What Startups Should Know about Series B Financings When Negotiating Series A

Raising a Series B financing is a major milestone in the life of a company. However, from the negotiation of the term sheet to the closing process, you will face a set of issues that is unlike what you experienced in the Series A financing. Here are some issues to keep in mind about Series B financings, some of which are important to know when negotiating your Series A:

  • Starting Point for Negotiation of Terms. By the time you raise a Series B financing, there is already at least one investor at the table who has received a set of rights in the prior financing, and these rights will need to be taken into account when negotiating the terms of Series B. This means that the appropriate starting point for negotiating the Series B term sheet is typically the Series A term sheet. You should understand that Series B investors will typically require at least all of the rights that Series A received. So, if you make significant concessions on terms in a Series A financing, you may be in effect conceding these terms to future investors as well.
  • Specific Deal Terms. The general principle of having to account for both existing and new investors has implications for many of the specific Series B terms. To take one important example, a venture-backed company’s certificate of incorporation will usually include provisions requiring a vote of the investors before the company can take certain major actions, such as selling the company or raising a new round of financing. One of the important questions in a Series B financing is whether these actions will now require a single combined vote of the Series A and Series B investors, or if the Series A and Series B investors must each approve these matters separately. It’s typically to your advantage to have a single combined vote because this reduces the number of corporate hoops you need to jump through before taking action, but the Series A and Series B investors may want separate votes to ensure that they can protect their respective interests.
  • Negotiation Process. Series A investment documents typically provide that you cannot raise a Series B financing without the consent of the Series A investors. This means that, even if the Series A investors aren’t directly involved in the negotiations between you and the Series B investor, they may still want to review the Series B terms and documentation before approving the deal (or have their lawyers review them), which can lead to additional rounds of negotiation. Typically, the lead Series A investor will have a director on your board and would therefore be aware of the Series B terms, at least at a high level, well in advance of closing. However, if the Series A director has not been closely involved in the deal, or if there are multiple Series A investors who each need to approve the deal, then the financing could turn into a three (or more) ring circus, with you, the Series A investors, and the Series B investors trying to ensure their respective interests are protected. While every situation is different, it’s generally advisable for you to figure out early which of the Series A investors will need to approve the Series B financing and get in front of this process, so as to avoid the prospect of a last-minute review and negotiation of documents by Series A investors. You should also factor the Series A investors’ review and negotiation into your deal timeline and therefore into your planning as to when you need to start the Series B process to ensure you have enough runway to get to closing.
  • Down Rounds. If you are raising a Series B financing at a lower valuation than the Series A, this raises an additional set of issues. While all the potential complexities of down rounds are beyond the scope of this article, a key point to be aware of is that Series A documents typically contain antidilution protections, which give the Series A investors the economic equivalent of additional shares if the company subsequently does a down round. This creates additional dilution for the founders on top of the direct dilution from the Series B investment, and is part of the true cost to the founders of doing a down round.

The above issues are relevant not only for your second round of funding, but also for preparing for Series A, since decisions made at the time of Series A may well have ramifications into Series B and beyond. By keeping the above issues in mind and planning accordingly, you can set yourself up for a successful Series A and Series B, and so position yourself for bigger and better achievements in the future.


