A term sheet is essentially a contract to make a contract; it describes in generalities the terms to be included in a more definitive agreement to be signed after further details are negotiated. Term sheets are usually non-binding in most respects, meaning the parties are not obligated to sign a definitive agreement if they can’t agree on terms.

Term sheets are most useful for significant transactions, such as financings, collaborations or acquisitions, where both parties want to ensure they’re on the same page before the lawyers start drafting documents. This can save both parties considerable time and expense.

Let’s say your company hires a consultant and agrees that he’ll receive a 3% ownership stake in the company in exchange for his services. The consultant then sends you his standard form of service agreement, which describes the compensation arrangement like this:

As payment for the services provided by the consultant, the company will issue to the consultant 3% of the company’s capital stock. [BAD]

This seemingly innocuous sentence arguably entitles the consultant to 3% of the company in perpetuity because it doesn’t tie it to a specific date or a specific number of shares. This certainly wasn’t the result you intended, but that’s how the sentence could be interpreted.

If you must use percentages instead of actual share numbers (ex. because the number of shares is a moving target), always reference a point in time. The problem with the sentence in the example above could be ameliorated by specifying when the consultant will own 3%:

As payment for the services provided by the consultant, the company will issue to the consultant shares equal to 3% of the company’s capital stock on the date the shares are issued. [OK]

The better approach, however, is to use actual share numbers so there’s no potential for disagreement. If the company in our example already had 100,000 shares issued and outstanding, we could rewrite the sentence to read:

As payment for the services provided by the consultant, the company will issue to the consultant 3,093 shares of the company’s capital stock, which represent approximately 3% of the company’s capital stock on the date of this agreement. [BETTER]

But there are still two problems with this sentence. First, it doesn’t specify the type of stock the consultant will receive so, if the company has both preferred and common stock, it’s not clear which the consultant should receive. Second, the sentence doesn’t specify whether the consultant is receiving 3% of the company’s authorized capital stock, issued and outstanding capital stock or fully-diluted capital stock. The final sentence should read something like this:

As payment for the services provided by the consultant, the company will issue to the consultant 3,093 shares of the company’s common stock, which represent approximately 3% of the company’s issued and outstanding capital stock on the date of this agreement. [BEST]

If you have any cautionary tales, please share them with our other readers by leaving a comment.

Time-based vesting usually occurs over one to five years, with four years being the most common vesting period for rank-and-file employees of tech companies. The equity usually vests in equal monthly or quarterly installments over the entire vesting period, except that it is common to have one year of vesting deferred until the end of the first year (this is called “cliff” vesting). So an employee granted options to purchase 480 shares that vest monthly over four years with a one year cliff would, if they remained employed by the company, have options to purchase 120 shares vest on the first anniversary of the date the option was granted and options to purchase an additional 10 shares vest every month thereafter for the following three years until all options had vested.

Vesting upon the occurrence of specified events, or “milestones,” is more common for senior executives, whose compensation may be tied, in part, to the performance of the company, and for independent contractors whose compensation is tied to the performance of clearly defined tasks. The events that trigger vesting can be whatever the company and the recipient agree to, but it is important that they are sufficiently well defined that there will be no room to debate whether and when they are completed.

Neither this agreement nor any of the rights, interests or obligations hereunder may be assigned, in whole or in part, by operation of law or otherwise, by any of the parties hereto without the prior written consent of the other parties hereto.

While the right to assign is often reciprocal, it is not uncommon for one party (usually the party with the stronger negotiating position) to have the right to assign the contract without consent in certain circumstances.

When entering into an agreement, ask yourself two questions:

1. Would it matter if the other party was acquired by my nearest competitor? If your only obligation under the contract is to pay money for goods or services provided by the other party, it may not matter, but if you are disclosing confidential information about your business you likely don’t want it falling into the wrong hands. If the answer to the question is “yes, it would matter” you’ll want the agreement to place some limits on the other party’s ability to transfer its obligations under the contract.

2. Do I need the ability to transfer the agreement without permission of the other party in certain circumstances? For contracts with employees and other service providers, and for contracts that are material to your business, you may want to reserve the right to transfer the agreement in connection with a sale of your company (perhaps excluding a sale to the other party’s competitor), but for many contracts you may be indifferent and more concerned with limiting your partner’s right to assign the contract.

