consisting of the chief
executive officer, one other founder (usually the chief technical officer in a
technology company and the chief scientific officer in a life science
company), and one outside and independent director who supplies missing
expertise in an area that will benefit the company—in the industry, in finance,
or with connections to strategic partners. The second management director
should understand that he or she will most likely need to resign after a
financing to make room for a venture capitalist designee. We have found that
with this board structure the company is more likely to prevail in a
negotiation with venture capitalists regarding the number of board seats to

which the venture capitalists will be entitled. The venture capitalists should
then realize the entrepreneurs understand a board’s function and have
tendered a positive working model with neither party having a majority.
Founders are understandably reluctant to cede control to a group of

financially focused investors who are not as thoroughly involved in the
company’s day-to-day business as management is. Some clients are reluctant
to “waste time” justifying everything they do to individuals who “just don’t
get it.” This tension exists because investors believe they need substantial
control to protect their investments, while entrepreneurs want to be given the
money and be trusted to “do the right thing.” The job of counsel is to
structure a compromise so both sides are reasonably satisfied—to manage
expectations and needs, and to permit the parties to become true business
partners.
Where investors have the right to only one board seat, they will expect
contractual provisions giving them veto rights over certain significant actions
that may be taken by the company. These actions usually include the right to
merge, sell the company, sell a material portion of the company’s assets,
amend the charter, borrow amounts in excess of an agreed-upon amount,
enter into certain types of transactions, and so on. The object of the company
is to attempt to minimize or circumscribe these rights so the investors have a
veto right only if their board designee does not approve the action. This
works to the company’s advantage, because the board designee has a fiduciary
duty to act in the interest of the company, including all of its stockholders.
Investor stockholders, however, do not have the same level of fiduciary duty
and can vote as stockholders, not directors, to protect their own interests.9
When a financing round is syndicated by venture capitalists, which happens

more often in later-stage rounds (so the venture capitalists mitigate their
risk and secure the benefit of the added venture capital access, funds, and
experience), investors may have conflicts about board membership. In later-
9
In many states, the majority stockholders may have a fiduciary duty to the minority
stockholders, which provides a measure of protection for the common stockholders of the
company—the founders, employees, and often friends and family.
stage deals, as the amount of money raised generally increases (with some
deals now raising more than $100 million in one round), these issues may
become even more contentious. Because of the inherent conflict in the
fiduciary obligation the venture capitalist director designee has both to the
company’s stockholders and to his or her venture capital fund’s limited
partners, some venture capitalists may prefer not to designate a director but
to have the right to have an observer attend board meetings and receive the
same information furnished to directors. They rely on contractual
provisions for their protection.
Capitalization and Founder Ownership
One of the major concerns of founders, especially at their company’s early

stages, is how large a piece of their company they will have to yield in order
to obtain financing. We have discussed this earlier in the “Valuation”
subsection. Most founders are unwilling to give up a majority of their
ownership to investors at an early stage because they realize they will have
an ever-shrinking piece of the pie as the company seeks additional
financings in its later stages. There are many ways an experienced venture
capital lawyer can help management address this thorny issue:
• Counsel can help management estimate the amount of funding the

company needs to progress to its next stage, when the company’s
valuation will hopefully be higher and the percentage of the
company it gives up will thus be smaller.
• Founders should be made to consider that voting control of the

company may not be as important to them as the ultimate value of
the company in which they are likely to be significant stockholders.
• Counsel can help entrepreneurs obtain critical common stock

voting requirements for key issues such as board control and
change of management to protect entrepreneurs against arbitrary or
inappropriate action by the venture capitalists or their director
designees.
• Management may be able to make up some lost ground by

negotiating for additional stock options or shares of restricted
stock, some of which may have performance vesting provisions, so
if the company does well management will be able to regain some
portion of its lost ownership.
Founders often do not adequately take into account the reserved pool of
equity that must be available for future grants to employees, directors, and
others. Before undertaking a financing, counsel should focus management
on how to calculate what a justifiable and appropriate option pool will be.
The dilution that results from any increase to the option pool will almost
always be absorbed by the existing stockholders, and not jointly with the
investors. Therefore, founders are reluctant to reserve too large a pool. On
the other hand, they should not underestimate the company’s need to
attract top-quality employees and compensate them adequately with equity.
Investors will generally have a good idea of the quantity necessary, so
founders are better off if they make an informed decision about this.
Broadly speaking, the company should assess what key roles it will need to
fill in its management in the following twelve to eighteen months, and how
much equity it will need to offer to those prospective employees. Counsel
should know what the current typical grants are for various positions—
whether sales, marketing, business development, chief technology officer,
chief financial officer, or top engineers—and how much of a cushion
venture capitalists will expect. At present, a rule of thumb is that the equity
pool should be about 20 percent of the fully diluted equity of the company.
This can vary significantly, however. If most of the key roles are already
filled, the pool may be 15 percent, and if a large number of roles will need
to be filled (as will often be the case in young companies), the pool may be
as large as 30 percent. It is better for the founders to work this out with
their counsel than to have it urged on them by venture capitalists or angels,
who are often seen as having a different agenda than the founders. In this
regard, the company and the investors should share an interest in keeping
top management motivated to meet or exceed expectations. Professional
investors are aware of the need to keep management and employees
content so they are not distracted from their labor and focus their time and
energies on the rapid growth and progress of the company.
Corporate Clean-Up and Due Diligence
Before seeking financing, it is important for the company to undergo an

internal due diligence process. Prospective investors will do a thorough job
of due diligence in deciding whether to invest in a potential portfolio
company. A venture capital or professional angel fund will undertake at
least a financial and legal due diligence review. Often, especially with respect
to life science companies, investors will undertake an intellectual property
review as well. The better prepared a company is, the faster and more
smoothly the process will go. In addition, the investor (and its counsel) will
be reassured by the professional manner in which the company has
conducted itself. Many entrepreneurs are initially shocked when they receive
due diligence checklists from investors and their counsel. The checklists are
overwhelming to many first-time entrepreneurs, who may deem them
intrusive and overreaching. Counsel can warn founders of the impending
inevitable due diligence investigation and assure them that it is
conventional. If a venture capitalist or its counsel overreaches, however, the
company’s counsel should attempt to limit the scope of the investigation.
Experienced counsel will undertake a review of the company’s corporate

documents in order to ascertain that they are in good order and, if not, take
appropriate action before potential investors start looking into the
company’s operations. The most frequent problems found in a review are:
• A lack of appropriate written directors’ and stockholders’ actions

(either in the form of corporate minutes or actions in lieu of
meetings)
• Failure to document material oral agreements and arrangements

adequately, particularly with consultants
• Failure to take adequate steps to protect the company’s intellectual

property (including having all employees and consultants sign a
thorough form of proprietary information and confidentiality
agreement acceptable in the industry and training its employees
about the importance of keeping information confidential)
• Having entered into agreements without prior counsel review

(which can result in the company losing valuable protections or
giving too much away, especially in licensing arrangements)
• Not properly documenting stock option or restricted stock

issuances to employees
• Obligating the company to give away far more of the company’s

stock or options for stock than it intends or realizes
The earlier a company brings in experienced counsel, the less often these
issues will present problems.
Finders and Other Purported Sources of Financing
It is not unusual for even sophisticated clients to make mistakes that create
unnecessary challenges as they seek outside funding. One of the most
frequent of these that we have encountered has been the willingness of
young companies to engage aggressive lower-tier investment banks or
“finders”10 who represent that they will be able to raise funds on the
companies’ behalf. In their haste to obtain investment, entrepreneurs often
agree to extravagant terms, including paying large non-refundable retainers,
agreeing to high success fees, and giving away far too much equity. In our
experience, very few such banks or finders have succeeded in
accomplishing much other than enriching themselves. These banks and
finders are generally far too expensive for the services they purport to
provide, and venture capitalists are reluctant to have them involved because
they perceive them being compensated either out of cash or stock of the
company without adding value. Similarly, entrepreneurs often sign such
deals without consulting qualified lawyers and generally promise to the
10
We use the term finders loosely. Strictly speaking, finders are individuals or entities
that do little more than introduce one party to another. Under federal securities laws,
finders are not permitted to receive a fee based on the success of the financing unless they
are registered broker-dealers, except if they do no more than provide the introduction. If
they are engaged at all in the structuring or negotiation of the transaction, they must be
registered to get the success fees upon which they usually insist.
finder too much of the proceeds of the prospective financing or stock of