Raising investment  capital  for  a  busi‐ ness  isn’t  easy  in  this  climate  and  most  entrepreneurs  are  willing  to  take any help they can get. Few entre‐ preneurs have sufficient personal con‐ tacts  to  fund  an  offering  and  when  they  are  not  an  attractive  candidate  for  the  venture  capital  market,  they  enlist  the  services  of  well‐connected  individuals  who  make  introductions  and open up  their contact lists. These  individuals who act as intermediaries  in  the  capital  raising  process  are  called “finders.”  The problem is these “finders” may be  acting as unregistered broker‐dealers.  The Securities and Exchange Commis‐ sion  (SEC),  the  Financial  Industry  Regulatory Authority (FINRA), as well  as  state  regulatory  agencies  highly  regulate  the  activities  of  broker‐ dealers.  In  the  past,  private  place‐ ments  involving  unregistered  finders  ran  little  risk  to  the  finder  or  the  is‐ suer.  The  SEC  rarely  investigated  or  pursued  finder  arrangements,  and  sought  enforcement  only  when  the  unlicensed match‐making occurred in  connection  with  much  more  signifi‐ cant wrongdoing.    This  has  changed.  Over  the  past  18  months,  the SEC has actively pursued  investigation and enforcement actions  for violation of the broker‐dealer laws  as  they relate  to unregistered  finders.   In  addition,  in  this  current  economic  climate  where  investors  in  private  placements  have  seen  their  invest‐ ments  sour,  or  at  best  their  path  to  liquidity  shut  down,  investors  are  bringing  private  actions  against  issu‐ ers to rescind their investments.   California  Corporations  Code Section  25501.5  gives  investors  the  right  to  rescind a  transaction when an unreg‐ istered  broker‐dealer  procures  their  investment.  If  the  investor  no  longer  holds the securities, he or she may sue  for damages. Pursuant to its authority  under an amendment  to Code of Civil  Procedure Section  1029.8,  the  court  may  award  attorney’s  fees,  costs  and  treble damages up to $10,000.  As a  result  of  the civil and  regulatory  exposure,  companies  seeking  to  at‐ tract  private  capital  have  wisely  re‐ considered  their  use  of  finders.  If  not  doing away with  finder arrangements  entirely,  they  have  tailored  their  ar‐ rangements to ensure  their  finders  fit  within  a  very  narrowly‐tailored  ex‐ emption from registration.   The “Finder’s Exemption” From Broker­Dealer Registration Section  15  of  the Securities  Exchange  Act  of  1934,  as  amended,  defines  a  “broker” as any person engaged in the  business  of  effecting  transactions  in  securities.  Section  15(c)(6)  makes  it  unlawful  for  a  person  not  registered  as a broker‐dealer to effect any trans‐ action  in  securities.  California’s  “blue  sky” securities laws essentially restate  the  federal  law.  Corporations  Code  Section 25004 defines a broker‐dealer  as any person engaged in the business  of  effecting  transactions  in  securities  in  California.  Under  Section  25210,  any  person  acting  as  a  broker‐dealer  must  be  licensed  by  the  Department  of  Corporations  unless  they  are  oth‐ erwise exempt.   Finders  argue  they  are  not  “effecting  transactions” in  securities, and  there‐ fore  are  not  acting  as  broker‐dealers,  when  they  facilitate  investments.  Finders  and  issuers  have  historically  relied  on  a  1991  SEC  no‐action letter  (Paul Anka, July 24, 1991)  to  support  this  position.    In  the  Anka  no‐action  letter,  the  SEC  blessed  a  “finder’s  ex‐ emption”  for  persons  that  merely  open  up  their  contact  lists  or  make  introductions  to  potential  investors.  The  SEC  found  it  important  that  the  finder  merely  furnished  his  contact  list of accredited investors and did not  negotiate or offer advice in the financ‐ ing. Although  the SEC looked askance  at  the  compensation  arrangement  where  the  finder was  paid  a  percent‐ age of the money he raised, it noted he  had  not  previously  arranged  invest‐ ments and agreed he would not do so  in the future.   JUNE 2009 JOHN P. CLEARY John P. Cleary is a nominee for the North County Bar Association’s 2010 Writer’s Award for the following article which appeared in the November 2009 edition of North County Lawyer Magazine. Copyright @2009 Procopio, Cory, Hargreaves & Savitch LLP.  