Term Sheet Series — Post #3 — Conditions to Closing and Expenses

By Luciana Jhon Urrunaga, Esq. and Anibal Manzano, Esq.

This is post #3 in our Term Sheet Series for venture capital equity financings (a/k/a priced rounds) (e.g., Series A financings). You can find our previous posts here.

I. Conditions to Closing

Conditions to closing are any conditions that must be fulfilled in order to close an investment. The NVCA Model Term Sheet states that “standard conditions to closing” shall apply, which typically includes the satisfactory completion of legal and financial due diligence, qualification of the shares under applicable Blue-Sky laws, the filing of an amended Certificate of Incorporation (or charter), and a legal opinion from company counsel.

Due Diligence

Due diligence refers to the legal and financial investigation of the company that investors will perform before closing a deal. The closing is conditioned on the “satisfactory completion” of due diligence because if the investor finds a discrepancy or red flag during their investigation, they need a way to “cancel” the investment. Due diligence requests include a wide range of documents—from formation documents to agreements regarding previous stock issuances. Founders should aim to have an organized data room to present to investors as early in the process as possible. Delays in providing documentation to investors can delay the closing of an investment for weeks—even months. Additionally, waiting until the last minute to review the company’s data room can result in finding last minute inconsistencies that must then be ratified through additional paperwork, further delaying the process.

Blue Sky Laws

Blue Sky laws are State regulations established as safeguards for investors against securities fraud. These laws typically require sellers of securities to register their offerings within the applicable State and provide details about the offering. They serve as an additional layer of protection to federal securities laws. Your attorneys will determine which State’s Blue-Sky laws apply to the offering and whether the offering falls under any exemption that would prevent the company from having to go through a lengthy registration process. Most venture fund offerings are exempt from Blue Sky law registration requirements by way of preemption through an exemption to registration under federal securities laws (e.g., a private offering under Rule 506(b)), but the company may still have to submit a notice filing in certain states.

Amended Certificate of Incorporation

Because your offering will likely require the creation of a new class of stock or the addition of authorized shares, an amended certificate of incorporation (or equivalent organizational document for a foreign holding company) must be filed in your company’s jurisdiction of incorporation. This amended certificate will authorize and establish the rights of the newly issued shares of stock.

Legal Opinion

Certain investors will require that the company’s counsel provide a legal opinion prior to closing. A legal opinion is a formal letter from company’s counsel which contains various conclusions regarding legal matters pertaining to the company. It is intended to give the investor an additional layer of comfort regarding the company’s legal status, but is not a substitute for due diligence. Whether a legal opinion is required and what its contents should contain is determined on a case-by-case basis, but these opinions typically include matters like the company’s valid incorporation and the valid issuance of stock.

Other Conditions to Closing

Additional conditions to closing can vary depending on the industry the company is involved with. Investors might require certain governmental certifications or clearances before closing an investment. It is important to look out for uncommon conditions to closing that would potentially hamper the closing.

II. Expenses

The term sheet will also lay out whether the founder or the investor’s counsel will de drafting the transaction documents as well as who will be responsible for taking care of the legal fees associated with the deal. Typically, company counsel with draft the documents and the company will take care of its own legal fees plus any legal fees incurred by the investor in connection with the financing. This provision can be for “reasonable expenses” or the parties can set a cap on the legal fees covered, which is the recommended option. The expenses section in a term sheet can be binding condition. If it is, then the company would be liable for a potential investor’s legal expenses even if the transaction does not close. Therefore, companies seeking equity financing should consider protecting themselves by making the payment of an investor’s legal fees to subject to the closing of the investment transaction; which is the more sensible approach, considering that the company will have cash proceeds from the investment transaction to enable it to pay the closing costs.