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Overview of the Term Sheet
At this point during the negotiation process the entrepreneur and investor discuss the major issues surrounding the transaction. The term sheet is the result of initial negotiation and agreement between the parties regarding the funding transaction. Term sheet negotiations begin once the investor and entrepreneur are serious about consummating an equity investment deal. The term sheet is not binding, as parties want to retain the ability to negotiate further or withdraw from the deal if market conditions change or due diligence reveals some previously unanticipated realities about the target business venture.
The most common elements negotiated in the term sheet include:
- Business Valuation
- Resulting Capital Structure (E.g., Size of Option Pool)
- Type of Security (E.g., Preferred Convertible shares with Participation Rights and a Liquidation Preference)
- Conversion Rights
- Anti-Dilution Protection (and Carve Outs)
- Preemptive Rights
- Redemption Rights
- Registration Rights
- Information Rights
- Voting Rights
- Dividend Rights
- Board Seats or Observer Rights
The parties often agreement to several binding provisions, including exclusivity and confidentiality of negotiations and responsibility for legal fees if the transaction is consummated. Investors want exclusivity in their negotiations and non-disclosure of the terms sheets in order to prevent a competitive situation for the funding deal. While the term sheet is generally not binding, these terms provide the foundation for the agreement. Once these terms are decided they are rarely changed at a later stage of the transaction. Each party then depends upon counsel in strategizing, negotiating, and finalizing these and other ancillary terms of the agreement.
Dividend rights are a common attribute of preferred stock and are detailed in the . Early stage investors are rarely concerned with dividends; nonetheless, the parties will address dividend rights as a method of controlling the decision to issue a dividend. Dividend rights may be structured in a number of manners, which is almost always done in comparison to common shareholders. The dividend may state a dividend right as a percentage of issue price of the shares (generally 6 – 12% to match interest rates on debt), which represents some conversion rate to common stock. The most common methods of structure dividend rights are as follows:
- Cumulative vs Non-Cumulative Dividends – Cumulative dividends accumulate when a dividend is not issued by the business. That is, if no dividend is issued in a given year, then the amount that would have been issued accumulates for the preferred shareholder. If the company provides a dividend at any point in the future (or the company is sold or the preferred shares are redeemed), the preferred shareholder is entitled to the amount of all accumulated dividends. This entitlement gives the preferred shareholder priority over common shareholders in receiving the entitled dividend. The amount of the dividend is calculated as a percentage of share prices and the final payment may be based on simple or compound interest on the dividend amount. Companies will generally negotiate to waive accrued preferred dividends if or when the preferred shares are converted to common shares. The dividend is used as a protection device for the preferred shareholders. Upon conversion, preferred shareholders should be relegated to the same position as common shareholders (including dividend rights).
- Participating Dividends – Preferred shareholders participate in any dividends issued to common shareholders. The amount of the preferred dividend may be equal to common shareholders (calculated on an as-converted basis) or any multiple of the common shareholder’s dividend.
Startup venture cannot generally afford to issue dividends. The nature of the growth-based venture is that all available funds are reinvested into growing the business. As such, startup ventures generally incur extensive losses throughout the growth process. The operational costs above revenue are financed by the funds provided from outside equity investors. Investors well understand this objective and do not expect a dividend. If the company is able to distribute a dividend, then this is a negative signal to investors regarding the business’ growth path.
Investors in a startup venture want to make certain that they will receive a return of their money invested before the entrepreneur receives any funds for the sale of the business venture, merger, liquidation, or public offering. Investors achieve this desire by incorporating an liquidation preference into the preferred class of share. Commonly, investors will negotiate to receive some multiple (2x, 3x, 4x, etc.) of their money invested, before other shareholders receive any of the proceeds from the business exit event. The liquidation preference is used to minimize the risk of loss to the investor above that of other non-preferred, shareholders. The business venture has to perform very well for non-preferred shareholders to receive any return. This serves as a control mechanism to prevent the entrepreneur (or common shareholders) from seeking an early exit that does not produce a return or ample return for the investor. You commonly see a multiple liquidation preference when the investment is in a risky venture or the startup is having difficulty in raising funds otherwise. The key attributes of preferred stock liquidation preference is as follows:
- The amount of the preference (represented as a multiple of amount invested);
- The priority of payment of proceeds (E.g., series B, Series A, then common shareholders);
- Participation rights of preferred shareholders after receiving the entitled liquidation preference.
The liquidation preference can be far more important to the investor than the valuation of the firm. For example, if an investor receives 5x money invested (without subsequent participation rights), it does not matter if she owns 1% or 99% of the business for purposes of return. After receiving the 5x preference, all of the rest of the funds go to the common shareholders.
The liquidation preference is also extremely useful in creating a higher value class of preferred shares in comparison to the low market value of the common shares. This can allow for more flexibility in the award of shares and options as employee incentives.
Participation Rights & Caps
In some cases, the investor will negotiate for the ability to participate with common shareholders in the distribution of proceeds after receiving the liquidation preference. That is, the investor is paid the full liquidation preference, then they participate with common shareholders in receiving a percentage of the remainder of proceeds from the sale or exit event. The percentage of participation is generally based on the ownership percentage represented by the preferred shares. The common shareholders are generally allowed to “catch up”, meaning that they receive an amount equal to the liquidation preference before the preferred shareholder participates in distribution of any remaining proceeds. This is obviously a very advantageous provision for investors. The advantage is slightly limited when a cap is placed on participation rights. This means that once the a preferred shareholder receives a certain amount or given percentage of proceeds, participation stops. Without caps on participation rights, it would never be advantageous for a shareholder owning participating convertible preferred to voluntary convert her shares to common shares. This only takes place when the total distribution to the preferred shareholder would be greater if he simply received the a distribution based on his ownership percentage in the company, rather than the liquidation preference plus capped participation amount.