the company.
One of the most egregious examples involved a venture capitalist client that
wanted to finance an engineer who had an expiring right to receive an
assignment of valuable intellectual property from a company he was leaving.
This intellectual property would have enabled him to start a potentially
valuable technology company. In his haste to obtain financing, he had
signed agreements presented to him by a number of investment bankers
and finders. Most of the agreements were either unlimited in scope or the
promised compensation was not clearly based on successful performance
by the investment bank/finder. The engineer had unwittingly promised,
after issuance of all the warrants and options provided for in these
agreements, an aggregate of a majority interest in the company he had
formed. Countless hours (and dollars) were spent negotiating the reduction
of the fees and equity of the finders down to an acceptable level for our
venture capitalist client, and the deal literally closed the day before the
expiration of the assignment right. Without these arduously negotiated
reductions, our client would have walked away. If this entrepreneur had
engaged experienced counsel prior to retaining the banks and finders, all of
the time, energy, and money expended would have been saved and the
near-disaster would have been averted.
Going for the Gold: Obtaining Financing
Determining the Appropriate Type of Investor and Model
The appropriate investor and form of financing depends largely on the

stage of a company’s life cycle. All too often, entrepreneurs approach
venture capitalists at an early stage of development, either because they are
not aware of alternative sources of funding or because they believe they are
further along in their business than they are. Venture capital counsel
generally have their fingers on the pulse of venture capitalists—they work
with them as often as they work with companies—and they should have a
good idea of the stage at which a company is most likely to be funded at a
valuation that will not dilute the entrepreneurs so heavily as to make the
financing unpalatable.
Attorneys should educate their clients about the various forms of

financing that are appropriate for the different stages of their life cycles.
These range from “friends and family” to angels and venture capitalists
and even beyond, as some private equity firms are beginning to invest in
or purchase late-stage technology and life science companies that are
unable, because of an unready market, to go public.
Friends and Family
This type of financing typically occurs at a relatively early stage in a

company’s life, usually after the founders have infused all the capital they
can afford, and sometimes more. This is technically angel financing, in
that the people who put money into the company at this stage are truly
angelic sorts, when the risk is greatest and the reward most attenuated.
This phase of financing is often accomplished through the sale of the
company’s common stock, without many additional rights. One trap for
the unwary in this round of financing is a valuation by the founders far
above market value. Friends and family may well be willing to “help” their
loved ones by infusing cash at high valuations at a much-needed time
without overly diluting the founders. But while this seems positive at the
time, it creates unrealistic expectations both for the founders and the
investors. The next round of financing is highly unlikely to be at the same
or a higher valuation, once more sophisticated investors are involved.
This leads inexorably toward undue dilution for the early investors and
potentially hard feelings. Founders should be counseled about this risk
and be given recommendations for alternative structures that may
ameliorate this situation.11
Angels
In the earlier days of venture capital, angels were in fact friends and family,
or groups of wealthy but not necessarily sophisticated investors nicknamed
the “doctors and dentists.” Over the years, this category of investors has
11
One such alternative is the use of convertible debt, which we discuss below. Another is
the use of a pure debt instrument with warrants attached, giving the lenders an upside as a
thank-you for their invaluable support.
morphed into a more formal network of high net worth individuals who are
more sophisticated and more hands-on in oversight of their investments.
Effectively, there are two subcategories of angel investors. The first is the
individual high net worth individual, who may or may not have experience
and expertise in the industry or type of company in which he or she is
investing. We have seen many former entrepreneurs, who have had
successful exits from their companies, become early-stage investors. Many
of these angels can be extremely valuable to an early-stage company because
of their relevant experience—they have taken companies through the early
stages and understand what it takes for them to grow and thrive. Others,
however, believe they know what is best for all companies based on their
personal experience, and if their experience has not been all positive, there
can be negative ramifications for the companies in which they invest. One
extreme example of this was with a former founder of a company who felt
ill-used when he was demoted from chief executive officer to chief
technical officer in an early financing round. The company went on to be
hugely successful, netting the founder hundreds of millions of dollars.
Despite this, he harbored resentment and profound distrust of investors,
and he became an early-stage investor himself. The terms of his
investments were generally extremely onerous for the companies in which
he invested, because they included a veto right over any venture capital
investors. Experienced counsel would have recognized this term as one of
the more chilling terms possible for a future financing and warned the
founders not to accept it. We were asked for help in undoing this unusual
blocking right, which took a great deal of effort and money that could have
been saved by retaining skilled attorneys at an earlier stage.
Venture Capitalists
Most venture capitalists do not invest in extremely early-stage companies,

although there are some who undertake seed financings. In the earlier days
of venture capital investing, seed financings used to be the first round of
financing an emerging company received (other than amounts infused by
founders and their families, virtually all of which took the form of common
stock or debt instruments). Now, seed financings by venture capitalists may
or may not be the first round of preferred stock (as we will discuss in more
depth below), but they almost never are as early-stage as they used to be.
Most venture capitalists now do not invest small amounts of funds

($500,000 to $2 million) into companies, which is often exactly what young
companies may need. For one thing, the size of venture capital funds has
skyrocketed since the late 1990s, in the midst of the dot.com boom. Funds
that used to manage $50 to $100 million started raising $500 million to $1
billion funds. Making small investments became unwieldy and ultimately
impossible, because it would take too many investments to invest the fund
fully and require too much venture capitalist attention on each investment
for an inadequate return. Providing real oversight to the portfolio
companies and fulfilling their fiduciary duties to their fund investors
became possible only if the funds invested larger amounts. Large amounts,
in turn, could only be invested appropriately into later-stage companies.
Thus, the angel investor boom was born. In a swing back to early-stage
investments, however, some venture capitalists have begun investing small
amounts in relatively raw start-ups. Charles River Ventures, for example,
has begun a program to invest $250,000 in promising new companies to
help them grow their businesses to the stage where a larger investment
would be appropriate.
Corporate Venture Capitalists and Strategic Alliances
Many entrepreneurs are unaware that corporations often have venture arms
and stand ready to invest in young companies in which there are synergies.
The investments are often, but not always, accompanied by some sort of
strategic relationship—for joint development of a product or service,
marketing, or distribution, among others. This can be a blessing or a curse
for a young company. There are many advantages to an investment by a
corporate investor, among which are the credibility it gives the company, a
greater valuation than a financially minded venture capitalist might offer,
less pressure regarding financial milestones and a financial return on
investment, and less desire for board and management oversight. However,
companies must be mindful that alliances with corporate venture capitalists
carry risks as well. Well-versed attorneys will counsel their clients that an
investment by a corporate partner, especially at an early stage, has risks
attached as well, including the possibility that competitors to the investing
corporation may not adopt the company’s product or service, seeing it as an
extension of the competitor. Furthermore, the acquired company may not
be perceived as having sufficient importance to the bottom line of the

acquiror, with consequent lack of adequate support and attention. While
these have been issues for some years in the life sciences arena, they have
become equally true in the technology world as well. Technology companies
are well advised to look to corporate investors where there are synergies,
but not the appearance of anti-competitive behavior on the part of the
corporate partner. More than a few early-stage companies have been
swallowed up by large companies that invest in order to lock up their
portfolio companies and thus avoid a potential competitor. Another risk is
that the relationship with the large company is at a lower management level
that may not see significant advantage to itself by investing time and effort
in supporting the early-stage company and may even see it as a potential
rival.
Among very active corporate investors are Intel, Motorola, AMD, Nokia,
3M, and Siemens. These investors often invest in technology companies in
which their products will be used. After recovering from the burst of the
dot.com bubble, corporations are beginning to invest again with gusto,
which is good news for technology companies.
Initial Financing
A company’s first financing event is among its most important events. It