Remember that unless you have some negotiating leverage, the other party is likely to insist on the same rights to assign the agreement as you have, so if the answer to both questions is “yes,” you may have to decide whether it’s more important to restrict the other party’s right to assign or to have the right to assign yourself.

Precedents are documents similar in substance to the document the lawyer is being asked to draft that the lawyer can modify to fit his client’s needs. If the lawyer has good precedents to work from, he doesn’t need to spend time crafting original language when Copy + Paste will suffice. The best precedents are those closest in substance to the document being drafted. Even if the lawyer has some general precedents in his own files, the entrepreneur can often provide precedents that are more specific to the company’s line of business and, therefore, more helpful.

A common situation where it is easy for entrepreneurs to find precedents is in preparing privacy policies and terms of use for a website. If your company’s website needs a privacy policy or terms of use, you can help your lawyer out by locating precedents from the websites of your competitors and other companies with a similar business model or similar product features. Send a few of these to your lawyer and, if you want to save a bit more lawyer time, tell your lawyer what you like or dislike about the precedents you located and how you see your business as different from the other companies. Your lawyer can use the examples you found as a basis for drafting your terms of use and privacy policy, or at least he can use pieces of your precedents and work them into his own form.  Either way, you’ve reduced the time the lawyer needs to spend drafting, which saves you money.

To take a simple example, let’s say a company’s capitalization looks like this:

• Authorized Capital: 1,000,000 shares consisting of:
  • 800,000 shares of common stock; and
  • 200,000 shares of preferred stock that converts to common at a ratio of 1:1.
• Issued and Outstanding Capital:
  • 500,000 shares of common stock
  • 200,000 shares of preferred stock
• Options: 100,000 shares of common stock reserved for the option pool, from which options to purchase 25,000 shares of common stock are currently outstanding

To calculate the company’s fully-diluted capital, we simply take the sum of (a) the number of shares of common stock issued and outstanding (500,000 shares) plus (b) the number of shares of common stock issuable upon conversion of the issued and outstanding preferred stock (200,000 shares) plus (c) the number of shares of common stock issuable upon exercise of outstanding options (25,000 shares), which gives us a total fully-diluted capital of 725,000 shares of common stock.

There are two other important things to note about the way fully-diluted capital is calculated. First, the calculation typically (but not always) includes common stock issuable upon exercise of options and other derivative securities regardless of whether the right to exercise is vested or unvested. Second, fully-diluted capital typically does not include common stock reserved for option grants unless the options are already outstanding. Excluding unvested option or including unissued options can significantly alter the fully-diluted capital.

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In our very first post we said that our purpose in undertaking this Anatomy of a Term Sheet series was to give our readers the ability to better evaluate financing term sheets. We sincerely hope we’ve been able to shed at least a little light on the subject and we welcome your questions on any topic that is still a mystery. We close the series with a summary of the most important points we’ve covered the past two months and a list of other great blogs with information about financing and other subjects important to entrepreneurs and startups.

Key Takeaways

1.    Broadly speaking, the main areas of negotiation between entrepreneurs and investors are: (a) economics of the investment – valuation, dividends, liquidation preference, anti-diultion and redemption rights; and (b) control of the company – stockholder voting and protective provisions, matters requiring investor director approval, composition of the Board, preemptive rights, pay-to-play, drag-along and vesting of founders’ stock.

2.    In addition to valuation, dividends and liquidation preference can have a significant impact on the relative economic rights of the founders and the investors. It is important to understand the interplay among these provisions when evaluating proposed terms.

3.    The employee option pool should be sufficient to satisfy the company’s need to incentivize employees and other service providers for the foreseeable future. Be sure to understand whether the option pool is included in the pre- or post-money valuation and how this impacts the economics of the transaction.

4.    Obtaining approval for corporate actions from the directors designated by the investors is procedurally much simpler than obtaining consent from the investors themselves. Ideally, investors should only get a separate stockholder vote on major corporate actions, such as a sale of the company.

5.    Full ratchet anti-dilution is very investor favorable; weighted average anti-dilution is more common.

6.    A Pay-to-Play can help mitigate the negative impact of anti-dilution protections in a down-round financing.

7.    If the company is paying the investor’s legal fees, try to include a cap on those fees in the term sheet.

8.    Don’t try to negotiate-away the investors’ Registration Rights, but do try to include Registration Rights for the founders.