Liquidation Preference in Series B Rounds
Preferred shares with a liquidation preference in a seed or series A round will generally be the only preferred class of shares issued. The liquidation preference and its priority may become an issue with later rounds of investment. Series B investors will want priority or equal participation rights with the series A preferred shareholders. The series A preferred shareholders may fight this and cause issues in negotiating a funding deal. Further, the terms of the series A liquidation preference may be generous (e.g., 2x or 3x multiple), such that it would greatly burden the common shareholders to give the same level of preference to subsequent investors.
- Example: Series A shareholders invest $1 million with 2x liquidation preference. The first $2 million of proceeds from sale are accounted for. If a series B investor receives a 2x liquidation preference on a $15M preference, then the first $32 million from a sale or exit is promised to investors. The common shareholders stand very far down the line in priority of payment. If investor push an exit event that does not result in a huge valuation, then the common shareholder could receive very little for their work and effort.
A common method of dealing with series A investors in later stage funding is to cram down their rights. This means that the earlier investors’ preferred shares are exchanged for the new preferred class of shares. The series A investors will only go along with this is if the series B funding is part of an up round and stands to produce far greater value for all shareholders involved.
Stock Redemption Rights
Redemption occurs when the company repurchases shares from the company’s equity holders. Redemption rights are the rights of the shareholder to force the company to repurchase shares. Redemption rights are generally either mandatory or optional.
- Example: Unless prohibited by Delaware law governing distributions to stockholders, the Series A Preferred shall be redeemable at the option of holders of at least [__]% of the Series A Preferred commencing any time after [________] at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in three equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].
Optional Redemption Rights
Optional (Demand) redemption facilitates the venture capitalist’s desire to exit a venture when the amount of value created from any additional capital is approximately equal to the amount of new capital invested. It is a foreseeable risk, however, that the firm will not grow and develop sufficiently to return the investor’s capital (along with any interest or preferred returns) during the projected investment period. A demand redemption right is a strong control provision that minimizes the risk to the investor of becoming stuck in a failing business. The right allows the investor to control the entrepreneur’s ability to seek an early exit from the venture, which could result in a failure of the business to meet the investor’s expectations for returns. At the same time, these rights augment the risk to the entrepreneur that the investor will effectively bankrupt the business by demanding a return of capital through a repurchase or her shares. The right generally involves the entire class of investors. To exercise the right, a majority or super-majority of the class will have to vote for redemption. The investors not seeking redemption may opt out of redemption. The redemption may occur all at once or over a period of time.
Demand redemption rights are present in many stock purchase agreements, but the rights are rarely exercised. The reason is because there is likely little or no money left to return to the shareholder. If the money were returned to the shareholder, it would undoubtedly cause preferential payment issues with debtors of the business, who could easily force involuntary bankruptcy on the startup venture. Investors may attempt to negotiate penalty provisions into the agreement requiring the company to sign a promissory note or give up board control in the event of a failed redemption request. The enforceability of these provisions are questionable and could again give rise to priority issues under state law.
Mandatory redemption, in contrast to demand reduction, normally occurs at a stated time, upon a specific occurrence, or staggered over a period of time. The questions become, when is the mandatory redemption right triggered and, as with voluntary redemption, what will be the redemption price? The price is generally the purchase price along with any accrued and unpaid dividends (if applicable). Most redemption provisions do not allow for redemption until a sale of the company or at least a set period of time following the financing.
Assuming the company has sufficient assets to do so, if the business has not reached a point where it can sell or otherwise liquidate investor interest, the investor has the right to force the company to redeem some or all of the her shares. While mandatory reduction imputes a level of decision-making by the investor at a given point, it lacks the extensive control afforded by the demand right. While the mandatory redemption provision is a risk allocation provision in favor of the investor, it reduces the level of control of the investor in determining when redemption occurs. The time frame will be reasonable in light of company performance goals and the venture capitalists time from for dissolving the fund.
Redemptions and Conflicts of Interest
These control mechanisms demonstrate a distinct disparity in the intentions of the entrepreneur and the investor. While the entrepreneur seeks to continue the growth of the business, redemptions rights stand to thwart that growth in the event the investor either chooses to exit or the business fails to achieve certain growth goals that call for mandatory redemption. They may also create a risk to entrepreneur’s ability to attract future investors, as any future invested funds could be used to redeem the earlier investor rather than for business growth. In reality, the redemption provision is more used as leverage by the investors to force the hands of the directors when the company does not seem to be progressing.
Conversion rights refers to the shareholder’s ability to convert the preferred shares into common shares. Conversion rights are important as they affect the calculation of other rights of shareholders. Most calculations use the number of outstanding shares “on an as-converted basis”. This means that the total number of stock is calculated by including the shares into which preferred shares would convert. “Conversion rights come in two forms: optional and mandatory.
Mandatory conversion, as the name implies, mandates conversion of the preferred shares into common shares upon certain events. Generally, the key event is the initial public offering of the company’s shares. An IPO of a pre-determined total value and a per share value will trigger the conversion. This is generally defined as a “Qualified IPO” in the articles of incorporation. The per share amount of the IPO will generally be a multiple of the price paid for the preferred shares (e.g., 5x in series A financing or 3x in later financing). In this case, the public offering is difficult to undertake (investors don’t like it) when there is an outstanding class of preferred shares that is not the subject of the public offering.