can set the stage for future financings and give the company some critically
needed funds to build its business model to the point where it can seek
further financing from angels and venture capitalists. Management, which
consists largely at this phase of the founders, must decide who the most
likely investors will be, and target that group. Unfortunately, founders are
often not well versed in whom to seek out, how to go about finding
investors, what these investors will require, and the onerous process that
may await them. What the founders need most at this stage is a trusted
advisor, someone they can turn to for the answers they need and who may
be able to make introductions to funding sources. Perhaps most
importantly, they need someone who can keep them from making mistakes
from which it may take time, energy, and money to recover. An experienced
venture capital counsel can provide all these services and steer management
away from inappropriate or unrealistic targets, as well as from finders and

lower-tier investment banks that prey on young companies.
Helping clients delay talking to venture capitalists until the appropriate time
is one of the more value-added things a good lawyer can do. It is best not to
shop the company around. Venture capitalists do not like to waste their
time and energy on companies that are too early-stage or outside the
venture capitalist’s areas of interest. If they are approached too early,
venture capitalists can develop a negative attitude about the company that
will survive the company’s early stage.
We advise our clients that, as a rule, there are two appropriate sources for
the first stage of financing—friends and family members, and angel
investors. We have already described these types of investors generally.
Friends and Family
Founders may wish to tap into their networks of family and friends before
reaching out for more institutionalized forms of financing. One of the
most common mistakes entrepreneurs make is to offer securities (in
whatever form) to these friendly investors before ascertaining that there is
an available exemption under the federal and state securities laws. We
have represented venture capitalists in portfolio company investments in
which offers of rescission had to be made to early-stage investors who did
not qualify as “accredited investors.”12 This is a costly procedure for a
relatively young company. An ounce of securities law prevention is worth
a pound of rescission cure.
12
Accredited investors are defined in Regulation D promulgated under the Securities Act
of 1933, as amended. Regulation D provides a safe harbor for offers and sales made to
individuals or entities that meet certain financial thresholds. The idea behind the
Regulation D exemption is that by having a certain level of financial wherewithal, these
investors have a certain level of sophistication and can afford to lose their investments in
a worst-case scenario. The threshold for individual investors is that they either (a) have
had income of at least $200,000 for the past two years and the expectation of at least that
amount in the coming year or (b) a net worth of at least $1 million.
There are three forms such a financing can take. It is simplest to have a
first round of friends and family money invested in common stock, with
no special rights. It is important for these investors to understand that
they are coming into the company at a nascent stage and will most likely
be diluted heavily by institutional financing as the company grows. These
investors are the next step for the company after the founders are no
longer able to bootstrap the company with their personal resources.
If the founders or investors feel it would be unfair to put this group into
the same “sweat equity” class of stock as the founders, we suggest
considering a pared-down Series A preferred stock that has a liquidation
preference over the common stock, but few if any other rights, so that in
the event of liquidation the investors get their money back before the
founders do. Another alternative structure is convertible debt, in which the
principal and interest automatically convert into equity in the next round of
equity financing. Convertible debt has advantages and disadvantages, as we
will describe more fully in the “Angels” section below.
Experience has taught us that later-stage investors like to see a relatively

clean capitalization structure in their portfolio companies. It is important,
then, to structure even the earliest financings with a goal of keeping a
simple capital structure. If a company has several series of preferred stock
outstanding before even approaching venture capitalists, the venture
capitalists may either pass on investing in the company or require a
restructuring of the company, which is costly and most likely will have the
effect of wiping out the early-stage investors. In order to manage the
expectation of the parties, it is best to create a structure that will survive
later stages of financings.
Angels
As the angel investor market has matured, the types and sophistication of
the investment vehicles used by them has evolved. Angels are now starting
to demand a seat at the table in later rounds of financing, as they have
found themselves diluted dramatically over time, rather than rewarded for
taking a higher degree of risk than venture capitalists and other later-stage
investors. The easiest way of dealing with this issue is by using convertible
debt as the funding structure.
A convertible debt financing consists typically of a note purchase agreement

and a convertible promissory note. Examples of these documents can be
found in the forms of convertible note purchase agreement and convertible
promissory note, respectively. The simplest structure for this type of
financing provides that the note will convert automatically into the same
type of shares that are sold in the next round of financing that meets certain
minimum thresholds (e.g., as to aggregate amount raised or type of
investor). Usually, the principal and accrued but unpaid interest convert at
the same price per share as in that subsequent financing, minus some
discount. The discount rewards the angel investor for taking a higher degree
of risk by investing in the company at an earlier stage than a venture
capitalist would be willing to do.
For the angels, there are upsides and downsides to this structure. Allowing
venture capitalists to negotiate the terms of the preferred stock in a larger
financing is likely to result in more and better rights in the ultimate
preferred stock the angels receive, because venture capitalists are more
likely to obtain more valuable liquidation preferences, board and board
observer seats, protective provisions, and anti-dilution protection, than a
small angel round can. The downside for the angels is that the valuation
negotiation will occur at a later stage of the company’s life cycle, after it has
been able to use the funds raised from the angels to achieve sufficient
traction and milestones to negotiate a higher valuation. This is where the
conversion discount, more fully explained below, plays an important role.
For the company, putting off the valuation can be a huge advantage.
Negotiating the terms of a convertible debt financing is fraught with

challenges. Many entrepreneurs do not understand this type of structure or
are not aware of nuances that could have an effect on later financings.
Among the issues are (i) what is the appropriate discount off the purchase
price of the shares sold in the next round of financing13—we generally
13
In lieu of a discount, some investors choose to receive warrants exercisable for the type
of shares sold in the financing, exercisable at a de minimis price per share. The issuance
propose a sliding percentage, reflecting the level of risk faced by the angels
(e.g., 10 percent if the equity financing occurs within the first six to nine
months, 15 percent if it occurs within the first twelve months, and 20
percent if it occurs within eighteen months)—depending, of course, on the
ultimate due date of the notes; (ii) whether the note holders receive a right
of first refusal or first offer on any new financings by the company, which
can have a chilling effect on the company’s ability to obtain later financing;
(iii) what level of majority of note holders can determine whether the notes
can be pre-paid; (iv) what is the appropriate due date for the promissory
notes (i.e., how far out should the deadline be for the contemplated equity
financing that will trigger the automatic conversion of the debt); and
(iv) should the notes be secured by the company’s assets, which are
usually at this point its intellectual property (we strongly recommend
against this).
Counsel can act as a partner to the company to help weigh the plusses and
minuses of a convertible debt financing, and then negotiate the best
possible deal on the company’s behalf.
More and more, however, angels are demanding the right to receive their
own series of preferred stock, opting to obtain immediate equity and
clout, as well as a valuation that is more favorable to them than is likely in
a convertible debt financing. Angels are realizing they may be acting
against their interests by providing the funds that will increase the
company’s valuation and result in the angels receiving less ownership in
the company than had they negotiated the valuation at the time they
actually provided the funds. Here again, it is critical for the company to
negotiate carefully the rights the angels receive, including the liquidation
preference, blocking rights for future financings, rights to participate in
future financings, board seats, and anti-dilution protection. Experienced
counsel is likely to know how much it is possible to push back on the
rights requested by angels. They can point out other deals the angels
themselves may have done, or that other angels have agreed to, and
of warrants without a purchase price can result in an original issuance discount for the
investor, which creates a phantom taxable income. Thus, most deals are now done using a
discount from the purchase price.
should know the basic standards for these early-stage investments. They
should also be able to alert the company—and the angels—as to whether
and to what extent any prospective terms may make later financings more
difficult or hamper the valuation discussions. Sophisticated angels are
likely to listen to opposing counsel they respect.
We have included as Appendix M a form of term sheet for a Series A

preferred stock angel financing that has been drafted from the company’s
perspective. In the term sheet, we have provided for the grant of a limited
number of rights to the Series A preferred stock, which gives the company
the freedom to grant more rights to later investors when more money is put
in without being put in a position of having to ask the angels to give up rights
that have already been granted.
After the Initial Financing
The consummation of the initial financing is a major achievement in the life

of a young company. It provides validation, credibility, and much-needed
cash to take the company to its next stage—and next financing. The company
must now use the funds carefully and in a focused way in order to meet its
goals, while at the same time being accountable to outside investors (and
potentially a board member or observer) for the first time. Getting used to
this accountability—having regular board meetings, sticking to its business
plan, and not resenting outside questioning—is a transition that is difficult for
some young companies. Here, experienced counsel can be quite useful as a
sounding board and in guiding management through the initial phases of this
period in its life cycle. Counsel will be able to advise management about
ordinary course growing pains and help put into place new policies and
procedures that will protect both management and the board. For example,
the company will likely be hiring new employees at this stage, and if it has not
already done so, it should adopt an employee manual, possibly retain a payroll
service, and engage in more formal review processes.
The company may at this stage be moving toward attaining revenue or

