©2004 A. Paul Mahaffy. All rights reserved.

Introduction

Many private companies arrive at a stage when they have to look beyond the family and friends of their founding shareholders as sources of additional equity financing and seek deeper pools of capital. They may attempt to find a wealthy individual to act as an "angel" and make an investment using his own personal funds. But such an individual is not easy to find. Private companies are more likely to approach professional fund managers who invest other people's money.

Getting the attention of one of these professional investors is not easy, especially when the criteria they set can be difficult for many private companies to meet. Chances are that a company will have to have, at a minimum, a highly marketable product or service, an achievable business plan, an experienced and capable management team, and the potential to generate $75 to $100 million in revenue within three years. The company should also have a network of sophisticated strategic partners and a board of well-connected directors, and preferably be placed among the top three in its market space.

Whenever the company satisfies these criteria and gets the attention of a professional investor willing to invest, the basic terms of the proposed investment are often set out in what's commonly called a "term sheet". The term sheet is intended to be replaced by a number of more comprehensive, definitive agreements, including a subscription agreement and shareholders agreement, along with amendments to the company's articles and by-laws, as the parties get closer to finalizing the investment. The term sheet may or may not be legally binding, although it may well be both, containing some items which are binding and many items which are not binding.

This paper will attempt to review the basic terms generally governing an equity investment in a private company by a professional investor. It will attempt to discuss how these terms are viewed by the owner-managers of the company as well as by the professional investor, and will look at the variations of these terms which each may propose to the other during the negotiation of the investment.

This paper will assume that the investment is being made by way of convertible preferred shares, although some of the terms discussed may be relevant to an investment made by way of common shares, or by debentures or other debt instruments convertible into common shares or accompanied by warrants to acquire common shares. It will also assume that there will be only one holder of the company's preferred shares, to be called the "Investor", despite the common practice of having more than one professional investor "co-invest" in a company at the same time.

This paper will also consider a few of the terms which are requested by U.S. based investors, since such investors often co-invest with, and sometimes invest directly on their own without, participation by Canadian based investors. An initial public offering by a Canadian company which allows an investor an "exit" from its investment may just as likely take place on an American stock exchange, such as the NASDAQ, as on a Canadian exchange.

Owner-Manager vs. Investor Perspectives

While the owner-managers and the Investor may want the company to grow and prosper, their interests aren't always aligned, and the Investor may look at issues with a shorter time frame in mind. Even though both may fear a loss on their investment in the company, the owner-managers may be just as fearful of losing control of the company. The Investor, on the other hand, may fear being stuck with a bad investment which it can't unload on someone else. Therefore, the Investor's desire for an exit from the company with a guaranteed rate of return on its investment often conflicts with the owner-managers' desires to stay with the company indefinitely and personally identify with its continuing success.

Ordinarily the Investor will be prepared to give the owner-managers considerable latitude and autonomy in the running of the company so long as pre-approved budgets and business plans are being met. The subscription agreement, shareholders agreement and other documents covering the investment are often silent on how the company should be run on a day-to-day basis. Many of the provisions of these documents apply only on the occurrence of certain events or upon the satisfaction of certain conditions. However, because the Investor often views itself as supplying board representation, strategic planning, financial advice and industry contacts as well as capital, it generally retains a right to approve certain company decisions.

And because it is seeking to maximize its financial returns, the Investor will ensure that the documents set out the rules for subsequent issuances and transfers of equity interests. It may request that the documents provide the Investor with "co-sale rights" allowing it to participate in any equity sales by the owner-managers, and "drag along" rights allowing it to force the owner-managers to participate in any sale of its own equity interest. It may also request that the documents provide priority downside protection against loss, allowing the Investor to manage and control its investment if the company appears unable to meet the business plan, and to enjoy certain exit rights through a sale of the company to a strategic buyer or upon an initial public offering.

In contrast to what the Investor generally wants to be contained in the documents, the owner-managers of the company usually want to obtain funding as quickly as possible, minimize dilution of their own equity interests and ensure that they retain control over all of the key decision-making functions. They often want the documents to afford them some flexibility for tax and estate planning purposes, allowing their interests to be freely tradeable among family members, personal trusts and holding companies without the application of any mandatory prior approval or right of first refusal provisions.

Dividend Rights

Because the Investor expects to derive most of its financial return in the form of capital appreciation of its preferred shares, it may allow such shares to be dividend-free for a while so that the company's cash flow can be dedicated to funding future growth. However, the Investor may argue for a dividend to be made payable in the event of later stage or expansion financing when the company's projected cash flow is strong enough to provide the Investor with a current, as opposed to a deferred capital, return.