Option conversion is the shareholder’s right to convert the preferred shares into common shares when the result is more advantageous to the shareholders. Such is the case when the buyout of the converted common shares will yield a higher return that the return afforded the preferred shares. This situation frequently arises when there is a low liquidation preference multiple, a cap on participation rights for the shareholder, and the company sells for a large amount.
- Example: The series A investor invests $100 and receives preferred shares with a 2x liquidation preference (no participation rights) and equaling 20% of the business. If the company sells for $1,500, then the preferred shares are worth $200. The common shares, however, are worth $300 (20% of $1,500).
- Note: Generally, the optional conversion will take place upon a majority or super-majority vote of the shareholders of the preferred class of shares. Investors in different classes of shares will vote separately and will have differing levels of motivation to convert their shares.
The conversion ratio determines the number of common shares into which the preferred shares convert. The ratio is determined by taking the price of the preferred shares at the time of purchase as the denominator (on bottom) and the price of the common shares as the numerator (on top). For example, you pay $5 for a preferred share and the price of a common share is $1. The conversion ratio of preferred to common shares will be 1:5. The conversion rate is generally set at 1:1 at the time of issuance (e.g., $1 for $1).
The conversion ratio is subject to change. Any time new shares are issued, the existing shareholders will be subject to dilution. The addition of more preferred shares or common shares will dilute the preferred shareholder as the total number of shares increases. It is common to have anti-dilution protections that adjust the conversion ratio to counteract the effect of dilution through new issuances. See the Anti-dilution provision material for more information on the affect of different types of dilution protection on conversion ratios. If the new price for the preferred shares is reduced downward (say $4), then it automatically affect the conversion ratio (1:4, rather than 1:5).
- Example: Preferred shares are issued at $1, which is also the price for common shares, for 1000 shares. The conversion ratio is 1:1. After dilution in the next round of financing, the price of conversion of the new series of preferred share is $.50. The conversion ratio on the original issuance of preferred shares will change to 2 (1 divided by.5). The 1000 shares will convert into 2000 shares.
Sample Conversion Language
Automatic Conversion: Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a [firm commitment] underwritten public offering with a price of [___] times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $[_______] (a “QPO”), or (ii) upon the written consent of the holders of [__]% of the Series A Preferred.
Optional Conversion: The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”
Dilution & Anti-Dilution Protection
Dilution is the reduction in the percentage ownership interest of an existing investor when a company issues new equity or the number of outstanding shares otherwise increases (exercising options, warrants, stock split, etc.). Anti-dilution provisions protect early investors from the risk of dilution by later rounds or stages of investment. Dilution is not always negative, as the value of a shareholder’s ownership may go up with the issuance of new shares. The issue is that the shareholder now owns a smaller percentage of the company. For investors who seek a return based upon their ownership percentage in the company at the time of an exit event, dilution is detrimental. The issuance of new equity at a lower price that an earlier issuance (known as a “down round”) always has a negative effect on shareholders.
Anti-dilution provisions generally protect preferred shareholders by altering the conversion ratio at which the preferred share will convert into common stock. Without some form of anti-dilution protection, the investor bears the fully risk of loss of value through any form of dilution. Anti-dilution provisions are generally divided into full-ratchet anti-dilution and weighted-average anti-dilution. While full-ratchet, anti-dilution provisions are the strongest control provisions and provide the greatest protection to the investor, weighted-average anti-dilution provisions are most common. The extent of protection afforded an investor under a weighted-average, anti-dilution provision depends heavily upon the formula used to calculate outstanding shares, referred to as narrow-based and broad-based calculations. The narrow-based formula for determining anti-dilution protection offers greater protection to investor through a lower conversion price.
Point of Conflict Between Preferred and Common Shareholders
Protecting a present shareholder from dilution in future financing rounds is a strong preference. Entrepreneurs, who possess common stock, cannot reserve anti-dilution protection for themselves, as common stock is not convertible to another form of equity. As such, investors with anti-dilution protection enjoy a benefit above that of entrepreneurs and non-preferred investors. While this control mechanism reduces the risk to the investor, it generally exposes the entrepreneur to a greater risk of dilution from later rounds of equity financing. A point of conflict arises where the special treatment of investors with regard to dilution protects the investor at the expense of the entrepreneur. This provision has the potential to introduce a point of conflict between the parties during future rounds of financing. For example, it may affect the willingness of the entrepreneur to seek future rounds of equity funding, even when additional equity funding is in the best interest of the venture. Any such point of conflict serves as a hindrance to achieving a relational contract where cooperation drives increased firm performance.
References for Dilution
Full Ratchet Anti-Dilution Protection
Full-ratchet, anti-dilution protection prevents an investor from being diluted at all from subsequent investment. Basically, the conversion price of the preferred stock (the price at which the preferred stock is converted to common stock) is reduced to allow the investor to convert the preferred shares into a given percentage of the outstanding common stock. Specifically, the conversion price changes to match the conversion price of shares issued in future rounds (if it is a “down round” where the conversion price is lower than in prior rounds). This allows the preferred shareholder to take advantage of an “up round” along with the common shareholders, and avoid any of the loss of value associated with a down round. In this case, the other equity holders (such as the entrepreneurs) bear the full weight of the dilution and the protected investor does not share the dilution. It can, however, negatively affect the ability to obtain later funding, due to the limiting effect on future issuances of stock. Basically, the preferred shareholder is less likely to participate in the next round as they are getting a conversion adjustment and receiving more shares without putting in additional value. Further, the follow-on investors will be paying less for the shares due to the earlier preferred shareholder’s conversion rights.