commercializing its product or service (this will likely not be true in medical
device or biotech companies, but they may seek strategic partners for
development purposes). The licensing, joint development, and other
agreements entered into at this stage are particularly critical, because their
breadth will have a profound impact on the company’s ability in the future to
enter into related agreements. At this phase of the company’s life cycle,
management is often tempted to rely on short and simple agreements in the
interest of moving forward quickly and showing progress. They may feel
lawyers are a hindrance rather than a help when they insist on spelling out the
scope, term, and exclusivity of these arrangements. It can be helpful to give
clients a checklist of the major issues they should consider when negotiating
the business terms of a license agreement. This list should illustrate the
potential complexity and dangers involved in a poorly negotiated license
agreement. We have provided a template of a checklist for license agreements
as Appendix L.
We had a client that only wanted three-page license agreements. Instead of

agreeing or preparing a fifteen- or twenty-page agreement, we explained why
we needed to add protective provisions. We reviewed the need for specificity
in the field in which the licensee could use our client’s product so the client
would be able to license the product in other fields. We pointed out the need
for performance milestones if he were going to grant exclusive rights to the
licensee so he wouldn’t be tied up with a non-performing license and be
unable to terminate the agreement and enter into alternative arrangements. In
addition, we insisted that our client think seriously about the company’s
international strategy if the license grant was to be worldwide. In this
increasingly global economy, entering into opportunistic international licenses
can profoundly and adversely affect future growth. International strategy
must be carefully thought out, discussed at the board level, and applied
consistently. After our client heard our concerns about the company’s long-
term success, he agreed we should prepare a more detailed agreement. As a
result, we provided for our client the important protections it needed.
Later-Stage Financings
After growing enough so it has sufficient traction and is ready for the next
important stage of its life cycle, the company will probably seek financing to
help it attain its next set of milestones, which are necessarily larger in scope.
More substantial goals translate into the need for a larger funding event. A
technology company may be ready to market its product aggressively and/or
develop other complementary or next-generation products. It might be
considering acquiring other companies or technologies as part of its strategy.
If it is a life science company, it has likely completed its Phase I testing and is
now ready to move into Phases II and III.
Raising this round of financing requires thought and strategy that should be
discussed at the board level. Here, the company’s counsel can be a powerful
ally and partner. Even before addressing issues of valuation and dilution to
the existing stockholders, the company needs to consider what kinds of
funding it should seek. Attorneys should carefully and thoughtfully counsel the
company as it contemplates these difficult questions. What sort of a financing
partner does a company need at this stage? Would a venture capitalist with
strong connections to strategic partners—marketing, development, roll-up
targets, among others—be a plus? Would these positives outweigh potential
negatives, including a possible lower valuation, more reporting requirements,
and the perceived interference by venture capitalists in the day-to-day
operations and decisions of management? Is the time ripe to seek out
strategic/corporate investors? What about a combination of these investors?
Does the venture capitalist tend to syndicate its investments? Who are the likely
candidates to approach? What is the most effective way to approach them?
What companies have they financed, and what has been the experience of
management with the venture capitalists in these companies? What is the
success rate of the companies financed by these investors? Have they financed
competitors or complementary companies?
Counsel should be able to help with most, if not all, of these threshold
questions as well as the more practical questions relating to the financing. Does
the investor demand a multiple on its liquidation preference14 so it will receive
more than the amount it invested before holders of any junior classes and series
of stock receive any distributions? If so, what is an appropriate multiple? How
many board seats will the investor(s) demand? What protective provisions will
14
A liquidation preference provides for the return an investor will get on its investment in
the event that the company is liquidated, prior to any distribution to other stockholders
holding equity with junior rights. In virtually all cases, a sale or merger of the company, by
whatever means, is deemed to be a liquidation, unless a majority (or supermajority) of the
holders of preferred vote otherwise, which they might if they would receive a larger
distribution as common holders (i.e., if the amount they received from their liquidation
preference would be less than the amount the holders of common stock were to be
distributed thereafter, which could happen if the company were sold at a very high purchase
price).
be required? Will the founders have to re-vest their stock or some portion of it?
What kind of valuation can the company expect?
In addition, counsel needs to remain vigilant about securities law issues in

connection with each financing,15 as well as ensuring that a financing will not
trigger defaults in any lending documents or change of control provisions in
any contracts to which the company is a party. We have seen instances in
which, for example, the consummation of two financings by a company
within a twelve-month period would have triggered change of control
provisions in a licensing agreement, which would have given the licensor of
important technology the right to terminate the agreement. This would, in
turn, have led to a material adverse effect in the company’s ability to do
business and potentially killed the financing. Because we spotted the issue
before the financing, we were able to obtain a waiver from the licensor and
avoid a serious issue.
Standard Venture Capitalist Financing Terms 16
The overwhelming majority of venture capital investments in portfolio

companies are made via the purchase of the company’s convertible preferred
15
Many entrepreneurs, and venture capitalists for that matter, are casual about the
manner in which they discuss potential offers of securities. Counsel needs to be aware of,
and guide the board and management with respect to, the manner in which offers are
made. Clients can come perilously close to making offers in states in which filings must
be made prior to any offers. Having built a relationship of trust, experienced counsel
should be able to manage this process without undue interference.
16
East Coast and West Coast venture capitalists tend to differ in their approaches to
financing terms. Our theory is that many East Coast lawyers have come to venture capital
with a background in bank financing or lending documents and may be aggressive both in
seeking numerous covenants and in trying to have the entrepreneurs join in some
warranties and representations. Many of these extra covenants tend to do more harm than
good on many levels, including building trust between the venture capitalist and
management, and tying up the operations of the company while consents and waivers are
sought. Entrepreneurs resist joining in the warranties and representations, arguing the
investment should be made based on the company’s business plan, the venture capitalist’s
due diligence process, the previous track record of the management team, and the
manifest desire of management to invest time and energy to make the company succeed
for everyone’s benefit. We are using a hybrid of West Coast and East Coast documents in
our appendices, leaning more toward the West Coast model.
stock. Terms of venture capital investments are relatively standard, although

there are likely to be nuances that are unique to each deal.17 In the
appendices, we have provided an example of a term sheet for a venture
capital financing, as well as the standard documentation for a venture capital
investment, other than the preferred stock purchase agreement (which is
substantially similar to the purchase agreement for the angel financing), terms
of a Series B preferred stock to be included in a restated certificate of
incorporation (using Delaware as the jurisdiction of incorporation, which is
the most common jurisdiction in venture-backed companies), and an investor
rights agreement.18
The basic terms of a venture capital investment include various preferences in

the terms of the preferred stock, including basic liquidation preferences,
automatic and mandatory conversion rights, anti-dilution protection, voting
rights (including board seats), and dividend rights. The investor rights
agreement contains provisions for registration rights, rights of first refusal on
issuances of new securities by the company and sales of existing securities by
investors and founders, co-sale rights in the event of sales by investors and
founders, and delivery of financial and other information to investors.
Usually, investors require company counsel to deliver its written legal opinion
on issues related to the financing.19
17
In an effort to streamline the investment process and cut down on increasingly large
attorneys’ fees, a group of venture capital funds’ in-house counsel attempted to standardize
the documentation for these types of investments. Despite strong progress, the project never
gained sufficient traction because each fund’s outside counsel had its own forms and was
unwilling to use the standard forms. For one thing, venture capital portfolio company
investment documentation would have become commoditized, and lawyers would be
unable to justify the high fees they had been charging.
18
There are variations to these documents, but the substance of the documents as a whole is
relatively constant. Sometimes, the parties will enter into a separate registration rights
agreement and include the other provisions contained in an investor rights agreement in the
preferred stock purchase agreement.
19
We are not believers in the insistence on a legal opinion. The theory behind this
requirement is that counsel will be more likely to focus management of the company on the
veracity of the representations and warranties it is delivering to the investors in the preferred
stock purchase agreement if counsel itself must opine as to certain of them. In our
experience, good counsel does this even without having to provide an opinion. Opinion
carve-outs and assumptions have become an art form in large law firms, with separate
opinions committees, often comprised of the best and brightest attorneys in the firms,
devising non-opinions that masquerade as opinions. We state this without blaming firms for
We have provided standard documentation for a venture capital investment