The Investor will most likely require the company to first pay dividends to the holders of the preferred shares before paying dividends to the holders of the common shares. This preference is designed to encourage the owner-managers holding only the common shares to use the company's retained earnings for working capital purposes. This preference may apply to the payment of dividends in whatever amount may be declared by the company's board of directors, or apply only to a fixed dollar amount, usually between 5% to 10% of the original purchase price of the preferred shares, before dividends can be paid on the company's common shares.

In addition to requesting a preference for dividends on the preferred shares, the Investor may request that dividends be "participating", so that the Investor is entitled to receive additional dividends rateably with the holders of the company's common shares once all of the preferences have been satisfied.

Depending upon how the company's financial future is regarded by the Investor, the Investor may also require the company's preferred shares to have cumulative as well as preferential and participating dividends, so that unpaid dividends accumulate from year-to-year, and that all cumulative dividends must first be paid to the holders of the preferred shares before dividends can be paid to the holders of the common shares.

The imposition of preferential, participating or cumulative dividend requirements isn't necessarily onerous on the company. These requirements place a burden on the company only when the owner-managers want to pay dividends to the holders of the common shares, and are prevented from doing so unless they also pay the holders of the preferred shares. However, a heavy burden can be placed upon the company if the Investor demands mandatory cumulative dividends, requiring the company to accumulate and make periodic dividend payments on the preferred shares. Such a requirement may be imposed if the Investor believes its investment in the company carries considerable risk, even though the requirement may not be enforceable, depending upon the ability of the company to satisfy any prescribed solvency tests under corporate law such as subsection 38 (3) of the Ontario Business Corporations Act. In the absence of statutory prohibition, such a requirement may be justified if the Investor foresees little likelihood of an initial public offering or outside takeover of the company.

Redemption Rights

Although the preferred shares can be made redeemable by either the company, in calling the shares for repurchase, or by the Investor, in putting the shares to the company to receive cash back, it would be extremely unusual if the company was allowed optional redemption. However, it is quite usual for the Investor to insist that the company redeem the preferred shares under certain conditions, if the Investor so elects. The redemption price is normally comprised of the original purchase price of the preferred shares, adjusted for any stock dividends, combinations or splits, plus all accrued and unpaid dividends, and, in many cases, a redemption premium.

However, mandatory redemption of the preferred shares by the company on specified dates or upon specified events is not generally prescribed since it deprives the parties of the flexibility they may need to address the company's future capital needs. Mandatory redemption discourages other investors from participating in future rounds of company financing and can make it difficult for the company to obtain bank loans and trade credit.

Although the conditions under which a company may be required to redeem the preferred shares at the option of the Investor are far from standard, redemption is often permitted only after a sufficiently long period has elapsed, usually around five years. Payment upon such redemption is often required to be made in installments spread out over a number of months or even years. However, redemption may be accelerated in the event of a sale of a majority of the company's shares, or an initial public offering.

As an alternative to, or in addition to, prescribing redemption rights for the preferred shares, the Investor might be provided a "put" which gives the Investor the right, after a certain period of time if no other event permitting redemption has occurred, to sell its shares back to the company at a price equal to their fair market value as determined by an outside appraiser or upon application of a prescribed formula.

However, whether provided as "puts" or rights of redemption, these terms can be of limited practical value should the company be unable to pass the solvency tests prescribed under corporate law, such as subsections 30 (2) and 32 (2) of the Ontario Business Corporations Act.

Liquidation Preference

Although the Investor may not succeed in obtaining early redemption rights, it will certainly argue that it is entitled to a preference in getting its investment back in the event that the company is liquidated, either upon insolvency or a sale of substantially all of the company's assets. After payment is made out of the liquidation proceeds to secured and unsecured creditors, payment must then be made to the Investor before any payment can be made to the company's common shareholders. The amount of the payment to be made to the Investor is usually set at the original purchase price of the preferred shares, adjusted for any stock dividends, combinations or splits. The obligation to increase this amount to include any accrued but unpaid dividends, or, in the absence of cumulative dividends, a guaranteed return often between 5% and 10% of the original purchase price, can be the subject of intense negotiation.

In addition to receiving this preferential amount, the Investor may want to participate rateably in the distribution of the company's remaining proceeds of liquidation with the common shareholders. A frequent point of contention is whether the common shareholders should first receive back their own purchase price before the Investor then participates with the common shareholders in the remaining proceeds.