- Example: ABC, Inc., issues series A preferred shares at $1.00 conversion price (meaning the common shares were valued at $1). If the value of the stock drops to $.90 at the time of a series B issuance, then the series A shareholder will be able to convert her shares at $.90. This means the conversion ratio is 10/9. The series A shareholder will now receive an increased number of shares at conversion without putting in any additional capital.
- Note: If the series A investor does not participate in the series B financing, then the total percentage ownership in the startup will go down with the addition of total outstanding shares on an “as converted” basis.
Weighted Average Dilution
The most common anti-dilution protection is called “weighted-average,” anti-dilution protection. This approach employs a formula to adjust the rate at which preferred stock converts into common stock based upon:
- the amount of money previously raised by the company,
- the price per share at which it was raised,
- the amount of money being raised by the company in the subsequent dilutive financing, and
- the price per share at which such new money is being raised.
The weighted-average price (which will always be lower than the original purchase price following a dilutive financing) is then divided into the original purchase price in order to determine the number of shares of common stock into which each share of preferred stock is then convertible. This formula derives a new, reduced conversion price for the preferred stock. The result is an increased conversion ratio for the preferred stock. If new stock is issued at a price per share lower than the current conversion price for a particular series of preferred stock (a down round), the conversion price of the preferred series will be calculated by the following formula:
AP = OP x (CO + NCE) / (CO + CE)
AP = New or Adjusted Conversion Price
OP = Original Conversion Price of Preferred Shares
CO = Common stock Outstanding Pre-deal
CE = Value of Common Equivalent of Preferred Shared
NCE = Value of Common Equivalent in the New Issuance
Company A has 100 common shares and issues 100 preferred shares in a Series A financing at $1.00. As discussed in previous lectures, the preferred price matches the common stock price at the time, so the conversion ratio is 1:1 at the time. In a series B round the company issues 100 shares at $.50. The weighted-average, anti-dilution provision would offer protection to the series A preferred shareholders by adjusting the conversion price (the AP). To calculation the AP, let’s plug in the above formula.
OP = The original conversion price was $1.00
CO = The common outstanding in the simple scenario equals 100.
CE = The common equivalent of the preferred shares is the $100 (100 x $1)
NCE = The common equivalent of the preferred shares is $50 (100 x $.5)
AP = $1.00 x (100 + 50 / 100 +100) = $.75
Broad-Based vs. Narrow-Based Weighted Averaged Calculation
There are two primary variations of the weighted average formula depending on what constitutes “common outstanding” in the above formula. The first, and more common, is referred to as “broad-based, weighted average” while the second is referred to as “narrow-based, weighted average.” The broad-based weighted average formula calculation of “common outstanding” is commonly referred to as “fully-diluted capitalization”. This typically includes:
- all outstanding common stock,
- all outstanding preferred stock (on a converted to common basis),
- outstanding warrants (on an as exercised and as converted to common basis),
- outstanding options,
- options reserved for future grant, and
- any other convertible securities on an as converted to common basis.
The purpose behind this definition is to include all shares that are already subject to issuance. Authorized, but unissued, stock is not counted in the fully-diluted, capitalization number. The effect of including the additional shares in the broad-based formula reduces the magnitude of the anti-dilution adjustment given to holders of preferred stock as compared to the narrow-based formula.
The narrow-based, anti-dilution formula, in contrast, only includes the common stock issuable upon conversion of the particular series of shares of preferred stock in question. As an alternative, parties sometime negotiate versions of the narrow-based formula that includes the common stock issuable upon conversion of all shares of preferred stock outstanding in the common outstanding figure. The narrow-based formula provides a greater number of additional shares of common stock to be issued to the holders of preferred stock upon conversion than under the broad-based formula. The extent of the difference between the two formulas depends upon the size and relative pricing of the dilutive financing as well as the number of shares of preferred stock and common stock outstanding.
Carveouts to Anti-Dilution
Triggering anti-dilution protection can be detrimental to common shareholders, who are subject to dilution. As such, the common shareholder may attempt to negotiate barriers to triggering an anti-dilution provision (i.e., a change in the anti-dilution conversion ratio). Below are common carveouts to corporate actions that that will not trigger anti-dilution provisions:
- Converted Shares – Preferred shareholders converting their shares to common shares,
- Exercise of Options – Issuance of common shares pursuant to exercise of options, warrants, or other convertible securities,
- Stock Dividends – Issuance of common shares as a dividend to preferred shareholders,
- Division of Shares – Increased number of shares pursuant to a stock split,
- Employee Compensation – Common s `hares (or share equivalents) issued to individuals (such as employees or contractors) pursuant to a compensation or vesting schedule,
- Re-stated Certificate – Issuances make pursuant to an authorized amendment to articles of incorporation, such as a stock split or authorization of another class of shares,
- IPO – Shares issued pursuant to an IPO,
- Merger or Acquisition – Any shares issued pursuant to M&A or board-approved joint venture,
- Commercial Transactions – Shares issued as part of a board approved debt financing, commercial transaction, real property transactions,
- Settlements – Shares issued pursuant to any board-approved settlement,
- Board Approved Relations – Shares issued pursuant to board-approved strategic or operational aspects, such as R&D, technology license, or partnerships,
- Shares to Suppliers – Shares issued to suppliers as part of a board approved transaction,
- Majority Vote – Shares issued pursuant to approval of a majority of preferred shareholders.