9.    Preemptive Rights should not preclude the company from raising money from new investors.

10.    A company’s Board of Directors has significant control over its business, so it is important to understand how the composition of the Board and the process of designating directors impact the balance of power between the founders and the investors.

11.    It is important to try to negotiate limits on an investor Drag-Along to prevent the founders and other common stockholders from being forced into a fire-sale.

12.    If founders’ stock will be subject to vesting following the financing, a portion of the founders’ shares should be vested immediately to account for time-served and founders should seek to have the remainder vest monthly over no more than three years.

Other Blogs Entrepreneurs Should Read

• Brad Feld
• Startup Lawyer (Ryan Roberts)
• Startup Company Lawyer (Yokum Taku)
• Venture Hacks
• Startup Company Blog
• Joseph Ansanelli
• VC Deal Lawyer (Christopher McDemus)

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Way back in our discussion of the Summary of Offering Terms, we noted that the No Shop/Confidentiality provision is one of the two provisions in the term sheet that is usually “binding” on the company and the investors – meaning it is enforceable even if the rest of the contemplated financing is never completed. It is also the last provision of the NVCA term sheet we will cover in this series of posts as the other two provisions – “Existing Preferred Stock” and “Expiration” – are not negotiated terms.

The implications of both portions of the No Shop/Confidentiality provision are straightforward. The “No Shop” portion requires the company to refrain from actively pursuing any other investment or any sale of the company for a set period of time after the term sheet is signed. The “Confidentiality” portion prohibits the company from disclosing the terms of the term sheet, except on a need-to-know basis. Most of the time the only point of negotiation is the length of the No Shop period. This ranges from 30 to 90 days, but is typically 45 or 60 days (in this blogger’s experience). If the No Shop is shorter than 45 days, there’s a good chance it will expire before the transaction closes. A No Shop greater than 60 days allows the transaction to drag on too long. Once the term sheet is signed, both sides are usually anxious to get the transaction closed as quickly as possible.

Note that the NVCA term sheet includes an optional “break-up” fee in the event the No Shop provision is breached, but also notes that including such a fee is uncommon and generally only used in later-stage financings.

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Investors often want at least a portion of the stock owned by each founder of a company to be subject to vesting and a corresponding company buyback right if the founder ceases to be employed by the company within a certain period of time after a financing (the “vesting period”). The purpose of the buyback is to incentivize the founder to continue working for the company until the end of the vesting period (when a new equity incentive grant is usually made). This benefits not only the investors, but also the other stockholders (including the other founders) because shares repurchased by the company upon the departure of a founder will proportionately increase the value of all remaining shares.

The standard vesting term for equity incentive grants in an early stage company, such as options granted to employees, is four years, with 25% of the grant vesting after one year (this is called a “cliff”) and the remainder vesting monthly or quarterly over the remaining three years. The NVCA term sheet’s “Founders’ Stock” provision follows this basic formula for the vesting of founders’ stock. If, however, the founders have worked for the company for a reasonable period of time before the financing (typically a year or more before a Series A financing), investors are often willing to exempt a portion of each founder’s shares from vesting (usually up to 25%), while allowing the remainder to vest monthly over three to four years (with no cliff). In addition, founders are often able to negotiate for full or partial acceleration of vesting if (a) the founder quits for “good reason” (generally defined as actions by the company that adversely affect the founder’s employment), (b) the company fires the founder without “cause” (generally defined as bad acts by the founder) or (c) the company is acquired. In the case of an acquisition, acceleration may apply upon the occurrence of the acquisition (called “single trigger” acceleration) or only if the founder’s employment is terminated (usually without cause or for good reason) within a certain period of time after the acquisition (called “double trigger” acceleration). The specifics of accelerated vesting – including the definitions of “cause” and “good reason” and the choice of single or double trigger acceleration – are typically negotiated during the drafting of the transaction documents rather than at the term sheet stage.