Another point of contention is whether the liquidation preference enjoyed by the Investor should be subordinated in any subsequent round of financing so that new investors will have a senior position on liquidation or at least rank pari passu with the Investor. This debate can be complicated if liquidation is defined in the documents to include the acquisition of the company or its merger into another entity.

Voting Rights

The Investor is ordinarily granted the same number of votes as the votes carried by the common shares into which its preferred shares are convertible, generally on a one vote per share basis. However, in order for the Investor to carry out the special rights it might enjoy in electing directors and vetoing certain company decisions (described in more detail under the headings "Board of Directors" and "Management and Control" below), the Investor may insist that certain actions require the approval of the preferred shareholders voting as a separate class. Practically speaking, a written shareholder resolution approving a proposed action which is signed by the Investor as the sole preferred shareholder is the same as a written formal consent to such action signed by the Investor.

Conversion Rights

There may not be much debate over when the preferred shares can be converted into common shares of the company, although the conversion rate can represent a contentious issue in the negotiations. Ordinarily the preferred shares are convertible into common shares at the option of the Investor at any time and are automatically converted into common shares on a mandatory basis in the event that the company makes an initial public offering or an offer is received to buy not less than a majority of its shares. Automatic conversion in the event of an IPO is seldom debated because the company is able to simplify its capital structure as a pre-requisite to the IPO, and the Investor is able to participate in it. Because the special voting rights and other terms of the preferred shares are often inconsistent with the terms, or absence of terms, of public market securities, the preferred shares are designed to simply disappear on an IPO through conversion.

There may be some debate, however, on the size of an IPO which triggers the conversion. The owner-managers and Investor will generally try to establish a size sufficient to create an adequate "float" when the common shares trade publicly. Furthermore, as part of the conversion, the Investor may argue for payment of accrued but unpaid dividends, either in cash or shares, although accrued dividends are often waived. In the case of automatic conversion on a takeover offer, a minimum share price might also be required.

The conversion rate, along with the percentage ownership of the company which the Investor wants to acquire, depends on the "pre-money valuation" of the company, which is the value of the company before the funds of the Investor are contributed, and the dollar amount of the funds to be contributed. The rate also depends on the projected value of the company, and the likelihood of the Investor receiving its required rate of return on invested capital in the event of a future sale of its shares in the company.

Determining the conversion rate can become quite complex, especially when later rounds of financing from other investors are anticipated and the percentage ownership of the Investor is diluted as a result. Generally speaking, the conversion rate of the preferred shares into the company's common shares is calculated by dividing the original purchase price of the preferred shares by a "conversion price" which is initially set at the original purchase price to achieve a 1-to-1 conversion of preferred shares into common shares.

Anti-Dilution Protection

This conversion price is then automatically adjusted for any stock dividends, combinations or splits, in order that the preferred shares will convert into the number of common shares which will maintain the Investor's percentage of equity in the company. This provision is seldom debated.

What is usually debated is an adjustment to the conversion price should the company need to issue additional equity in subsequent rounds of financing at less than the original purchase price paid for the preferred shares by the Investor. The Investor will often insist that it be given the rights to obtain more common shares on conversion, without additional aggregate consideration, in the event that the company subsequently issues new common shares or equivalent securities at a price below the then current conversion price. The conversion price of the preferred shares is effectively decreased, resulting in more common shares per preferred share being issued upon conversion.

In requesting this anti-dilution protection, the Investor ordinarily argues that because there is no readily available, independent market price for the company's shares, it should be protected against having overpaid. Furthermore, the owner-managers holding common shares should have to pay through dilution if they don't succeed in increasing the value of the company by the next round of financing. From their point of view, however, any decrease in the value of the company could result from events beyond their control. In conceding to the inclusion of such anti-dilution protection, the company is arguably denied the flexibility it may need in a downturn to raise new financing at a lower price.

If anti-dilution protection is to be afforded to the Investor, the debate then shifts to whether a "weighted average" formula or "ratchet" formula should apply. The weighted average formula uses the discounted price and number of the new common shares sold in adjusting the conversion price of the preferred shares downwards. Under this formula, the sale by the company of a large number of common shares at a price slightly lower than the conversion price, and the sale of a small number of common shares at a much lower price, collectively result in a relatively small adjustment to the conversion price of the preferred shares. The ratchet formula, on the other hand, automatically decreases the conversion price of the preferred shares to the lowest price at which the new common shares have been issued, regardless of the number of new shares issued.