The amount or number of common shares issued that will not trigger anti-dilution is typically limited to a specific number, board approval (majority or unanimous), or approval of a majority of preferred shareholders. Also, an amendment to the articles of incorporation pursuant to the bylaws can be used to avoid a trigger.
Preemptive Right of First Offer
Rights of first offer grant shareholders the right to purchase new shares issued by the corporation before others have the opportunity to purchase. The primary purpose of the provision is to allow current shareholders to avoid dilution of ownership by participating as purchasers of any new issuance of shares by the corporation. The provision generally allows shareholders the right to purchase an amount or percentage of new shares that equals to their current percentage ownership in the company (“pro rata” participation). The shareholder with preemptive rights must decline to purchase her pro-rata share before other investors can purchase those shares. If the shareholder declines to participate, the shares are available for purchase by other shareholders based upon their pro-rata share.
- Note: While anti-dilution provisions protect shareholders from loss of value in down rounds, this provision maintains the percentage of ownership. This is key, as percentage of ownership directly affects return at time of exit, voting rights, and protective provisions.
Preemptive rights generally granted to preferred shareholders may be limited in certain respects. Such limitations commonly include:
- Major Investor – Rights of first offer apply to holders of a certain amount or percentage of shares (“Major Investors”).
- Percentage Requirements – Basically, the pro-rata calculation is based upon the total number of preferred shares, rather than all common and common equivalent shares oustanding.
- Qualified Issuances – The preemptive rights do not kick in under certain circumstances. Generally, if the situation does not qualify as an issuance for purposes of anti-dilution protection, then it is not an issuance for purpose of preemptive rights.
- Beyond Pro-Rate Rights – The investor may request the right to purchase an amount of shares in excess of their pro-rate ownership percentage. This may include purchasing the pro-rate percentage of shareholders who do not participate in the follow-on financing round.
Pay-to-Play Preemptive Rights
A common provision is the “pay-to-play” provision, which incentivizes investors to take part in future rounds of financing of the startup. These provisions require that an investor invest in future equity rounds at an amount equivalent to their percentage of equity in the business (“pro rata”) to avoid dilution and potential loss of certain preferential rights. For example, the pay-to-play provisions are often linked to anti-dilution protection. If an investor fails to participate in a dilutive financing on a pro-rata basis, then they forfeit their anti-dilution protection rights in the current financing round (and potentially any future financing rounds). This is effectuated by a conversion provision in the preferred shares that state that the shares will convert to an alternative class of shares (that only exists for this purpose) that contains all preferential provisions except the anti-dilution protections. This is a method of getting around state prohibitions on impairment of preferred shareholder rights. In some cases, failure to participate may forfeit any or all preferred rights by converting the shares to common stock.
The problem with this situation is that it causes all current investors to participate only at their current percentage and does not allow for a percentage to go to new investors. The method of addressing this is to allocate a specific number of new shares to existing shareholders and then require shareholders to purchase a pro-rate percentage of that block of shares. The company may provide that the pay-to-play provisions only apply to shareholders of a certain percentage of a class of preferred shares.
Right of First Refusal
An alternative form of preemptive rights, known as rights of first refusal, regards sales by existing shareholders. Rights of first refusal are control mechanisms that generally grant the company the right of first refusal to purchase shares being offered for sale by an existing shareholder. For example, the business may hold the first right to purchase any shares sold by any shareholder, who can only sell the shares to an outside party if the business first refuses to purchase them. The business (through the decisions of owners or directors) will retain the option of refusing to purchase the shares. If the business elects to purchase the shares, however, the shareholder is entitled to the price per share agreed upon by a disinterested, third party. Preemption rights are often accompanied by ancillary shareholder agreements that further limit the ability of investors to sell or otherwise transfer ownership in the company. These provisions protect the existing business owners from a perceived risk of opportunistic behavior by other shareholders. While these provisions stand to affect both investor and entrepreneur, more commonly it protects the entrepreneur from an investor who wishes to exit the venture through the sale of her shares to unknown, and potentially undesirable, third parties.
Co-Sale rights are control provisions that protect the investor’s interest by preventing founders from selling their equity interest and leaving the equity investor still holding their shares. Specifically, if a manager sells her shares, preferred shareholders have the right to participate in that sale in a pro-rata basis. While these provisions mitigate, rather than shift, risk among the parties, they demonstrate a general lack of trust in the intention of the entrepreneur with regard to the venture. The Co-sale rights generally work in conjunction with rights of first refusal. If the rights of first refusal are not exercised by the company or by preferred shareholders and the manager sells the shares to a third party, then the preferred shareholders may participate in that sale.
Investors will want all or large numbers of common shareholders to be subject to the rights of first refusal and co-sale rights. Founders, on the other hand, will want certain types of transfers (such as bequests and transfers to family) to be exempt from any right of first refusal or co-sale provisions. Further, founders may want to limit the rights to preferred shareholders holding a minimum number of percentage of outstanding preferred shares. These provisions require that any seller of securities notify the board of an intended transfer to evaluate company and shareholder rights.