All rights reserved. www.procopio.com │ 2 California  case  law  and  interpretive  guidance  from  the  Commissioner  of  Corporations also address the issue of  finders.  In  each  instance,  the  finder’s  exemption  has  been  narrowly  con‐ strued  to exclude most capital raising  efforts by unregistered finders.    Based  on  available  authority,  several  issues  must be  examined before  en‐ gaging a  finder. Each issue is relevant  to whether a finder will be deemed an  unregistered  broker‐dealer  for  pur‐ poses  of  regulatory  action  or  liability  under Section  25501.5.  The  determi‐ nation is not a balancing  test of  these  factors.  Rather,  violation  of  one  of  these  factors  will  render  the  finder  arrangement illegal.   1. Is the Finder Providing Services Other Than Simple Introductions? Black’s  Law  Dictionary,  Sixth  Edition,  defines  a  finder  as  “an  intermediary  who  contracts  to  find,  introduce  and  bring  together  parties  to  a  business  opportunity, leaving ultimate negotia‐ tions  and  consummation  of  business  transactions  to  the principals.” A per‐ son  loses  his  or  her  finder  status  by  taking any role, however minor, in the  ultimate  sale  of  the  securities.  The  finder’s  involvement  must  start  and  stop with making introductions.   Issuers  must  ensure  the  finder  is  not  involved in presentations to investors,  negotiation  of  transactions,  structur‐ ing  of  deal  terms  and  similar  activi‐ ties. Other activities that will render a  finder non‐exempt include:   • providing advice or recommenda‐ tions  about  the  merits  of  a  par‐ ticular transaction.   • providing  assistance  to  investors  in  completing  the  purchase  agreement,  subscription  agree‐ ment or other documentation.   • providing  financing  to  any inves‐ tor for purchase of the securities.   • providing assistance to the issuer  in  drafting  or  distributing  any  material  including  financial  data  or sales materials.   • introducing  the  issuer  to  com‐ mercial  banks,  lawyers  or  other  professionals  to  facilitate  the  fi‐ nancing.   • handling  the  funds  or  securities  involved in the transaction.   The  more  information  and  assistance  the  finder  gives  to  investors  or  the  issuer,  the  less  likely  he  or  she  will  maintain exempt  status. Even arrang‐ ing  meetings  between  the  issuer  and  prospective  investor  will  jeopardize  the exemption. Both issuers and  find‐ ers  are  well‐advised  to  ensure  the  scope  of  engagement  is  clearly  and  conspicuously  committed  to  writing  and followed in practice.  2. Does the Finder Regularly Engage in the Business of Facilitating Investments? As  the  SEC  first  made  clear  in  the   Anka no‐action letter, the regularity of  a  finder’s activity is crucial  to  the de‐ termination of whether he is acting as  a  broker‐dealer. Nothing is more  cer‐ tain  to  blow  the  finder’s  exemption  than engaging a person who regularly  acts as a finder.  Individuals who profess to be “profes‐ sional  finders”  may  be  successful  in  raising  money,  but  they  will  put  that  money  at  risk  and  expose  the  com‐ pany  to  the  potential  of  regulatory  action, fines, penalties, litigation and a  myriad  of  other  consequences.  If  an  issuer  is  looking  for  a  proven  finder,  the  only  safe action  is  to  employ  a  registered broker‐dealer or placement  agent.   3. Is the Finder’s Compensation Dependent on Success in Raising Capital?   It is  a  common misperception  among  entrepreneurs  and  finders  that  the  payment  of  a  fee  in  cash  or  equity  is  acceptable if  the  finder merely makes  introductions.    This  is  wrong.    It  is  a  myth  perpetuated  by  entrepreneurs  and finders who have not been caught.  It  is  verboten  to  pay  a  finder  a  fee  based  on  the  amount  of  capital  he  or  she is  responsible  for  bringing  to  the  company.  SEC  no‐action  letters  post‐ Anka  and  recent  guidance  from  the  SEC could not be clearer that success‐ based  compensation  is  the  primary  characteristic  of  broker‐dealer  activ‐ ity. Whenever  the  finder will be com‐ pensated  based  on  success  in  raising  capital,  he  or  she  has  the  “salesman’s  stake”  characteristic  of  a  broker.    