in the appendices. Despite the relatively standard nature of these types of
investments, there are still areas in which counsel can provide significant
value to their clients, many of which occur at the term sheet phase of the
transaction. Among these are the following:
Liquidation Preference
Over the years, the liquidation preference has become one of the most
contentious areas of negotiation between venture capitalists and companies.
The liquidation preference was originally designed to ensure that the venture
capitalists received the return of the amount of their investment (plus any
dividends that might have accrued) if the company was sold, merged, or
liquidated.20 In other words, if the venture capitalists’ investment did not
result in a “home run,” the venture capitalists would at least be made whole
before any distributions were made to holders of common stock. In the
earlier days of venture capital financings, the venture capitalists demanded
they receive the greater of the amount they had invested and the fair market
value of the stock as of the liquidation time. Increasingly, venture capitalists
have been seeking greater and greater returns on their investments before the
holders of junior series of preferred stock and common stock are entitled to
receive any distributions. Since a sale of the company (a more common event
these days) is typically deemed to be a liquidation event, giving rise to
payment of the liquidation preference, venture capitalists have become far
more focused on this feature. Some venture capitalists seek multiples of two
(or even more) times the amount invested as a liquidation preference, as well
doing this. Lawyers should not be guarantors of a company. It is the investors’

responsibility to engage in an adequate due diligence process to provide enough comfort to
enter into a financing. In our combined years of practice, we have not ever seen investors
sue a law firm because of its opinion. Instead, by requiring an opinion the legal fees soar
because of internal due diligence policies and requirements of the law firms delivering
the opinion. Extensive internal memoranda are created, and the company’s ultimate
proceeds from the financing are lessened.
20
It is important to remember that the lion’s share of successful exit scenarios in the past
were initial public offerings, in which the liquidation preference was irrelevant. Now that
exits via a sale of the company are far more prevalent than initial public offerings, the
liquidation preference has emerged as a much more important feature of the venture
capital financing.
as a right to share with the holders of common stock in the proceeds as if

they had converted their preferred stock into common stock. Founders, on
the other hand, do not want to lessen the amount to which they are entitled
to receive, since they are the ones who put in the sweat equity and built the
company to the stage at which a successful sale occurs.
The tension between entrepreneurs and venture capitalists over this issue
often reaches a high level. Fortunately, many venture capitalists have
recognized this, and there is some flexibility on their parts. Here is where
counsel can help management reach a middle ground. In part, discussions
have moved away from an absolute and toward creativity. Venture
capitalists have begun looking at the liquidation preference as a way to
adjust the valuation of the company in the event that it does not meet
certain performance milestones for growth. Counsel will be able to help
management negotiate reasonable, objectively measured criteria for these
milestones. The general idea is that the venture capitalists valued the
company in part based on management’s belief that it could attain certain
goals with the funds being provided in the financing. If that assertion turns
out to be incorrect, the valuation should not have been as high, and the
investors will be entitled to receive more money upon a liquidation event
than they would if the goal had been reached. The flip side of this is that
management will obtain the valuation and return it believes appropriate if it
is able to deliver on its projections.21
21
An alternative to an adjustment to the liquidation preference is the issuance of warrants
for additional shares of the company’s stock, which would become exercisable only if
certain agreed-upon milestones are not met. Company counsel must be similarly vigilant
in ensuring that the milestones are crafted in an objective, measurable fashion. In any
warrant issued to venture capitalists, they will require a “cashless exercise” provision
(using warrants to exercise instead of cash) so that in exercising the warrants, venture
capitalists will not have to pay cash for the shares being acquired. Many entrepreneurs
dislike this provision because they feel it gives an extra benefit to the venture capitalists.
However, the actual number of shares the company will have to issue to the venture
capitalists upon exercise will decrease in any cashless exercise, and the dilution to the
entrepreneurs will be reduced accordingly.
Conversion Rights and Anti-Dilution Protection
Counsel should be careful in negotiating these rights. Typically, preferred

stock initially converts into one share of common stock for each share of
preferred stock held. It is in the company’s interest for the conversion ratio
to remain constant to the extent possible. However, the 1:1 conversion
ratio may change based on several factors. The most critical of these is what
is known as “anti-dilution protection,” of which there are several forms.
The most draconian of these is “full ratchet” protection, which we try to
avoid. In full ratchet protection, if the company sells later rounds of equity
at a purchase price per share that is less than the price at which the venture
capitalists bought their shares, the conversion price of the preferred stock
purchased by the venture capitalists is lowered to the amount of the later
purchase price, no matter how small the amount of stock that is sold.
Clearly, this kind of protection can have profound and negative
ramifications for the holders of common stock, who can find themselves
with significantly less of the company than they bargained for. From the
company’s perspective, it is much more favorable, and we believe
reasonable, to use one of the weighted average formulae so the current
investors would receive an adjustment in the event of a future down round,
but not as extreme as full ratchet protection.22 One of the other scenarios in
which the conversion feature may be adjusted is if certain performance
milestones have not been met. This is an alternative mechanism to the one
more commonly used in liquidation preferences, as we have described
above.
22
There are two types of weighted average formulae: broad-based and narrow-based. The
broad-based formula includes using in the formula all shares of common stock that are
authorized for issuance under the company’s stock option plan. The narrow-based
formula includes using only the shares for which options have already been granted.
Either one of these formulae gives a lower level of anti-dilution protection to the investor,
but most venture capitalists are willing to accept either of them because they are more
reasonable than ratchet provisions and they believe in working in partnership with their
portfolio companies. What may happen in the course of discussions regarding anti-
dilution protection is a reconsideration of the agreed-upon valuation, because an accurate
valuation (not easy to determine) should cause the provision to be moot.
Redemption
Some venture capitalists require that the preferred stock be redeemable if,
in five to seven years, the company has not yet had an exit event. The
redemption feature is considered by some to be the equivalent of a vestigial
organ. Historically, it was meant to give the venture capitalists a weapon to
use in the event that management did not move toward an initial public
offering or a sale of the company, because it believed either that more value
could be added to the company or that it had become comfortable with a
level of performance unsatisfactory to the investors. That weapon has not
proved particularly useful, and many venture capitalists have dropped the
requirement. Our advice is to include it if the venture capitalists insist on it.
Redemption rights are usually structured so that, once exercised, the
redemption takes place over two to three years. One protection for the
company is that payments of the redemption price should only come out of
available capital so the company is not in a position to bankrupt itself in
paying the venture capitalists.
Protective Provisions
Protective provisions can seem like an innocuous way for the venture
capitalists to protect their investments. Essentially, they give the venture
capitalists the ability to keep management’s feet to the fire and require
venture capitalist approval for actions that are outside the ordinary course
of the company’s business. Certain of these are so standard that we will not
discuss them here. However, experienced counsel will point out the
provisions that are likely to hamper the ability of the company to react
quickly to a fast-changing market. Since most “extraordinary” decisions
require board approval, we try (usually successfully) to permit a separate
vote only if some super-majority of the board—usually including the
venture capitalist designee (or at least one, if there are more than one on the
board)—does not approve the proposed decision. The advantage of this is
that in voting as a board member, the venture capitalist designee is bound
by his or her fiduciary duty to the company and all of its stockholders.
When voting as a preferred stockholder, the venture capitalists generally are
not similarly bound. One other thing for counsel to seek is to provide for
the smallest possible majority of preferred holders necessary to approve the

protective provisions. This is a difficult battle, because it can get in the way
of the relations between and among various venture capitalists. It calls for
walking a delicate line, a feat more easily done by counsel with experience
and credibility with venture capitalists and their counsel.
Strategic Investors
At this later stage of a company’s development, one or more strategic

investors may benefit the company in a number of ways. If a strategic
investor leads the financing round, the valuation may well be higher than a
venture capitalist valuation, no investor board seat is likely to be required,
and many of the typical venture capitalist protective provisions will not
apply. Even if a venture capitalist leads the round and a strategic investor
participates, there are several additional advantages. Strategic investors tend
to be large, well-known corporations, and their agreement to infuse money
and other assets into a young company can provide tremendous cachet and
credibility for the company. In the case of life science companies, having
one of the big pharmaceutical companies invest and enter into some sort of
strategic agreement at the same time can make a huge difference in the
success of the company.
Choosing the right strategic partners is not always a simple task.