“Voting rights” generally refers to the right granted to preferred shareholders to participate in voting along-side common shareholders. This is an important power, as the ability to vote on corporate affairs is often a primary characteristic separating preferred and common shareholders. The articles may allow for special voting rights for preferred and common shareholders. This can alter the state law default rule that each class of shareholder approve any major action, such as amendment to the articles of incorporation. Generally, startup certificate of incorporation should provide that the number of authorized common shares may be changed pursuant to a vote of a majority of common and preferred shares. Such a provision can allow for overriding of preferred shareholder descent to corporate actions (such as authorization or issuance of new shares). Further, it may protect investors from a majority of common shareholders taking action without the consent of preferred shareholders (such as authorizing additional shares).
- Note: California corporate law does not allow the articles of incorporation to change the default rule that a majority of common shareholders vote separately to approve the authorization of additional shares of common stock. This provision protects common shareholders against oppression from investors holding a large number of preferred shares. Delaware, however, allows for the voting of all shareholders as a single class to approve certain major corporate decisions, such as authorization of new shares.
Another common voting rights provision allows investors the exclusive right to elect a certain number of directors. This allows for investor control that often exceeds the percentage ownership in the company. Anti-dilution rights will affect voting rights of preferred shareholders, as it alters the conversion ratio for the preferred shares into common stock.
Sample Voting Rights Provision
The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) [so long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding,] the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the “Series A Directors”), and (ii) as required by law.
Another common investor control provision, known as “protective rights”, requires voting approval (either majority or unanimous vote) by a class of preferred shareholder for certain events, such as pursuing an exit event. These rights allow the preferred shareholder the ability to thwart or hold up certain corporate action. The company will establish the minimum number of authorized shares and the voting threshold (majority, super-majority, or unanimous approval) that must be present for the protective rights to apply. For example, if a very small percentage of a single class of preferred share is outstanding, the company does not want this class of shares to be able to control company decisions through their voting rights.
The parties may select many types of events that require preferred shareholder approval. Common protective provisions allowing for preferred shareholder approval include:
- Modification of Articles or Bylaws – If any such modification would change the rights or preferences of that series or preferred shareholder,
- # Of Authorized Shares – Changes in the number of preferred shares in any class,
- Class of Shares – Creating any other class of preferred shares with dividend, liquidation, or voting preferences different than those of the outstanding preferred,
- M&A – Approving Any merge, sale or reorganization of the corporation,
- Share Repurchases – Any acquisition of common stock, other than repurchases pursuant other than a board-approved repurchase pursuant to buy-sell provision or agreement,
- Dividends – Pays or declares any distribution to common or preferred shareholders (except as previously stated in the articles),
- Dissolution – Approving dissolution of the company,
- Board Size – Increasing size of the board
- Security Interests – Granting a security interest in a substantial percentage of company assets,
- Major Asset Acquisitions – Particularly if assets are acquired through merger or acquisition,
- Stock Option Plan – Establishing a new option plan or authorizing new shares as part of an option plan,
- Board-Specific Approval – The preferred shareholders may request any number of special protective rights requiring board approval (by directors elected by the preferred shareholders or by a designated percentage of directors) of certain actions, such as:
- Loans or distributions of cash or stock to other entities (unless a wholly-owned subsidiary),
- Loans or advances to individuals outside of the ordinary course of business,
- Any guarantees or sureties outside of the ordinary course of business,
- Any corporate investments (other than prime securities), such as investment in other companies, with long-term maturity,
- Incurring indebtedness outside of the approved budget (an outside of the ordinary course),
- Transactions with key employees or insiders that exceed a predetermined amount (except as in the ordinary course, pursuant to reasonable needs of the company, and under reasonable, board-approved terms),
- Executive Matters – Hiring, firing, or changing compensation (including options plans) of executives,
- Operational Matters – Major changes to the companies current lines of business,
- Intellectual Property – Transactions affecting intellectual property rights done outside of the ordinary course of business,
Protective provisions are generally reserved within the articles of incorporation to make it more difficult to change or amend. The Articles will generally contain a “no impairment” clause restricting the ability of shareholders to impair the rights of preferred shareholders through any number of methods. The board-specific approvals are generally in the bylaws or shareholder agreements in an attempt to avoid legal restrictions in state corporate governance law (e.g., California Corporations Code). Note that the articles of incorporation must authorize each particular class of shares. Each series of preferred share may have different protective rights. Companies generally seek to establish uniform protective rights across preferred shareholders, but later round shareholders may negotiate superior rights for their class of shares.
Drag-along rights, on the other hand, are control provisions that can protect against minority shareholders holding up a deal for the sale of the company. Specifically, it requires a stockholder to vote in favor of sale if the transaction is approved by a certain percentage of stockholders and/or board members. The provisions generally expire upon a qualified initial public offering of company shares. The specific characteristics of the drag-alone provision generally include:
- Subject to Drag-Along – Investors will negotiate for certain common shareholders to be subject to the drag-along provision (to ensure liquidity of their investment). Dissent by a large group of shareholders or sufficient minority shareholders could thwart the transaction or cause the transaction to lose it’s tax-exempt status in a 1031 exchange.
- Minimum Threshold – Parties will identify the percentage of shareholders (total shareholders and percentage in each class) which could trigger the drag-along provision.
- Minimum Price – Investors may set a minimum price per share in the sale for the drag-along provision to take effect. This is the case for shareholders with lower priority who may not receive a distribution after the liquidation preferences of higher-priority shareholders is paid.