It is also important to understand the extent of the company’s buyback right. The company will always have the right to repurchase any unvested shares from a founder if the founder’s employment terminates for any reason (typically at the price the founder paid for such shares), but some investors may also want the company to have the right to buy back vested shares (typically at a price equal to the fair market value of the company’s common stock at the time of termination). Founders should strongly resist giving the company the right to buy back vested shares under any circumstances, but founders sometimes agree to allow the company to buy back vested shares upon termination for cause in exchange for acceleration of vesting if the founder’s employment is terminated without cause or for good reason.

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Drag Along

A Drag Along provision (also known as a “Bring-Along”) compels a group of stockholders to vote in favor of a transaction approved by another group of stockholders and/or the company’s Board of Directors. A Drag Along is most often used to “drag” minority stockholders and can be particularly important in a transaction, such as a merger or a stock tender offer, where approval by all or almost all stockholders may be imperative. It can also be used, however, to allow a minority of stockholders to drag the majority; which is often the case in the context of a financing where the Drag Along may require most or all stockholders to vote in favor of any Deemed Liquidation Event or other sale transaction approved by the investors.

Venture capitalists typically insist on a Drag Along right because it facilitates a potential exit by preventing the common stockholders from thwarting a sale of the company. The Drag Along is most likely to be exercised if a company is presented with a modest acquisition offer where the common stockholders would receive little or nothing from the transaction after payment of the investors’ Liquidation Preference, but it might be exercised anytime the differing business and economic goals and incentives of the investors’ and common stockholders cause them to disagree about the merits of a potential acquisition. In such a scenario, the investors want the ability to compel the common stockholders to approve the transaction if the investors conclude it is in their (the investors’) best interest. In essence, the Drag Along gives the investors the ability to impose their outlook for the company on the common stockholders.

A Drag Along provision can be a tough pill for founders to swallow, but it has become commonplace (though not universal) in venture deals and is likely to be even more important to investors after the recent economic downturn because they will be extra sensitive to the need for potential exits. There are a number of ways, however, that a standard investor Drag Along right may be modified to make it less draconian. At the term sheet stage, the primary means of softening the Drag Along right are: (1) providing that exercise of the right requires a vote of all stockholders, not just the investors; (2) setting a higher threshold for such a vote (the threshold typically ranges from a majority to 67% of the stockholders entitled to vote); and (3) providing that approval of the companies Board of Directors is also required to trigger the Drag Along (but recall from our post on Election of the Board of Directors that investors can have significant influence on the Board). Other limitations on the Drag Along, usually negotiated by the lawyers during the drafting of the transaction documents, may restrict the terms and conditions of a transaction in which the Drag Along is exercised.

Note that if the investors agree to require a vote of all stockholders to trigger the Drag Along, the threshold should not be set so high as to allow a small group of common stockholders to thwart a transaction.

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The NVCA model Series A financing documents cover two common provisions in the Voting Agreement: (1) the agreement among the stockholders to elect certain individuals to the company’s Board of Directors, which we deal with in this post, and (2) the Drag Along, which we’ll cover in our next post.

Election of the Board of Directors

The Board plays a pivotal role in the management of a company because it overseas the company’s officers (and has the power to replace them) and because Board approval is required for many corporate actions, including any action that materially impacts the corporation’s business. Not surprisingly, then, the composition of a company’s Board can be a contentious point of negotiation in a financing.

After a Series A financing, a company’s Board will typically consist of three or five directors (an odd number helps prevent deadlocks), with one or two directors elected by the investors, an equal number elected by the common stockholders (including the founders), and one director elected by all of the stockholders voting together. Since the common stockholders often control a majority of a company’s voting shares even after a Series A financing, the balance of power on the Board would favor the common stockholders because they would control the election of the last director. Although the right to elect a director or two, combined with the Investor Director Approval provisions, would give investors significant influence over Board decisions, in many instances the investors’ director(s) could be outvoted. To exert additional control over the Board, therefore, at the time of a financing investors typically seek to require that the company’s common stockholders agree on who will have the right to designate each director, and agree to vote their shares in favor of the election of each designee.

