Fill in the blanks

In the future, will the early stage venture capital market resemble the real-estate rental market? If the model venture capital financing documents issued by the National Venture Capital Association continue to gain traction, the answer could be yes.

The documents used to seal a lease agreement are almost always off-the-shelf, standardized forms that vary only in several key areas – amount of monthly rent, deposit amount, term of lease, etc. Parties to the transaction just fill in the blanks. Rental agreements are so common that neither party wants to waste time and money haggling over the most basic terms.

The documentation process has historically been far different in the rarified world of venture capital, where each investment is given a bespoke, white-glove treatment by legal counsel. But with venture capital financings now taking place by the bushel load, a legal community that once viewed these transactions as opportunities to negotiate is, by choice and/or necessity, increasingly treating the deals as commodities worthy of the same fill-in-the-blank treatment seen in the rental market.

?The whole thing is a bit Wizard of Oz, frankly, says Sarah Reed, in-house general counsel to Waltham, Massachusetts-based private equity firm Charles River Ventures. ?People don't realize how relatively easy it is to document these deals. There are just a few essential business issues to be resolved.?

Reed was the driver behind the creation of a set of template legal documents commonly seen in early stage venture capital financings. She says she grew tired of searching for inconsistencies and errors in sections of documents that she felt should have been boilerplate (see Reed's guest article, facing page).

Reed was not alone in voicing frustration at the time and expense of venture financing documents. ?How this came up was board members asking, ?Why do we have to pay legal fees over and over again for the same documents?? says Mark Heesen, the president of the NVCA.

Indeed, the expense of legal work surrounding venture financings has long been a source of frustration or fear for entrepreneurs, many of whom experience ?major sticker shock when they get a bill from their law firm for the Series A financing, according to a legal source. ?It could be from $50,000 to $75,000 to $100,000, say the source. ?That sets them up for a bad relationship with their lawyers.?

Venture capital general partners, to be sure, are interested in seeing valuable early stage capital spent creating value, or on critical legal work like vendor agreements and distribution agreements

Particularly irksome to entrepreneurs and GPs, according to the NVCA's introduction to the model documents on its Web site, are the back-and-forth negotiations on venture financings between lawyers for investors and for the entrepreneurs. Many attorneys are loath to say they have no comments on a draft document submitted by the other side, fearing this will be perceived as lack of vigilance for their clients.

After an extensive process that saw many members of the legal and private equity community submitting their best ideas, the NVCA earlier this year issued its first set of model venture financing documents. A revised set was posted to the NVCA Web site last month. The documents include a term sheet; stock purchase agreement; certificate of incorporation; investor rights agreement; voting agreement; right of first refusal and co-sale agreement; management rights letter; and indemnification agreement.

The template documents come with extensive footnotes from the legal experts who created them explaining the meaning of, logic behind and considerations stemming from many terms. For example, a footnote to a break-up fee term in the model term sheet reads:?It is unusual to provide for such ?breakup? fees in connection with a venture capital financing, but might be something to consider where there is a substantial possibility the Company may be sold prior to consummation of the financing (e.g., a later stage deal).?

SAINT REED
As the model documents were put together, there was some resistance from legal professionals entrenched in the venture industry. In addition to having the effect of potentially decreasing easy billable hours, one legal source complains that the documents tend to be company-friendly, as opposed to investor friendly. But initial hostility slowly yielded to recognition that the templates might make everyone's lives and businesses easier.

None felt gratitude more than small entrepreneurs and the small venture capitalists who back them. Rather than spend time and money struggling to create brand new financing documents, these people can simply bring out the NVCA templates and move more quickly to business building. ?One guy said to me,?You're a saint. You should be canonized,? says Reed, when she revealed to this devotee her role in creating the model documents.

Small, regional law firms, which occasionally but not exclusively work on venture financings, also benefit from using the model documents for client investments.

Even larger law firms that specialize in private equity advisory work now at least integrate the documents into their work. In a recent email to the NVCA, a partner at a veteran venture capital firm thanked the association for its efforts and noted that, while not wholesale adopting the model documents for its investment activities, the firm had updated its own template documents to reflect some of the best ideas of the NVCA documents. The partner also noted that he had asked the law firms that work with his firm to include in the terms put forward by the NVCA, including those related to protective provisions, deemed liquidation, voting agreement proxy, and amendment to preferred stock rights and preferences.

Heesen notes that the model documents gives legal counsel to venture capital firms a greater ability to negotiate smoothly with entrepreneurs: ?The entrepreneur might say, ?Oh, what an egregious term,? and you can say, ?Well, no, these are standard terms.??