- Liquidity Qualifiers – Shareholders may require that any sale be in exchange for liquid assets for the drag-along provision to apply. This allows the shareholder to avoid being trapped holding an illiquid asset.
- Exemptions from Warranties and Representations – The sale of the shares will inevitably include representation and warranties as negotiated between the parties to the sale. The dragged-along shareholder may wish to exclude herself from those representations and warranties (which could entail liability if false or misleading).
These provisions have a risk shifting effect and may protect or detriment either the investor or entrepreneur, depending upon the equity structure. While a majority-shareholder entrepreneur is protected against investor hold up, a minor entrepreneur risks losing control of her company to facilitate an investor exit. The status of the entrepreneur as majority shareholder is subject to change, as the ownership interest of the entrepreneur is diluted with every subsequent round of investment. Most shareholders will reserve dissenters rights, which allows the shareholder to receive the cash-value (or a cash value) for their shares.
Example of Drag Along Rights
For example, a startup X decides to collect investment from a venture capital for raising capital. The founder of the startup holds 51% of the shares and sells the 49% shares to the venture capitalist. The owner of the company negotiates a drag-along with the venture capitalist, so in future, if the owner decides to sell out the company, the venture capitalist won’t have the power to stand in the way
The drag-along rights are beneficial for the minority shareholders as well, as it ensures the minority shareholders sell their shares on the same terms and conditions as the majority shareholders.
Registration rights are control provisions that allow an investor to force the business to file a registration statement with the Securities and Exchange Commission (SEC) and state regulators. The Securities Act of 1933 regulates the transfer or sale of securities. Specifically, it requires that securities be registered prior to sale or exchange. The registration process can be costly and burdensome. As such, startups rely heavily on exemptions for the securities registration requirements. Many of these exemptions restrict the sale of securities to certain third parties, thereby reducing the liquidity of the securities. Specifically, Rule 144 restricts the sale or exchange of certain securities for one year following their issuance. Forcing registration of shares makes the shares liquid and allows investors to easily sell the shares and exit the venture.
Registration rights are often defined to s specific class of shares (generally common stock). And these rights are generally grouped into “piggyback” and “demand” registration rights.
Demand & Piggyback Registration Rights
Demand rights provide the investor with the ability to force the business to register a class of shares with the SEC. Demand rights are often contingent on the occurrence or non-occurrence of certain events or conditions, such as a certain period of time. Piggyback rights allow an investor or class of investors to be a part of any registration of the business’s securities. That is, if another class of security holder registers a class of security, the investor with registration rights can also participate in that registration.
Demand registration rights will generally have any of the following attributes:
- S-3 Registration – Holders of a certain class and percentage of securities may require registration via form S-3. Registration is generally completed on form S-1. S-3 is less burdensome, as it allows for the reference of disclosures made in other filings. The S-3 may only be used 1 year following an IPO. The number of shares and dollar value of a S-3 registration will be limited.
- Number of Registrations – The articles may restrict the number of registrations a holder of preferred shares may demand. This may not be an issue as preferred shares have conversion rights to common shares, which is generally the target of registration demands.
- Timing of Registration – The time period is generally linked to a major funding event, such as 3 years after the original investor or 180 days following an IPO of the common shares.
- Value of Registration – Registration rights are generally limited to periods when the price of the preferred shares is 3-5x the purchase price of the preferred shares and a total aggregate value of the issuance (e.g., $10 million).
- Expenses – Shareholder may allocate the cost of registration (or any portion thereof) to the company. The costs associated with registration (i.e., legal fees) can be incredibly expensive. The cause of the expense is the extensive due diligence involved with making the mandatory disclosures. Failure to make accurate disclosures can lead to extensive civil and potentially criminal liability. In some cases, the expenses born by the company will be capped at a certain dollar value based upon the size of the registration.
- Lock-up Period – Shareholders agree that shares registered as part of an IPO will not be traded or exchanged for a period sufficient to comply withe regulatory requirements (180 days following the completion of the underwriting process). This reduces the likelihood of challenges to insider trading or market manipulation claims.
- Termination of Registration Rights – Generally upon an event where the corporation is liquidated, shares become unrestricted, or on a date related to an IPO.
- “Best-Efforts Requirement” – The investors may include a clause requiring the best efforts of the company in effectively carrying out the registration.
Piggy-back Registration Rights will generally have any of the following attributes:
- Share Reduction – Underwriters in an IPO may generally cut back the ability of investors to participate in the offering. As such, piggyback registration rights will generally allow investors to limit the ability of underwriters to cut back their participation in any follow-on issuances. The rights may assure the shareholders the ability to participate up to a given % in any subsequent financings.
- Priority – The investors may negotiate for their shares to have priority in any registration of shares above any other holders of non-company shares. This would allow those shareholders to participate in the registration while others cannot.
- Eligible Participants – The parties will negotiate whether common shareholders have the ability to participate in the registration. Otherwise, they are limited in their ability to liquidate their holdings.
Allowing investors to control the decision to make a public offering of the business shares protects the investor when the entrepreneur has majority control and complete decision-making authority over the business. The shareholder can either sell her shares in any public offering or force a public offering as a method of exiting the venture. While piggyback registration rights mitigate the investor’s perceived risk, demand rights shift control to the investor and risk to the entrepreneur. Specifically, an investor may demand registration to pursue an exit that does not benefit the entrepreneur or the business. This particular situation is known as “grandstanding”, when the investor seeks an exit to promote personal interests rather than those of the business. In practice, parties negotiate to limit the ability of the investor to unilaterally initiate a public offering. As such, registration rights are more of a tool that offers the investor leverage or control in the relationship.