In  the  SEC’s  view,  it  is  this  “salesman’s  stake”  that creates  the risk of unscru‐ pulous  activity  and  the  need  for  the  regulation  and  oversight  that  broker‐ dealer registration provides.  I have heard countless proposals from  entrepreneurs  and  consultants  seek‐ ing  to  avoid  the  success‐based  com‐ pensation  prohibition.  The  most  common  would  involve  hiring  the  finder  as  a  “consultant”  and  paying  him  a  “consulting  fee”  for  unspecific  business  purposes,  payable  if  and  when  the company achieves a certain  funding threshold.  No matter how the  arrangement is structured, if the fee is  tied  to  the  finder’s  activity  in  raising  investment  capital,  and  he  would  not  have  received  the  fee  absent  his  suc‐ cess in doing so, then it is not permis‐ sible.   The safest course is to pay the finder a  fixed  fee regardless of the outcome of  his  or  her  efforts  (for  example,  the  finder receives a $10,000 fee for mak‐ ing  the  introduction  regardless  of  whether  the  investor  purchases  shares).  This  of  course  requires  the  assumption of some risk on the part of  the  entrepreneur  in  the  event  the  in‐ troduction  does  not  lead  to  an  in‐ vestment.  If  practicality  requires  a  success‐based  compensation  ar‐ rangement,  the  only  solution  is  to  have  the  finder  affiliate  with  a  regis‐ tered  broker‐dealer,  essentially  be‐ coming  a  “back  office”  entity.  For  smaller transactions, this is not a real‐ istic  solution  because  the  finder  would  have  to  pass  the  relevant  li‐ censing  exams,  find  a  firm  willing  to  undertake supervisory duties over his  activities and he certainly would have  to  share a  portion  of  the  fee with  the  supervising firm.  The Consequences of Using an Un­ Copyright @2009 Procopio, Cory, Hargreaves & Savitch LLP.  All rights reserved. www.procopio.com │ 3 registered Finder Using  an  unregistered  finder  to  help  fund  a  deal  poses  significant  risks  to  both  parties involved.  The issuer will  face regulatory action by  the SEC and  state authorities, and may face private  actions by investors for damages or to  rescind  their  investments.  Using  an  unregistered finder will call into ques‐ tion  reliance  on  the Regulation D pri‐ vate  placement  exemption  and  be‐ cause  Section  25501.5  allows  inves‐ tors  to  rescind  investments  procured  through  the  use  of  unregistered  find‐ ers, the  funds  raised  will  be  at  risk  during  the  statute  of  limitations  pe‐ riod.    The  contingency  created  through  the  rescission  right  also  causes  accounting  troubles.  Finally,  if  the  investors  demand  a  legal  opinion  to close the transaction, the issuer will  also  have  a  hard  time  convincing  counsel to issue one.   Using an unregistered  finder will also  jeopardize future efforts to raise capi‐ tal. A common sanction sought by the  SEC  against  issuers  utilizing  unregis‐ tered finders is to bar the issuer from  conducting  Regulation  D  offerings  in  the  future. This, of course, could have  a  lethal  effect  on  a  start‐up  company  dependent on private capital.  In addi‐ tion,  some  regulators  have  at  least  informally  advised  issuers  that  the  use of non‐exempt finders will render  the company liable as aiders and abet‐ tors of securities law violations under  Section  20(e)  of  the  Securities  Ex‐ change  Act  of  1934.  For  emerging  growth companies planning to tap the  public  markets  in  the  future,  these  issues  will  at  best  be  spoilers  during  the  road  show  presentations  to  large  banks.   The  consequences  to  the  finder  also  are  severe. If  a  finder’s  activities  do  not  fall  within  the  exemption  from  registration,  his  or  her  agreement  with  the  issuer  will  be  wholly  unen‐ forceable  in  court.  As  a  result,  the  finder has no way to enforce payment  by  the  issuing  company  and  may  not  be  compensated  for  his  or  her  ser‐ vices.  In addition, non‐exempt  finders  are  susceptible  to  civil  and  criminal  penalties under both federal and state  law.