The owner-managers holding common shares generally want the weighted average formula to apply if discount stock is offered in the future, given the greater dilution of their shares if the ratchet formula is applied instead. To arrive at a formula, a hybrid of both the weighted average and the ratchet formulas may end up being used, such as applying the ratchet formula for the first two years of the Investor's investment and the weighted average formula thereafter in an effort to discourage the early issuance of discount stock. Alternatively, the ratchet formula might apply only if the discount stock is issued at a price below a specified threshold price.

Exceptions to these anti-dilution provisions may be requested by the owner-managers. The most common exception relates to the pool of shares, ranging somewhere between 5% and 20% of the outstanding fully-diluted shares of the company, which is set aside for issuance to key employees. The size of this pool may be adjusted from time to time to accommodate any future share issuances which have been approved by the Investor.

Board of Directors

The general approach of the Investor, as mentioned above, is to leave the owner-managers free to operate the company on a day-to-day basis so long as the company is complying with its budgets and business plans and meeting any milestones that have been agreed upon. However, the Investor will usually insist that it be given the right to nominate one or more directors to the company's board, or at least be given the right to have a nominee attend board meetings as an observer. Observers are usually entitled to receive notice of and to attend meetings of the board of directors, but are not entitled to vote. The Investor may prefer to limit the involvement of its nominees to observer status if the board already consists of nominees of other professional investors, or as a way of avoiding director liability or the policies of certain stock exchanges which place escrow requirements during an IPO on shareholders having board representation.

In addition to the Investor's nominees, the owner-managers holding common shares will also have the right to nominate a certain number of directors. The shareholders agreement will usually require the parties to vote in favour of the election of the prescribed nominees to the board of directors and to fill any vacancy on the board with the nominee of the party who was represented by a vacating director. The parties will also be required to remove any nominee director who contravenes or votes against the wishes of the party nominating him. A related provision may limit the number of directors so that the right to nominate directors is equal to the right to control a specified portion of the board.

The Investor may request that the shareholders agreement require audit and compensation committees of the board to be established, comprised solely of directors unrelated to the owner-managers, and that directors' and officers' liability insurance be put into place. The Investor will usually require board meetings to be held quarterly, if not more frequently, and will insist that the quorum requirements not allow such meetings to proceed in the absence of its nominee director.

To provide the Investor with the right to become more involved should the company's financial position deteriorate, the shareholders agreement may contain "voting switch provisions". These provisions give the Investor the right to elect more directors, even a majority of the company's board, upon the occurrence of certain materially adverse events, such as the failure by the company to meet specified milestones or the breach by the company of a covenant in any of the definitive agreements. These provisions may even include the right to relieve any of the current owner-managers from their management duties upon relatively short notice without cause, but subject to an obligation to pay appropriate severance and to buy back any company shares the owner-managers may hold.

Management and Control

In addition to its right to elect directors, the Investor ordinarily wants to play some role, possibly by exercising veto rights, in important management matters. These matters generally include operating budgets, major capital expenditures, executive hiring and firing, compensation levels, equity and debt financings, material strategic alliances, larger acquisitions and sales, dividend payments, share redemptions, and other significant actions out of the ordinary course of the company's business.

The shareholders agreement may specify that control over these particular matters be implemented by the Investor as a preferred shareholder voting on them as a separate class, or by establishing super-majority voting rules at the board level, or by simply requiring written approval of the Investor. The Investor may even insist that the right to vote on such matters as a separate class be incorporated into the terms of the preferred shares and reflected in the company's articles or other charter documents, instead of being merely reflected in a shareholders agreement. However, depending upon the nature of such terms and the need of the parties for confidentiality, it may not be appropriate for the terms to be placed in the company's articles and thereby subject to possible public scrutiny.

Employees

To ensure that the company's key management positions are filled by people with suitable skills and experience, the Investor may require that the shareholders agreement specifically name certain individuals recommended by the Investor to serve, for example, as the chief financial officer or chief marketing officer of the company. The Investor will usually require that all of the company's top managers enter into comprehensive employment agreements not only setting out their respective duties, compensation (including bonus entitlement and participation in stock purchase and option plans), and rights on termination, but also their assignment of intellectual property rights and their non-disclosure, non-competition and no "moonlighting" obligations. The maintenance of "key person" insurance for them will also be a requirement.