Experienced counsel can help in this targeting process, because they should
know or be able to obtain information about the reputations of the
prospective partners. We have seen companies wooed by strategic partners
they thought would add tremendous value. Instead of adding value, these
partners were mostly interested in keeping the companies from competing.
They entered into agreements that tied the companies up and ultimately
caused them to fail. It is crucial for companies to do extensive due diligence
before agreeing to accept funds from and enter into strategic agreements
with these large corporations. Having knowledgeable counsel at the
companies’ side could have prevented them from entering into
arrangements that ultimately resulted in their demise.
Counsel can help its clients determine the appropriate type of strategic
relationship to enter into with the strategic investor. Among the possibilities
are joint development arrangements, marketing and/or distribution

arrangements, and licensing deals. Each of these has its own extensive
possibilities and pitfalls, and experienced counsel is crucial in ensuring that
the company’s interest is at all times preserved.
For example, in a joint development agreement, who will own the resulting
intellectual property? If it will be jointly owned, will there be restrictions on
either or both parties in how it is used? What about derivative products that
result from the company’s original intellectual property? If the company
enters into a marketing/distribution agreement that gives the strategic
partner the right to market the company’s products, will it be exclusive? In
what territories? Will there be performance criteria in order for the partner
to retain its exclusive rights, and how will they be measured? How long will
the relationship last? Licensing deals have their own specific issues—
crafting the scope of the license, its exclusivity (if any), territory,
performance milestones, and potentially source code escrow provisions. It
is challenging, especially when the strategic partner generally has a
disproportionate negotiating power. Companies need counsel who are
comfortable and conversant in these types of deals, who are experienced
negotiators, and who understand the landscape of the industry in which the
company is and will be operating. This type of counsel is far more than a
mere scribe. He or she needs to be an active partner at all stages of the
negotiations, especially the early stages, when many of the business terms of
the relationship are first discussed and may be inadvertently cemented. We
have often been in the very uncomfortable position of attempting to undo
some of the terms our clients have initially agreed upon with strategic
partners because they didn’t fully understand the ramifications of the terms.
We try to work with our clients before they start negotiating so they are
aware of important issues. As a result, we find our clients are more likely to
contact us before they agree upon critical provisions.
Growing Pains
Once the company has raised venture capital funds, it can move into a
growth phase. This may mean expanding its product line, moving into a
sales and marketing phase, going from research and development or clinical
trials into distribution mode, or acquiring other companies in a roll-up
strategy. At this stage, the board of directors will be focused on whether all
of the members of the existing management make the appropriate team to
take the company to its next stage, which may be the exit stage. It is often
here that the chief executive officer is no longer the right person. A chief
executive officer who has been successful in getting the company through
its early stages may recognize that someone else may have better skills at
moving the company forward. The existing chief executive officer often
becomes the chairman of the company or can be persuaded to become the
chief technology officer or chief scientific officer—a move designed to
keep him or her within the organization and continuing to add value and
vision—and a new, more experienced chief executive officer brought in.
Companies will also often retain a more experienced chief financial officer
at this stage who will help not only with financial elements of the company
but also with overall strategy from a financial perspective. In the current
regulatory environment, and in particular the specter of being faced with
Sarbanes-Oxley compliance as the company moves toward an exit, a chief
financial officer is a crucial component of the management team.
As management shifts, the company will also likely be adding more

employees—engineers, sales and marketing people, and support staff. All of
this movement can be overwhelming to a company that has been small and
somewhat insular. The “feel” of the company often changes at this stage,
and for long-term members of the team, it can feel overwhelming.
Management should be mindful of this and help in this transition.
However, management is likely to be moving rapidly to grow the company,
and may not be aware of the shifts that are taking place. Counsel can be
helpful at this stage and point out the possibility that this may be occurring.
Visiting the company on a regular basis is important at this stage. Just by
walking around and talking to people, and listening to what is happening,
counsel may be able to gauge the mood of the employees. Because counsel
is not caught up in the everyday stresses of the company, he or she may
observe things management does not. Talking to the chief executive officer
or chief financial officer about these observations can make a big difference
in how the company handles this difficult transition, and allow the company
to move forward more smoothly and seamlessly into its exit phase.
Exit
The term “exit” is something of a misnomer. In reality, it means the venture

capitalist can exit from its investment in the portfolio company. This may
or may not result in the company terminating its existence. Historically,
indeed, the preferred exit was via an initial public offering, which meant the
company continued on to its next phase as a public company. However,
after an initial lock-up period following the initial public offering (typically
six months), if the stock price of the company remains stable, the venture
capitalist will likely commence to distribute the securities of the now-public
company to its limited partners, who in turn are free to dispose of the
securities (subject to Rule 144 of the Securities Act of 1933, as amended).
Thus begins the venture capitalist’s exit from its investment.
In the merger and acquisition scenario, the company as an entity will largely
exit from the stage. However, it is likely that some subset of management
and employees will continue on in the entity to which it was sold.
In either scenario, experienced counsel is essential at every step of the way

toward an exit event. After a later-stage financing of whatever nature,
counsel should be focused in part on keeping the client’s house in good
order so if an exit opportunity presents itself the company can spring into
action. Among other things, counsel should make sure corporate
housekeeping—board minutes and consents, annual stockholder meetings,
stock option and restricted stock grants, and employee issues, among
others—are up to date and in keeping with all laws, rules, and regulations.
Counsel should keep accurate records and organized files for agreements
the company has in place, all non-disclosure agreements with third parties,
all employment agreements and offer letters, and consulting, licensing,
distribution, and marketing agreements, as well as leases and other material
agreements, so investment banks or potential acquirors can conduct their
due diligence easily and efficiently. We have seen potentially lucrative exits
fail because of bad record-keeping and the ramifications thereof, such as
the company not being conversant with covenants in agreements it had
made. These covenants might not have been as troublesome had an
acquirer been informed of them at an early stage, but the deal had gone
almost all the way down the road to closing when the covenants came to
light. Because of this late disclosure, which came on the heels of several
other late material disclosures, the potential acquiror developed cold feet
because it began to worry about other issues that might come up after a
closing, and it walked away.
In addition, as the company gets larger, counsel should introduce the

concept of Rule 404 of Sarbanes-Oxley, because the company will need to
be mindful of and adopt best practices with respect to Rule 404 if it is likely
to be acquired by a public company or if it will become public through an
initial public offering. In a merger and acquisition deal, to the extent the
company is not compliant, the price of the acquisition may decrease, it may
take longer and be more costly from a legal and accounting perspective, or
the deal may not close if bringing the company into the larger company
becomes too onerous for the public company.
Companies can also benefit from counsel’s continued guidance of