The model document section of the NVCA's Web site has been much visited recently, according to Jeanne Metzger, vice president of marketing for the association. She, too, confirms that the documents have gained currency among even veteran legal professionals in the private equity industry. ?I was on a call recently with a large law firm and asked a lawyer if they used the documents, says Metzger. ?He said they used them as a reference, particularly when working on a transaction and certain terms are viewed as controversial. You can refer back to [the model documents] and show that no one is trying to play tricks.?

Alex Temel, a partner in the Boston office of law firm Proskauer Rose, notes that for him, the documents are good starting points, not end points. ?They are a convenient way to avoid having to negotiate technical legal issues such as reps and warranties and allowing principals to focus on critical and important economic terms, says Temel

Reed says the working group that formed the current template documents has no plans to attempt a similar effort aimed at standardizing fund formation documents, which are created in smaller volumes. For those who fear that all the secrecy and high-touch service are leaving private equity legal work, there's still hope.

Behind the models
Sarah Reed, general counsel at Waltham, Massachusetts private equity firm Charles River Ventures, describes the process that brought the NVCA model documents into being.

Fear and loathing: two great change catalysts that have led to many useful reforms. From my perspective as in-house counsel at an early stage venture capital firm, the regime crying out for reform was the legal documentation for ?vanilla venture capital financings. The source of the fear? The fact that, after my first full year on this job, and many years as a corporate attorney prior to that, I was still uncovering mistakes in, and learning improvements to, those documents. The loathing? Try reviewing at least one Registration Rights Agreement per week, for a twelve-month period, and then get back to me with your own reaction – assuming that you have not already slipped into a coma.

If I were a smarter person, it probably would have taken me fewer than twelve months on this job to figure out that the system was broken. As my partner at Charles River Ventures, Ted Dintersmith, put it, we were ?reinventing the flat tire each time we legally documented a financing transaction. Two sets of lawyers would drag out two sets of nearly but not quite identical form documents and spend at least (on a very good day) $25,000 each fiercely negotiating perhaps about 20 percent of the contents of those documents.

I fully expected that the reaction of my law firm peers to my proposal that we all get together to create the Mother of All Venture Financing Legal Documents would be, well, fear and loathing. I grossly underestimated them. The NVCA Model Documents project never would have gotten off the ground if experienced venture capital attorneys were not prepared to admit that, one, most of the stuff in these documents is ?boilerplate (granted that some boilerplate is better drafted than others) and, two, there is very little ?swing in the terms of these deals – that is, for example, there will certainly be a business negotiation about how rich the liquidation preference will be, but there will undoubtedly be a liquidation preference. I even heard a few participants express relief that finally they could stop wasting unnecessary and unproductive cycles on these documents.

If you imagine our work as a collaborative effort to write code, our group's goal was to create an open-source, industry standard for each document involved in venture capital financings. Each form would not only be thoroughly de-bugged, but would contain the best features of all of the different forms used by the leading law firms and lawyers around the country. Last, recognizing that the business terms (as opposed to the legal terms) in each deal are unique, the forms simply allow the user to fill in blanks and choose from a menu of options (e.g., full ratchet or broad-based weighted average anti-dilution protection).

Why didn't this happen earlier? In the tech industry, ?standards are either driven by the government or large customers/customer consortiums. In our industry, it is only recently that we have had a critical mass of ?customers – in our case, the customers being the in-house counsel at venture firms who have to deal with these documents day in and day out. Our group included representatives from more than a dozen venture capital firms, including many of the leading firms in our industry. When the customers said they wanted this product, it would have been difficult at best for their law-firm providers to object, even had they harbored a secret desire to do so.

As soon as I obtained ?buy-in from my peers at venture firms around the country, which usually took one quick call or email, signing up the law firms was easy. I started by calling all of the big players in our field, attempting to ensure geographic diversity in our group. By the time the project was well underway, I probably received at least one inquiry a week from a law firm asking if they could participate. That's when I started calling the Model Documents initiative ?Project Tom Sawyer. It was sure gratifying to have so many smart people interested in helping me to paint my fence.

So what do I do with all of that excess adrenalin capacity and spare time, now that the only part of the financing documents I need to read are the few places (if any) that are redlined against the NVCA form? I took trapeze lessons this summer, for starters. Take it from me – doing a backwards flip from a great height into a net is a lot less frightening and loathsome than reading your 473d Registration Rights Agreement.