The treatment of options and shares held by the owner-managers is often subject to considerable debate during the negotiation of the documents. Ordinarily any rights to acquire discounted shares or options will be vested in the owner-managers over a three to five year period. Any shares acquired will usually be subject to transfer restrictions, as well as call rights, in favour of the company upon the termination of employment, death or permanent disability of the owner-managers. The Investor will want to be assured that current management of the company will be motivated through appreciation in the value of the company's shares to stay and work, and will be discouraged from leaving by means of the call provisions.

Information Rights

The Investor will usually require the company to provide ongoing financial information to the Investor directly on a regular basis and not simply by way of its nominee director at board meetings. The information to be provided will include monthly or quarterly management financial statements and audited annual financial statements. Other information generally to be provided will include management budgets, forecasts and variance reports, along with research and development reports and certificates from the chief financial officer that all statutory deductions and other amounts for which directors may be personally liable have been appropriately withheld and remitted.

The Investor will usually be granted ongoing inspection and audit rights which permit it to visit and inspect the company's properties, examine the company's accounts and records, and discuss the company's affairs and finances with company officers. However, the owner-managers will likely try to qualify such rights by excluding the provision of any information which the company reasonably believes to be trade secrets or other confidential information unless the company is satisfied with the confidentiality arrangements made with the inspecting parties.

Pre-Emptive Rights

In order to maintain its percentage of equity ownership in the company, the Investor will insist that it be given a right of first refusal on the purchase of any shares, and any securities exchangeable or convertible into shares, including rights, options and warrants, which may be offered by the company in the future. This right, commonly called a "pre-emptive right", normally entitles the Investor to receive notice of the offering and to subscribe for a portion of the offering that is equal to its existing percentage of the company's outstanding equity under the same terms offered to other investors.

This right may also entitle the Investor to purchase shares not purchased by other shareholders under their own rights of first refusal. If less than all of the holders having such rights elect to participate, or if they participate for less than their full entitlement, the shareholders agreement may provide for the re-allotment of the unsubscribed portion among those already taking up their full entitlement. The available shares are simply pro-rated among the buying shareholders in proportion to their pre-existing shareholdings.

The owner-managers will often request reciprocal pre-emptive rights, if the shareholders agreement for the company doesn't already provide such rights, along with a number of exemptions. These requested exemptions from pre-emptive rights may cover shares issued to employees, officers, directors and consultants pursuant to incentive compensation arrangements, or to shares issued upon conversion of other company securities or in connection with stock dividends or stock splits, or to shares issued to commercial lenders and equipment lessors in the ordinary course of business. Shares issued pursuant to the company's acquisition of another entity may also be exempted, although the Investor may wish to restrict such exemption to only certain specified acquisitions.

Rights of First Refusal

The Investor will usually request that it be given a right of first refusal on the transfer of any company shares proposed by any other shareholders in the future. In contrast to pre-emptive rights which are intended to maintain its percentage of equity ownership in the company, rights of first refusal are intended to increase its equity ownership in the company in the event that any of the other shareholders decides to sell. As with pre-emptive rights, rights of first refusal often apply to any shares, or securities exchangeable or convertible into shares, including rights, options or warrants, and not just to the preferred shares or other shares of the same class as are already held by the Investor.

The owner-managers will often request reciprocal rights of first refusal, if the shareholders agreement for the company doesn't already provide such rights. They will also request a number of exemptions. Exemptions are ordinarily given for transfers to a registered retirement savings plan or other trust of which the shareholder is the beneficial owner, or to a shareholder's spouse, or to a shareholder's personal holding company provided that the shareholders of the holding company agree not to transfer their shares in the holding company unless they concurrently transfer the shares of the company to another exempt party.

In the case of corporate shareholders, exemptions from rights of first refusal may be available to cover transfers to affiliates. In the case of the Investor, exempt transfers will include transfers to other funds or corporations managed by the Investor, and possibly include distributions of shares in specie to the investors of such other funds or corporations.

Debate often occurs over which events specifically trigger the right of first refusal. Some shareholders agreements require that a "bona fide offer" must be received by the selling shareholder from a third party before notice is to be given to the other shareholders of their purchase rights. Obviously this requirement deters potential third party purchasers from incurring the time and expense involved in preparing a serious offer which may be ignored if any one of the other current shareholders elects to exercise its purchase rights.

As an alternative, the shareholders agreement may provide what is commonly called a "right of first offer", which permits the selling shareholder to simply give notice to the other shareholders of its intention to sell at an acceptable price. This alternative, however, may encourage the selling shareholder to specify an inflated price with the expectation that the other shareholders will elect to purchase at the inflated price rather than risk a third party becoming a shareholder.

