Typical Legal Provisions for a Seed Round
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What are the typical investor legal terms for a seed investment?
A seed investment is a very early-stage investment by angel investors or a venture venture capital fund in a startup venture. The seed investment round is negotiated as part of a “term sheet”. The term sheet is made up of many financial and legal terms relevant to the investment. The financial terms concern the price of equity or the valuation of the startup and the timing of the investment. The legal terms concern the structure of the business entity, the nature of the equity being issued, and representations by the startup’s counsel regarding the state of legal affairs concerning the startup. Each of these is reviewed below:
Contractual Provisions of a Seed Investment
Contracts for the purchase of equity by investors is carried out through contracts. Any contract may contain representations, warranties, restrictive covenants, and conditions precedent. Representations state facts about the company. Warranties represent that these facts will be true at some point in the future. Restrictive covenants prevent a party to the contract for undertaking certain actions. Conditions require that certain events take place or materialize before the parties are subject to the contract. Other conditions relieve a party from the contract upon the occurrence of a particular event.
Stock Purchase Provisions in Seed Investments
“Common stock” is the basic type of corporate equity. It entitles the common shareholder to one vote per share and basic dividend rights. Voting is generally for election of directors and major changes to the corporation. Startup owners generally hold common stock. Seed investors will generally require a special type of sock known as “preferred stock”. The preferred stock will have all sorts of legal rights as agreed upon by the startup and investors.
Most investors will require “conversion rights” for their preferred stock. This allows the investor to convert the preferred stock into the equivalent value or percentage of common stock at any time. This protects the investors in the event it becomes procedurally more valuable to own common stock. Also, there will sometimes be mandatory conversion provisions that require the conversion of preferred stock to common stock upon certain occurrences, such as an initial public offering.
Investors receiving preferred stock generally receive a “liquidation preference”. This means that the preferred shareholder will receive any distribution from the company before common shareholders can receive a distribution. Because startups rarely distribute dividends, this provision protects the investor’s interest in the event the company is sold or there is a sale of new stock that results in a distribution to existing owners. More often than not, the liquidation preference will be some multiple of the initial amount invested. For example, the investor will receive 1x, 2x, or 3x their investment before common shareholders receive a distribution.
“Participation rights” are rights of a preferred shareholder to receive a percentage of any distributions by the company that exceed the liquidation preference. The percentage of any distribution received is generally based upon the investor’s ownership percentage. The amount of the participation is generally “capped”. This means that the investor can only receive a percentage of distributions up to a certain amount of the distribution. If the company makes a larger distribution, the investor does not participate in that amount.
“Redemption” is when the startup is elects or is forced to repurchase the shares (preferred or common) of the shareholders. The value of the firm is either based on the value of the initial investment or the market value of the shares. An investor generally secures the write to force the company to redeem their shares upon certain occurrences. This is an “optional redemption right”. “Mandatory redemption” is when the company is forced to repurchase the shares of the investor at a specific time or upon specific occurrences. These occurrences can include an initial public offering, the sale of new equity, the company hitting or missing growth milestones, or at a specific time.
“Registration rights” allow an investor to force the startup to file a Form S-1 with the Securities and Exchange Commission. Filing this document is known as registration and is the first step in the process of undergoing a direct or initial public offering. The rights are generally divided into “piggy-back” and “demand” registration rights. Demand registration is the process previously described of forcing the company to file the S-1. Piggy-back registration rights means that the investor can join in or take part in the registration process if other investors require a registration. This is important when there are multiple classes of shares, as registration of one class of share does not include other classes.
Rights in Later Sales of Startup Equity
Future Equity Purchases
Investors will often secure rights (or sometimes be subject to the obligation) to purchase equity in any additional rounds of financing. Often, investors in new rounds of financing do not want to allow prior investors to purchase any of the new shares issued. Investors who want the ability to take part in the purchase should secure their rights in later rounds. Participating in future financing rounds will preserve the investor’s percentage of ownership in the company. Further, later rounds of preferred shares will often possess more beneficial rights for investors than earlier rounds. “Pay-to-play” provisions require an investor to purchase a percentage of any new offerings of equity in order to avoid their ownership percentage being reduced or diluted.
Generally, in a startup, the company requires any shareholders seeking to sell their shares to offer the shares to the company or to existing shareholders before seeking outside purchasers. These are known as “preemption rights”. A “right of first refusal” allows an existing shareholder to purchase any shares offered by other shareholders before those shares can be offered to the business entity or to outside investors. An important aspect of these rights is the method of calculating the value of other shareholder’s interests. The amount of repurchase can be a predetermined amount or subject to a valuation formula.
Co-Sale rights prevent startup founders from selling their equity interest. The investors do not want to be left holding their interests if the founders exit. “Tag along rights” allow the investors to sell their shares at the same time. “Drag along rights” require all investors to go along with a group sale. This protects against minority shareholders holding up a sale of the company.
Dilution is when a shareholder’s ownership interest in a startup is reduced because of a sale of more shares by the company. Anti-dilution rights protect the investors by forcing the recalculation of ownership percentage upon the sale of new equity to maintain their ownership percentage.
Control Provisions of a Seed Investment
The following are provision specifically focused upon grinding control to investors.
Special Voting Rights
“Voting rights” allow investors to vote for the election of directors or for the approval of certain business actions. The voting rights are either equal to or allowed some advantage above common shareholders. “Protective rights” gives a preferred class of shareholder the right to approve or reject certain company actions. Notably, preferred shareholders may require the ability to elect a certain number of directors.
“Information rights” allow an investor to require the company produce specific information about performance or transactions. This allow an additional level of oversight over the startup’s actions.
Special Employee Provisions
Investors may secure the ability to hire or incentivize managers of the startup. Many investors want to make certain that company founders remain with the company or step down from the leadership role at a specific time.
Investors may require a transfer of all intellectual property existing or created by employees in the future to be transferred to the company. This protects against key employees from leaving with company intellectual property.