management expectations. The board (if it included designees) may have a
different perspective on an exit than management. Venture capitalists may
want to wait for the company to attain a higher probable valuation if the
company is doing well so they can bump up their internal rates of return
and increase their ability to raise later venture capital funds. Or, if the
venture capitalists are not as committed to the company because they
don’t see a home run on exit, or if they are nearing the end of the fund’s
life cycle, they may push for a sale at a lower valuation than management
thinks is attainable in order to get the best deal it deems possible in a shorter
time frame. All of this is a balancing act, and we have acted as mediators
many times over the years, trying to bring the two sides together and obtain
the best and most lucrative exit possible.
The timing of a merger and acquisition deal in a company’s life cycle varies.
Large companies are on the lookout for early-stage bargains if they are
assured key management and other employees will continue to work with the
newly owned company after the acquisition. If a company that has yet to be
funded by venture capitalists has an attractive business model and a strong
team, it might be snapped up for a fraction of what it would have to pay after
venture capitalists came on board. It might be attractive for management of a
young company to sell it for $20 to $25 million (a high price for a start-up,
but not for a venture capital-backed company) and be able to keep all of the
proceeds (rather than going down a dilutive path with venture capitalists and
wait for a hoped-for return in the future) and become employees of a “hot”
company with additional stock options from that company. The premier
examples of this kind of acquiror are Google and Yahoo, but there are
numerous other large companies that would also be attractive. Counsel often
provides introductions for its clients to potential early-stage acquirors if this
type of arrangement becomes a real possibility for a company and helps them
negotiate the terms of a potential deal. Deal terms in an early-stage acquisition
would likely include some sort of earn-out for the company in order for the
acquiror to make sure the company’s product or service is as valuable as
management believes. Earn-outs are complicated and can result in little or no
extra consideration to the sellers unless the acquiror provides well-drafted
and enforceable assurances that it will provide adequate resources, funds,
managerial support, and expertise into the future. Counsel should know how
to draft these provisions and how aggressively to push for them.
Final Words of Wisdom
Negotiating Tactics
All too often, lawyers spend so much time trying to win every point that
they lose sight of the main objective of the negotiation: getting the deal
done. Counsel to a young company needs to be nimble and focus himself
or herself, as well as the client, on the issues that truly matter. It makes no
sense to concentrate excessively on matters that are relatively immaterial.
The lawyer should inform his or her clients that many provisions in venture
capital financing agreements have become standardized and that only a
limited number of provisions are truly important—obviously, those should
be carefully negotiated. In other words, don’t sweat the small stuff. For
example, most venture capital documents require the company to grant and
pay for at least two full registrations (together with unlimited rights to
“piggy-back” on company registrations) into the public markets. These full
registration rights are rarely invoked because the company, in our
experience, has almost invariably undertaken an initial public offering
without the investors having to demand (but consenting to) a registration,
because it is generally in everyone’s interest. Yet the number of demand
registrations is often fiercely negotiated. Our advice to clients is not to place
great importance on these provisions. This is also true of multiple

representations and warranties requested by venture capitalists. Lawyers
spend too much time agonizing over whether and where it may be
appropriate for a representation and warranty to be given with the
limitation “to the company’s knowledge” rather than as an absolute. There
are a few places where the knowledge qualifier is appropriate, and
experienced venture capital counsel will generally not object. During all of
our years as venture capital attorneys, we believe there is only one case of a
venture capitalist suing on the basis of an alleged breach of representations
and warranties. Yet the amount of attention placed on these by lawyers, and
the resulting legal fees incurred because of protracted negotiations, is large
and unnecessary. We suggest arguing for a provision that truly matters, but
not wasting everyone’s time, energy, and money on issues that are not
significant, because in the early-stage deals it is important and to the benefit
of all involved to get the deal done quickly and efficiently.
Similarly, companies should not bother asking for non-disclosure

agreements from venture capitalists before submitting a business plan.
Venture capitalists will almost never sign non-disclosure agreements. In any
event, detailed unprotected proprietary information does not belong in a
business plan. Venture capitalists who have been in business for any length
of time and expect to continue in business also have no time or interest in
disclosing proprietary information to others. However, before disclosing
information to a strategic investor, a well-drafted non-disclosure agreement
is critical, because the strategic party may indeed be a competitor.
First and foremost, lawyers must remember they are negotiating the
transaction as a representative of their client. They must at the outset of a
negotiation try to establish the proper atmosphere in their relationship with
the lawyers and principals on the other side, ignore rudeness, be as
adaptable as the deal requires, and try to anticipate and then listen
attentively to the requirements of the other side. Effective counsel can spot
troublesome issues in advance to avoid blindsiding or being blindsided, and
will be discreet. When important issues come up in face-to-face meetings, it
is often useful to take clients out of the room to explain potential
ramifications rather than presenting the arguments within hearing distance
of the other side. Finally, lawyers should almost always convey an air of
reasonableness, especially when the other side continuously takes a hard-
line approach in negotiations. It is helpful to try to determine their objective

in these cases and ask what they are trying to accomplish or what they need
in asking for a certain point. If they present a reasonable concern, there is
generally a way to construct a compromise. If their response is a version of
“this is the way we do things,” they should be asked to articulate clearly a
valid rationale for their point or give it up. Often at this point, we turn to
the principals on the other side and ask their opinion or ask our clients to
do so. The vast majority of the time, we negotiate a reasonable compromise
that protects our clients’ interests. When faced with younger, less seasoned
attorneys who tend to dig in their heels on disputed issues, often out of fear
of making a damaging mistake, we suggest bringing in the partner to resolve
matters.
Compromise is a critical negotiation tool when it does not jeopardize

anything of vital importance to the client. When Audrey was a young
associate, she was working with a partner on a multibillion-dollar deal. The
client wanted to announce the deal at the open of the market the next day,
so everyone worked through the night. The partner on the other side of the
deal was a hard-line negotiator unwilling to make a single concession. At
one moment, he was so exasperated that he ran out of the room, his face
red with rage. The solution arrived at was not to concede any important
points, but to give in on minor issues as a face-saver for the lawyer on the
other side, allowing for more reasoned negotiations on issues important to
our client. This was a career-changing lesson—and one that would benefit
every young lawyer—to enter into every negotiation with an appreciation of
the importance of prioritizing and understanding where to compromise.
Most lawyers consider successful negotiations to be those that involve
candid discussion among principals and lawyers with a pragmatic and client-
centered approach. There is an adage that a successful compromise is one
in which everyone ends up a little unhappy. We disagree in part, particularly
in the venture capital financing environment when the parties are obliged to
continue to work together for a long time. Rather, we view success to be
achieved when each party is satisfied that most of its priorities have been
met and feels positive about the other side and the deal. Venture capital
lawyers understand they are responsible in part for nurturing the
relationship between venture capitalists and management in order for them
to continue together after the financing as true partners. Creating an

adversarial relationship in the course of negotiations hurts all parties.
Sometimes, however, where an issue is sufficiently critical for the client, the
lawyer is obliged to resist concession or compromise. A last resort to
resolve what appears to be an insoluble issue is to propose that clients leave
the negotiating session to let the parties reflect at leisure and (depending on
the attitude of the client) imply a willingness to let the transaction fail. In
some cases, it may be necessary if all else fails to abandon a deal because an
outcome sufficiently satisfactory to the client cannot be achieved. In a
recent deal, a client, prior to our being involved, had been bullied by the
other side with respect to certain important items on a proposed term
sheet. Within a short time after the start of our initial negotiating meeting
with the other side, we realized that because of the prior history in the
relationship of the parties, drastic action, although risky, appeared to be the
only method to restore balance and to compel the other side to negotiate in
good faith. We asked our client if he was willing to walk away from the deal
if he could not get what he needed, and he agreed to do so. We then
presented the other side with a revised term sheet with a short deadline and
made it clear that if the revised term sheet was not accepted or negotiated in
good faith and agreed to by the deadline we set, we would walk away. We
faced of a lot of bluster, but the parties finally agreed on a term sheet within
minutes of the deadline. This time, by confronting the bullying tactics head-
on, we obtained the result the client wanted.
Lawyers and their clients need to remember a few words of wisdom: never
give an answer in the heat of the moment. Lawyers should always take a
pragmatic, business-minded approach that focuses on the client’s ultimate
goals. It is important to try to understand what the other side is really
saying, sometimes reading beyond the words expressed sometimes for the
sake of a particular posture. Lawyers should be creative in finding common
ground and crafting compromises. Finally, lawyers should be able to offer
their clients broad experience gained from similar situations, and the ability
to use such past experience to assist in achieving a successful outcome.
Staying on Top of One’s Game
Lawyers must stay on top of this dynamic and ever-changing field of