Co-Sale Rights

As a way of achieving liquidity of its investment as well as denying the owner-managers holding company shares an exit from the company before the Investor is able to exit, the Investor may insist upon "co-sale" rights. These provisions generally allow the Investor, and usually any other significant shareholders, to participate in a shareholder's proposed sale of company shares on a basis proportional to their respective percentage of equity ownership in the company. Ordinarily only a sale resulting in a change of control of the company, or a sale by the owner-managers of all or a substantial portion of their holdings of company shares, will trigger co-sale rights.

In contrast to "piggyback" rights which often allow other shareholders to have included all of their shares in a third party purchase offer, "co-sale" rights provide for the inclusion of only such portion of their shares which, when added to the portion held by the owner-managers, equals the number of shares which the third party wishes to purchase. The number of shares that the owner-managers can sell is effectively reduced and replaced by the number of shares that the Investor elects to sell to the third party. In the event that the third party wishes to purchase all of the company's outstanding shares, the difference between piggyback rights and co-sale rights disappears in practice.

Drag Along Rights

The Investor will often request it be given "drag along" rights enabling it to force the owner-managers to participate in a sale of company shares by the Investor to a third party. Such rights increase the marketability of the Investor's shares since a third party purchaser may be more likely to want all of the shares of the company rather than have to deal with other company shareholders after the purchase. The owner-managers often counter with a request that the drag along provisions also require the Investor to participate in a sale by the owner-managers.

Registration Rights

If the Investor is U.S. based or believes the company is likely to become eligible to list on NASDAQ or other American exchanges, it will request "registration rights". These rights allow the Investor to "demand" that the company qualify the Investor's shares in the company for public distribution, and thereby dictate the timing of a public offering. They also provide the Investor with "piggyback" rights under which its shares are included in any "primary registration", when the company files a registration statement to permit the sale of its shares from treasury, or in any "secondary registration", when the company files a registration statement to permit other shareholders to sell.

These rights are intended to give the Investor liquidity on an IPO when the perceived return from maintaining an ongoing investment in the company is below the Investor's threshold return requirements. The Investor is then able to liquidate its investment in the company and reinvest its funds elsewhere in the hope of earning a greater return.

Demand registration rights entitle the Investor to require the company to register the company's shares after a certain period of time, usually 3 to 5 years, with the Securities and Exchange Commission by filing a registration statement. The number of "demands" is usually negotiated, with the owner-managers insisting that one is enough and the Investor arguing for two or more. Granting demand registration rights can place a significant burden on the company given the time and cost involved if those rights are exercised. All expenses incurred in demand registrations are normally paid by the company. In practice, exercising the demand doesn't necessarily mean that a public offering will happen. Since the company's management has to go on the "road show" and make convincing presentations to the fund managers and brokers who will be buying the company's shares, management can usually resist the demand to register if business conditions are not favourable.

Piggyback registration rights obligate the company to use its best efforts to include the Investor's shares in any public registrations the company intends to make. However, such rights are always subject to the underwriter's discretion to exclude the Investor's shares from the offering. Such rights are also usually excluded from any offering of shares in the context of a corporate acquisition or employee stock option or purchase plan.

Loss of Rights

If the owner-managers have significant bargaining power, they may successfully argue that the Investor should lose certain rights if the Investor declines to invest additional funds when required later on or if the Investor's equity holdings in the company fall below a specified percentage. The owner-managers often argue that this possible loss of rights by the Investor is a trade-off for the possible gain of rights by the Investor to elect more directors through the voting switch provisions mentioned above upon the occurrence of a material adverse event.

For example, the owner-managers may insist that the Investor lose its anti-dilution protection, and perhaps its liquidation preference and right to nominate directors, if it fails to make a pro rata investment in any future company financing. Such a "pay-to-play" provision encourages future investment and assistance by the Investor in helping the company to grow. A pay-to-play provision generally forces the Investor failing to participate in a future financing to convert its preferred shares into common shares or into a series of preferred shares lacking price-based anti-dilution protection, or to simply waive any anti-dilution adjustments it might otherwise be entitled to as a preferred shareholder.

In an effort to reduce the extent of the Investor's potential veto, especially if exercisable by way of mandatory written approval of various prescribed matters, the owner-managers may insist that the veto should disappear once the Investor's equity ownership in the company is reduced below a certain percentage. They may also insist that the information rights granted to the Investor should disappear as well if the Investor's equity ownership is correspondingly reduced.