The Board of Directors section of the NVCA term sheet contemplates a typical five-person Board of Directors comprised of two directors designated by the investors, one director designated by the founders, the company’s CEO and one “independent” director who is not an employee of the company and who is “mutually acceptable” to the founders and the investors or to the other directors. A three person Board might consist of one investor director, one founder director and one independent. Both of these scenarios enhance the investors’ influence over the Board by giving them a say in the selection of directors who they do not have the sole power to elect. First, the investors gain a veto over the selection of the independent director, who otherwise would be selected by a simple majority vote. Second, where the company will have a five-person Board the investors ensure that one of the directors elected by the common stockholders will be the CEO. While the CEO is usually one of the founders at the time of the financing, as a company grows a founder-CEO is often replaced by an outsider who the investors will have considerable influence in selecting (recall that the hiring and firing of executive officers is typically one of the matters requiring Investor Director Approval).

Entrepreneurs should be cautious when negotiating the post-financing composition of the Board with investors. Some investors can add significant value to a company as members of the Board, but you do not want to give up complete control. Seed and angel investors often do not receive the right to elect any directors, and should be offered at most a minority position on the Board. In a venture capital financing in which the investors will own less than 50% of the company following the financing, founders can try to argue that the common stockholders should have the right to designate a majority of the Board (2 of 3 or 3 of 5), but this argument is likely to meet with stiff resistance and could backfire if the investors later come to own more than 50% of the company. Rather, it may be more effective to take steps to ensure the Board composition and decision-making remain as evenly balanced as possible by, for example: (a) requiring that the independent director and any new CEO be approved by unanimous consent of the other directors (which would necessarily include any director designated by the founders; (b) insisting that certain major corporate actions be approved by the director(s) designated by the founders, as well as the director(s) designated by the investors; and (c) if the CEO at the time of the financing is a founder, negotiating an employment contract for the founder-CEO that makes it difficult for the company to terminate her without “cause” (i.e. bad acts by the founder), where “cause” is narrowly defined.

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While the Investor Rights Agreement deals with the rights of the investors vis-à-vis the company, the Right of First Refusal and Co-Sale Agreement gives the company and the investors certain rights vis-à-vis the company’s common stockholders. The principal rights conferred are the eponymous Right of First Refusal (“ROFR” – rhymes with gopher) and Right of Co-Sale (a/k/a “Tag Along”), both of which apply to any proposed sale of stock by common stockholders prior to the company’s initial public offering. The Lock-up applies to sales by the common stockholders following the company’s initial public offering.

Right of First Refusal

The NVCA term sheet includes a standard ROFR provision where the company has the first right to purchase shares offered for sale by common stockholders and the investors have the right to purchase any shares the company does not elect to purchase. The ROFR order of priority may be reversed so that the investors’ right precedes that of the company. The impact of reversing the order is essentially economic: if an investor purchases shares she pays the purchase price out-of-pocket, so the money doesn’t drain the company’s coffers, but she also increases her ownership interest relative to all other stockholders, whereas a repurchase by the company would result in a proportionate increase in the value of shares held by all stockholders.

The NVCA term sheet also gives investors an oversubscription right to purchase a pro rata portion of any shares subject to the ROFR that are not purchased by other investors (this is akin to the Over-Allotment Right that arises in the context of the investors’ Preemptive Rights). The oversubscription right is particularly important to investors if, as is often the case, the ROFR must be exercised, collectively by the company and the investors, with respect to all shares proposed to be transferred in order to be given effect. This “all-or-none” restriction on the ROFR is beneficial to selling stockholders, especially those with a large equity stake in the company, because it prevents the company or the investors from dissuading a potential buyer (who may wish to obtain the selling stockholders entire equity stake in the company) by exercising the ROFR with respect to a portion of the shares offered for sale.

Note that in some cases, particularly where there are a number of smaller investors, the ROFR may be applied to the investors as well as the common stockholders. This is generally an inter-investor matter that has little practical significance to the company and the founders.

Right of Co-Sale

Where the ROFR gives investors the opportunity to purchase shares offered for sale, the Tag Along gives them the right to sell their shares (on an as-converted-to-common-stock basis, if necessary) to a purchaser alongside the prospective seller. The Tag Along comes into play to the extent shares offered for sale are not purchased through the ROFR, and it applies pro rata based on the relative ownership interest of the investors and the selling stockholder. As with the ROFR, the Tag Along may be applied to the sale of shares by investors as well as common stockholders, but unlike the ROFR there is never an oversubscription right if certain investors elect not to exercise the Tag Along.