References for Registration Rights
Board Observer Rights
Board observer rights, as the name states, allows investors to observe board meetings. This allows non-directors to be a part and presence in the corporate meetings. This includes taking part in discussions and committee meetings. The limitation is when attorney-client privilege is required. These rights are often reserved in the bylaws or in information agreements with investors.
The default rule upon a financing is that common shares vote for election of directors. If preferred shares receive voting rights, the conversion to common shares ratio is used to determine the number of votes held by the preferred shareholders. As discussed in the voting rights section, investors generally negotiate the right to vote for and elect directors. More specifically, however, they may demand the ability to elect a certain number of board seats. The number of directors on the board generally corresponds to the stage of financing. In early-stage companies, there may only be one director representing common shareholders and one director representing the issued class of preferred shares. The parties often negotiation for the election of a third director that must be agreed upon or elected by both common and preferred holders. Follow-on financings will generally lead to board expansion and a change in the sitting directors. This can be a point of contention between early and later-stage investors.
Management and Information Rights
Information rights require the company to provide investors with a certain level of information. State corporate law requires a certain level of disclosure (e.g., the articles and bylaws), but investors may require a higher level of record maintenance and disclosure. The rights are generally assured in a management rights letter, which has a secondary function beyond assuring disclosure rights to investors. The management rights letter may exempt VC firms investing a startups from certain federal regulations.
In short, ERISA (Employee Retirement Income Security Act of 1974) places specific requirements on certain institutional investors who are pension funds. Pension funds hold the plan assets in trust and invest a percentage of their investment portfolio in alternative assets, such as venture capital. Plan managers have fiduciary duties to the beneficiaries of the fund assets. As such, ERISA limits the ability of fund managers to undertake certain activities (further the IRS places requirements on the use of assets to qualify for certain tax treatment). When the pension fund invests in venture capital funds, this means that the fiduciary duties of fund managers also applies to the managers of the venture capital fund. To avoid this classification, the venture capital fund must qualify for an ERISA exemption; particularly, it must qualify under DOL regulations as a “venture capital operating company” (VCOC). To qualify as a VCOC, the venture capital fund must invest 50% or more of its assets in operating companies. An operating company is a company primarily engaged in a business other than capital investment. Further, the venture capital fund must have management rights in those companies and actively engage in management of at least one of those companies each year. This means substantially participating in or influencing the conduct of company. The management rights letter establishes this relationship between VC firm and portfolio company.
Special Employee Provisions
The parties often negotiate numerous employee-related provisions into the term sheet. These provisions serve as control mechanisms to either incentivize current management or allocate control over management to the investor. As discussed throughout, the control provisions employed by the investor seek to wrest away control of aspects of the business from individuals managing the business. Regarding the internal management of the venture, investors may want to control specific aspects of the hiring and incentivizing of managers. For example, the retention of current management (the entrepreneur and her team) may be an express condition to the funding deal.
The investor may see the entrepreneur leaving the venture as a significant risk for future success. In light of this perceived risk, following a round of equity investment, entrepreneurs generally receive additional ownership interest in the business that vests over predetermined period of time. These provisions add certainty that the entrepreneur will continue to manage the business for an extended period. If the entrepreneur leaves early, any non-vested stock is lost and the vested stock is subject to buyback at a predetermined price.
Within the capitalization structure, the parties routinely designate a specific percentage of company shares for use as incentives or as compensation to management. To avoid dilution, investors may request that there be sufficient equity reserves to adequately compensate and incentivize employers to perform at their best. As with founders, employees incentivized with equity ownership in the business will generally vest in their equity rights over a specified period of time. Allowing stock to vest over a specified period aligns company and employee interests and provides an incentive to grow the value of the business. This provision protects investors from losing money (or rather from the employee unjustly capitalizing) when the business is sold very early. If the employees fail to perform and are fired prior to all of the stock vesting, then there is less equity that the firm has to repurchase. As an additional protection feature, any employee equity agreements will have some form of restriction on transfer or sale.
Lastly, investors may want any inventions by members of the business to be the property of the business. Many startup ventures survive and grow only through new internal inventions or innovations. Investors may depend on these breakthroughs to drive business growth and value. Investors impose strict control rights over employees and contractors to reduce the risk of losing any invention or intellectual property. This risk is most relevant where the entrepreneur is the driver of innovation within the business, but also has divergent business interests.
Counsel & Expenses
The venture funding process often requires extensive legal services. An attorney serves the role of helping each party:
- Understanding the important considerations,
- Negotiate the funding deal (often with the other party’s counsel),
- Conduct or facilitate examination of the target company (due diligence), and
- Memorialize the transaction through drafting/reviewing legal documents.
The extent of attorney involvement varies depending on a number of factors, including:
- The stage of funding,
- Involvement of counsel (increased negotiation/document review),
- Amount of Due Diligence,
- Detail of drafting services required, and
- relationship be investors and entrepreneur (less negotiation).
The cost of legal fees are generally deducted from the funding received by the company. As such, the company pays for the legal fees of both parties. The investor’s counsel generally does not receive compensation if the deal does not go through. Also, the fees paid by company counsel may be capped at a specific dollar amount or as a percentage of the financing. In a series A financing it is common to see fees range from $5000 in a financing deal that requires little due diligence and drafting and up to $50,000 if there is extensive negotiation, diligence, and drafting.