technology and life science investing. Venture capital is now international
and covers a multitude of technical business areas from software to
telecommunication, biotechnology, medical devices, and the Internet, to
name a few. Useful reading material includes daily publications such as The
New York Times, The Wall Street Journal, The Deal, and Investors Business Daily,
magazines such as BusinessWeek, Fortune, and The Economist, and trade
publications in areas where the lawyer has existing or prospective clients.
For keeping up with legal trends and changes in the area of venture capital,
attendance at lectures by the Practicing Law Institute or comparable
organizations, and membership in the business law section of the American
Bar Association expose one to leading practitioners and furnish ideas for
up-to-date and relevant advice as well as ideas for the preparation of
materials. Keeping up with Web sites and blogs of prominent and
successful venture capitalists and industry experts is also useful. Google
alerts are an additional valuable tool. Well-connected lawyers also spend
considerable time talking to venture capitalists and entrepreneurs to keep
their fingers on the pulse of the various industries in which their clients are
engaged. Value-added attorneys know more than just the law—they know
what is happening on the business side of clients’ industries and are able to
bring to bear this knowledge in discussions, negotiations, and the
dissemination of advice.
Working with Clients
Finally, the most important part of a lawyer’s job is to develop and maintain
a relationship of trust with his or her clients. Clients should be able to view
their lawyers as part of the management team who will have access to all
aspects of the business. Some lawyers work on-site part-time and attend
management and board meetings. Having access to information
management may not realize is significant can be useful in helping the
lawyer guide the company through any situation, whether it involves a
financing, strategic relationship, employee issue, or any other negotiation. A
relationship of mutual trust and respect makes it more likely that company
management will talk to counsel about business issues that may have legal
consequences. As a result, the company may be prevented from promising

more than it can perform or signing deals with unfavorable outcomes.
The keys to trust are open communication, responsiveness, and a breadth

of knowledge and experience in the client’s industry, in financings, in
strategic relationships, and in exit events. Not to be overlooked, especially
at the early stages of the company’s life cycle, is the ability of the lawyer to
work creatively with management regarding legal fees. Counsel can have all
the other components of a perfect lawyer, but if the company is unable to
utilize those components because of the prohibitive costs, all the skills in
the world become meaningless. We have always believed early-stage
companies are an important investment by law firms. By being creative at
the early stages and not purely billing by the hour, the law firm should
engender loyalty and will likely find that as a company grows, its
management will be less reluctant to pay more expensive invoices. If
counsel chooses clients with care and uses the skills and knowledge they
have gained over the years in making educated guesses about which ones
are likely to succeed, they will be able to work successfully with young
companies and help them grow throughout their life cycles to continuing
levels of success.
Frederic Rubinstein has represented venture capitalists and emerging companies

since the 1970s and has been an active member of the venture capital community for most
of his career. He has mentored innumerable young companies and entrepreneurs over the
years, and his advice continues to be sought on the East Coast, the West Coast, in
Europe, and in Israel. He has been a partner at Kelley Drye & Warren LLP for more
than twenty years, part of it as chair of the venture capital and emerging companies
practice group, which he founded and continues to advise.
Mr. Rubinstein has advised major venture funds, investment groups, and their principals
in private placements of equity and debt, deals with internal venture fund matters,
securities law concerns, including private placement memoranda, and acquisition,
distribution, and marketing issues. He has also counseled emerging growth and middle-
market companies in their formation, early-stage, and mezzanine financing (including
equity, debt, and lease financing), protection of intellectual property, employment and
compensation issues, distribution, licensing, franchising, and leasing activities.
Mr. Rubinstein’s broad industry experience encompasses telecommunications, software,

biotechnology, fiber-optic technology, three-dimensional seismic oil and gas exploitation,
automobile technology, technology publishing and conferences, equipment leasing,
cogeneration maintenance, consulting, toy manufacturing and distribution, and
franchising.
Since 1991, Mr. Rubinstein has been listed in the corporate law section of The Best
Lawyers in America. He served as chair of the emerging growth ventures subcommittee
of the American Bar Association from 1988 to 1996. He has been a frequent speaker
on panels in the venture capital arena, including for the American Bar Association and
other organizations dealing with venture capital and emerging growth issues, and the
Securities Exchange Commission Annual Conference on Small Business Capital
Formation. He has also been a guest lecturer on venture capital at the Columbia
University Business School.
Mr. Rubinstein has an L.L.B. from Cornell University and a B.A. from Cornell. He is
a member of the New York Bar.
Audrey Roth has more than twenty years of experience representing technology and life
science companies from inception to exit (and beyond). Over the course of her career, she
has worked with venture capital funds and their portfolio companies as a partner and
head of the venture capital/emerging companies practice group at Kelley Drye & Warren
in New York City, a partner in the private equity group at Goodwin Procter in Boston,
and a partner and head of the private equity group at Sullivan & Worcester in Boston.
After eighteen years spent working for entrepreneurs, Ms. Roth decided the law firm
model didn’t work for their businesses and decided to join the entrepreneurial ranks
herself. She co-founded Convergent GC, which offers a new and unique model for
providing outsourced part-time general counsel services to technology and life science
companies. These companies typically do not require a full-time in-house resource, yet they
need more integrated corporate and commercial support than an outside law firm billing
hourly can provide.
Ms. Roth brings to her clients extensive expertise in organizing businesses, strategic
advice, equity and debt financings, licensing, mergers and acquisitions, strategic alliances,
and corporate governance issues, as well as day-to-day operational issues.
She has a J.D. from Columbia Law School, where she was the managing editor of the
Human Rights Law Review and a Harlan Fiske Stone scholar, and a B.A. from
the City University of New York, where she graduated magna cum laude. She is a
member of the New York and Massachusetts Bars.
Dedication: Mr. Rubinstein would like to dedicate this chapter to L.J. Sevin and Ben
Rosen, founders of the Sevin Rosen venture funds, who set a standard of perspicacity and
integrity in the venture business, financed Compaq Computer, Lotus Development, and
Electronic Arts, among many others, and provided the impetus to his retirement plan.
Ms. Roth would like to dedicate this chapter to Robin and Phoebe, without whose love,
support, and patience it could not have been written.
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ISBN 978-1-59622-648-7 Library of Congress Control Number: 2007921755

First Printing, 2006

Throughout the life cycle of an emerging company, an experienced, well-

A truly value-added lawyer is an active participant in all stages of the

compromised irrevocably, and it may be faced with obligations that are

Form of Advantages Disadvantages

• No corporate income tax2 • Generally, company may

C Corporation • No restrictions on who • Company is subject to

• Limited liability for • Each holder of a given

• Limited liability for

lawyers will advise entrepreneurs to organize initially as an S corporation in

An inappropriate choice of entity is not an insoluble problem for start-ups.

Intellectual Property Protection

There is no more important issue to a technology or life science company

An experienced attorney will encourage a prospective client to focus on

provide some basic information about whether infringement issues may

We have seen start-ups lose intellectual property protection by publishing

Even something as seemingly uncomplicated as choosing a corporate name

initial product or service. Having to change a company’s name after it has

Initial Stock Plan

One of the principal methods for young companies to attract quality

Stock option plans are somewhat complex and need to be structured

• Vesting. Typically, options should vest over four years, with no

• Acceleration upon change of control of the company. Prior to arranging a

An alternative mechanism for stock issuance to consider, particularly early

Other Value-Added Early Input by Venture Capital Lawyers

The earlier a company standardizes its employment policies and practices,

Experienced counsel can draft employee manuals and put standardized

capturing a significant share of the market? Is the company going to be first

One of the early mistakes young companies make is offering or selling

Readying the Company for Financing

Business Plan and Executive Summary

Experienced lawyers will participate in the creation or thorough review and

Entrepreneurs are understandably enthusiastic about their product or

capital lawyer’s role is to help create realistic expectations for the

It is also important to try to assess the amount of money a client requires in

There are also proposals an experienced attorney can suggest to negotiate a

reduced), increased protective provisions (using some of the typical debt-

Before a financing occurs, many founders underestimate the importance of

Many entrepreneurs place friends or family on the board either in an effort

negotiation with venture capitalists regarding the number of board seats to

Founders are understandably reluctant to cede control to a group of

When a financing round is syndicated by venture capitalists, which happens

Capitalization and Founder Ownership

One of the major concerns of founders, especially at their company’s early

• Counsel can help management estimate the amount of funding the

• Founders should be made to consider that voting control of the

• Counsel can help entrepreneurs obtain critical common stock

• Management may be able to make up some lost ground by

Corporate Clean-Up and Due Diligence

Before seeking financing, it is important for the company to undergo an

Experienced counsel will undertake a review of the company’s corporate

• A lack of appropriate written directors’ and stockholders’ actions

• Failure to document material oral agreements and arrangements

• Failure to take adequate steps to protect the company’s intellectual

• Having entered into agreements without prior counsel review

• Not properly documenting stock option or restricted stock

• Obligating the company to give away far more of the company’s

Finders and Other Purported Sources of Financing