Lock-Up

The Lock-Up requires the founders (and often other significant common stockholders) to agree that they will not sell their shares for a given period of time after the company’s initial public offering. The common stockholders’ lock-up may be somewhat more stringent than the investors’ lock-up (mentioned in our discussion of the investors’ Registration Rights) to give the investors a head-start on the founders in selling shares after the company goes public.

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None of the ROFR, Tag Along or Lock-Up is typically the subject of discussion at the term sheet stage, and there is rarely much negotiation when the transaction documents are drafted. There are, however, a few issues to consider. First, the common stockholders who must become party to the Right of First Refusal and Co-Sale Agreement (and therefore subject to its restrictions) may be limited to a specific group of stockholders (ex. the founders and executive officers) or to stockholders holding at least a minimum percentage of the company’s fully-diluted equity ownership (sometimes as low as 1%). The smaller the number of stockholders subject to the agreement, the easier it is to administer; both because the company does not need to require every stockholder to sign the agreement and because not every little transfer will trigger the ROFR and Tag Along. Likewise, where there are a number of small investors it may be beneficial – to the company and to the lead investors – to only give ROFR and Tag Along rights to the larger investors. Again, this eases the administrative burden on the company when the rights are triggered. Finally, both the ROFR and the Tag Along are usually subject to standard exceptions to permit stockholders to transfer shares for limited purposes, such as estate planning.

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We finish up our discussion of the Investor Rights Agreement with a quick overview of the remaining provisions, which typically are not the subject of much negotiation.

Non-Competition and Non-Solicitation Agreements – Investors will almost always insist that the company’s founders and any other key employees agree not to compete with the company or solicit away any employees, customers or other key business relationships for 1-2 years after they leave the company for any reason. Of course, founders/employees have an interest in keeping the term of their restrictions as short as possible, but founders should also realize that as long as they are with the company (and usually they expect to be for a long time) they benefit if former employees are subject to non-compete and non-solicit restrictions for longer terms.

Non-Disclosure and Developments Agreement – In any financing with sophisticated investors, the company will be required to ensure that all persons who may have had access to the company’s confidential information or a role in the development of the company’s intellectual property agree that such information and intellectual property is confidential and belongs to the company.

Board Matters – This provision deals with membership on Board committees, the frequency of Board meetings, obtaining Directors & Officers (D&O) insurance and director indemnification. These matters are typically of little consequence and any issues should be left to the lawyers to hash out when negotiating the final transaction documents. The only thing worth noting is that the company should insist that any indemnification offered to the investors’ director(s) is provided to all directors, so that other directors may benefit from this protection as well.

Employee Stock Options – Employee stock options for technology companies typically vest over four years, with 25% of the options vesting after one year and the remaining options vesting monthly or quarterly over the following three years. As we noted in our post discussing the general Offering Terms, the size of the employee option pool is typically set at around 15-20% of the company’s fully-diluted capital post-financing, give or take a few percentage points, at the time of a Series A.

Key Person Insurance – Investors often require that the company take out life insurance policies on the founders on the theory that they are the driving force behind the success of the company and their death would dramatically reduce the company’s prospects.

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As a preliminary matter, note that the “Right to Maintain Proportionate Ownership” is more commonly referred to as “Preemptive Rights” or the “Right of First Offer.” They are also sometimes referred to as the “Right of First Refusal,” though this term is more often used to refer to the right to purchase shares offered for resale by a stockholder (which we cover here).

Preemptive Rights give investors the first right to purchase shares offered for sale by the corporation in the future, subject to a few exceptions (typically the same as the exceptions to the Anti-dilution Provisions). There are three basic varieties of Preemptive Rights: (a) each investor is entitled to purchase just that portion of the offered shares necessary to allow her to maintain her percentage ownership of the company (i.e. if the investor owns 10% of the company before the offering, she would be entitled to purchase 10% of the shares offered), (b) each investor may purchase some multiple of her pro rata portion (i.e., if a 2X right, an investor owning 10% of the company before the offering would be entitled to purchase 20% of the shares offered) or (c) the investors, collectively, are entitled purchase all of the shares offered by the corporation and each investor is entitled to purchase her pro rata portion of the total based on ownership relative to other investors with Preemptive Rights. In all three varieties, investors may also have the right to purchase a pro rata portion of any shares not subscribed for by other investors with Preemptive Rights (this is called an Over-allotment or Over-subscription Right).