Representations and Warranties

Most of the representations and warranties to be given by the company, and possibly by the owner-managers, are most likely to be contained in the subscription agreement. The Investor generally requires representations from the company about (a) its good standing; (b) its capital structure; (c) the proper approval of the proposed financing; (d) the ownership of its assets; (e) the extent of its contracts and financial obligations; (f) the absence of litigation or probable claims against the company; (g) its compliance with applicable laws; and (h) anything else which may influence the Investor in making an informed decision about whether or not to invest in the company.

In support of the representations made by the company concerning its capital structure and the proper approval of the proposed financing, including the issuance of the preferred shares in conformity with applicable securities laws, the Investor will usually require delivery of an opinion from the company's legal counsel at closing on such items.

The owner-managers usually explore at the outset of the negotiations the preparedness of the Investor to permit these representations of the company to be restricted to only "material" items, or to the "actual knowledge" of only specified owner-managers. Furthermore, they are likely to insist upon representations from the Investor about (a) the proper approval of its investment; (b) its qualification to purchase the company's shares under applicable securities laws; and (c) the sufficiency of the access it has had to assess company information and ask all questions in order to allow it to make an informed investment decision.

Personal Liability

One of the more contentious issues usually arising during the negotiations is the extent to which any of the owner-managers should be personally liable to the Investor for any breach of the company's representations or covenants in any of the definitive agreements. The owner-managers are ordinarily prepared to accept personal liability only under the shareholders agreement as well as under any employment agreements and additional non-competition and confidentiality agreements which they may sign in their personal capacities.

However, few owner-managers are prepared to be jointly and severally liable with the company under any indemnity given in the subscription agreement to cover any losses the Investor may suffer as a result of the company's breach of the representations or covenants contained in it. Despite the Investor's argument that some of the risk of unknown company liabilities should be placed under an indemnity upon the owner-managers who are in a better position to know or at least find out, the owner-managers already bear, and will continue to bear, such risk by holding company shares.

Given that the issuance of company shares to the Investor does not result in the owner-managers receiving funds personally from the Investor, as they might if they were selling their own shares directly, most owner-managers are able to argue convincingly that they receive no reward for taking on the extra risk of a personal indemnity for the company's potential breach. Should their refusal to provide such an indemnity cause the Investor to deny funds, the owner-managers may offer, as an alternative, personal indemnities for which they are only severally liable to the extent of their respective proportionate holdings of company shares, collectively capped at the amount of the Investor's investment.

Due Diligence Period

The term sheet will ordinarily set out the rights and obligations of the parties, sometimes on a legally binding basis, covering the time after its signing when the Investor undertakes due diligence investigations of the company. Completion of the investment will usually be stated in the term sheet, and again in the subscription agreement, as being dependent upon the Investor's satisfaction with the results of the investigations. During such investigations, legal counsel will work together in preparing the definitive agreements which attempt to reflect the provisions of the term sheet. Negotiations often continue during this period, especially when the investigations reveal information which causes the Investor to request amendments to any of the provisions in the term sheet.

Rights of access during normal business hours to the company's various properties to review its accounts and records, interview certain employees and inspect the business being carried on are generally given to the Investor by the owner-managers, subject to a duty to maintain confidentiality. The Investor may also be given a right of introduction to the company's customers, suppliers, and consultants, all with a view to verifying the company's financial statements and projections of performance, as well as the representations to be made in the subscription agreement.

Lock-Up

Often the Investor will insist that the company agree to be bound by a "lock-up" during which the company will not discuss its funding needs with any other parties. The lock-up provision, often a legally binding term in the term sheet which is repeated in the subscription agreement, is intended to encourage the parties to focus on completing the transaction and not be distracted by other possible deals. Despite the potential recovery of its own expenses whether the transaction is completed or not, as discussed below, the Investor has to consider its "opportunity cost" when working on a deal. Because the Investor invests a lot of time in carrying out due diligence and in negotiating the documents, it wants to ensure that the company and the owner-managers won't be soliciting other professional investors at the same time and increasing the likelihood of the company switching to one of them.

The lock-up is often stated to be in effect until the closing of the transaction, or until a date by which the transaction is reasonably expected to close, whichever is earlier. However, as discussed below, there may well be more than one closing, and the Investor may argue that the lock-up should subsist until the final closing. Since the amount of time which the Investor ordinarily invests in the company is relatively greater up to the date of the initial closing, and relatively less when approaching subsequent closings (despite unexpected time required for ongoing monitoring and crisis management), the owner-managers often succeed in having any lock-up restricted to the period prior to the initial closing. However, the Investor is nonetheless protected thereafter through the veto rights it usually may exercise over future share issuances and significant company borrowing.

Time of Closing

The closing of the transaction may take place immediately upon the execution of the definitive agreements, or within a certain time after their execution. The length of time after the execution of the definitive agreements which is required in order to close may depend upon whether the Investor will need more time to complete additional due diligence instead of relying upon the representations made by the company in the subscription agreement. It may also depend upon the perceived difficulty in obtaining any internal approvals from the parties themselves or any consents required from third parties. Closing is usually dependent upon board of director or investment committee approval in the case of the Investor, and on board of director as well as shareholder approval in the case of the company. The owner-managers, on the other hand, may resist such a delay in closing, depending upon their assessment of the company's financial needs. The company may simply not have sufficient cash reserves to continue operating between the time the definitive agreements are executed and a subsequent closing date.

The Investor may prefer to advance monies in installments, or tranches, over time upon completion of certain milestones. Consequently it may request an initial closing, at which all of the definitive agreements are executed and delivered and an initial payment made in exchange for a certificate for a certain portion of the overall number of preferred shares being purchased. The Investor may then request one or more subsequent closings to take place within a certain period of time following applicable milestones, at which the balance of the purchase price will be paid in exchange for additional share certificates and other documents which update any information given in a previous closing which has become stale or misleading. The Investor may request that the subsequent closings remain subject to the discretion of the Investor, whether the applicable milestones have been met or not. The owner-managers will normally attempt to avoid having milestone dependent closings, and will certainly resist any request to make a closing subject to the discretion of the Investor. They want and need certainty for the company's funding schedules.

Use of Proceeds and Expenses

The Investor may require that the proceeds of its investment to be paid on each closing are to be used for the company's ongoing working capital requirements and any pre-approved capital expenditures, but are not to be used to pay any existing debts, particularly any monies owed to the owner-managers under any previously made loans or on account of past services rendered to the company. The Investor may even resist allowing payment of the company's transaction costs out of the proceeds.

However, the Investor will often require the company to pay the reasonable legal expenses incurred by the Investor in negotiating and drafting all of the documents and in conducting due diligence, whether the transaction closes or not. While the owner-managers are usually unable to refuse this request, they may succeed at having the amount of reimbursable expenses capped at a specific dollar amount. The Investor may also require the company to provide a cash retainer to the lawyers acting for the Investor, although the owner-managers may be able to negotiate this requirement away. The legal fees charged by the Investor's lawyers are generally deducted from the subscription price before being paid over to the company.

Conclusion

In attempting to address many of the foregoing items in their negotiations over the term sheet, the definitive agreements and the share provisions, the Investor and the owner-managers may find it difficult to reconcile their conflicting objectives and approaches.

If the Investor wants to proceed cautiously before investing in the company, it will demand broad access for reviewing relevant documents and spend considerable time in carrying out its due diligence investigations of the company. It may also insist that the closing of its investment in the company be subject to numerous conditions which many require considerable time and money to be spent in satisfying them. This caution on the part of the Investor often conflicts with the desire of the owner-managers to get the money in as quickly as possible with a minimum amount of time being spent by the owner-managers in dealing with due diligence requests and a minimum amount of money being spent by the company in satisfying conditions.

If the Investor wants to ensure that its investment in the company is protected once made, the Investor may insist on the right to veto future capital raising proposals and on anti-dilution protection. The Investor may also insist that it has to be able to exercise some control over the company's operations. This desire for protection on the part of the Investor comes into conflict with the desires of the owner-managers to raise money whenever they feel it is necessary and from whomever they feel is a desirable investor. It also comes into conflict with the overall desire of the owner-managers to have complete freedom to manage the company in their own way.

However the foregoing items are eventually resolved and reflected in the definitive agreements and the share provisions, the Investor and the owner-managers must still operate on the basis that their arrangements represent a longer term commercial relationship, despite their conflicting interests. They are not engaging in merely an isolated transaction. Without the liquidity which an investment in a public company might provide, the Investor, perhaps begrudgingly, must acknowledge that it may be involved with the company for some time to come, well after the time when its desired exit opportunity was to arise, but didn't.

The Investor, much to its own surprise and disappointment, may find itself negotiating all over again with the same owner-managers over its provision of additional funds to the company in a later, much needed "follow-on" round" of financing because no other source of equity financing is then available to the company.

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