Preemptive Rights are standard in Series A deals, but it is generally in the company’s interest to limit their scope so it has greater flexibility to raise money from outside investors. Ideally this means only giving investors the right to maintain their pro rata ownership in the company, though an Over-allotment Right is often granted, as in the NVCA term sheet, so the investors as a whole have the opportunity to maintain their pro rata ownership even if not all investors elect to participate. Another way Preemptive Rights are sometimes limited is by only granting them to “Major” investors, usually being venture capitalists and large angel investors. Note that limiting the scope of the Preemptive Rights is considerably less important where the investors are subject to a Pay-to-Pay. Where there is no Pay-to-Play, the company (and sometimes the lead investors) may still try to include a “use it or lose it” provision so that investors who do not fully exercise their Preemptive Rights lose them for future rounds.

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If you’re following along with the NVCA term sheet, please note that we’re combining the discussion of “Management and Information Rights” and “Investor Director Approval” into one post because they both relate to the role of investors in the management of the company. We’ll return to the “Right to Maintain Proportionate Ownership” provisions (which fall between this post’s two topics in the NVCA term sheet) in our next post.

Management and Information Rights

Management and Information Rights serve to ensure that even those investors who will not have the right to appoint a member of the Company’s Board of Directors are able to obtain certain information about the operation and finances of the company. The obvious reason investors insist on receiving these rights is that they want to keep tabs on the companies in which they invest, but this not why some investors require a “Management Rights letter” from the company. Without going into too much extraneous detail, receipt of a Management Rights letter is necessary for any venture capital fund that manages assets subject to the Employee Retirement Security Act of 1974 (ERISA), which many VC funds do, because such funds must have certain management rights in their portfolio companies to avoid being subject to certain obligations under ERISA. Note that while information rights are generally dealt with in the Investor Rights Agreement itself, the Management Rights letter is actually a separate document.

Management and information rights should be non-controversial and typically are not the subject of negotiation at the term sheet stage. If the round includes a number of small investors, the company (and the lead, i.e. “Major,” investors) may want to limit who is entitled to management and information rights; though providing rights to a few additional investors is usually of minimal practical consequence to the company. The frequency and timing with which the company is required to deliver information (such as financial statements) to the investors (typically within 30-45 days following the end of each month or quarter) is also of little practical consequence because companies are often producing this information for internal purposes anyway and investors are typically lenient in enforcing the deadlines. With that said, providing for less frequent updates with greater time to deliver information is inherently better for the company. Note that any investors who have information rights should be required to agree to keep the information they receive confidential, and a standard confidentiality provision should be included in the Investor Rights Agreement.

Investor Director Approval

The Investor Director Approval provisions are, along with the Protective Provisions we discussed previously, the primary mechanism for the investors to exert control over the activities of the corporation. Approval of the investors’ director(s) is often required for matters that could materially impact the company where seeking stockholder approval would either be inappropriate (because of the subject matter) or unduly burdensome. The NVCA term sheet includes a laundry list of matters that may require approval of the investors’ director(s), but the list is by no means exhaustive. For those not following along with the NVCA term sheet, it requires approval of the investors’ director(s) for matters such as: making loans to other companies or to individuals; guaranteeing indebtedness; incurring indebtedness in excess of a set dollar amount; entering into certain transactions with company insiders (officers, directors, etc.); hiring, firing or changing the compensation of executive officers; changing the company’s principal business; selling, licensing or otherwise conveying rights to the company’s material technology or intellectual property; and entering into strategic relationships involving payments to/from the company greater than a set dollar amount.

While companies are better off minimizing the decisions requiring approval of the investors (through the Protective Provisions) or their directors, being required to obtain approval of directors is preferable to being required to obtain stockholder approval for two reasons. First, the procedure for obtaining director approval is much simpler than for obtaining stockholder approval. Second, and arguably more important, directors have certain “fiduciary duties” towards the company and its stockholders (all of them) that prohibit them from putting their own interests ahead of the company’s, whereas stockholders are almost always entitled to act selfishly. Therefore, in negotiating the Investor Director Approval provisions it is a good idea to be pragmatic: attempt to eliminate from the approval requirement any actions that should be routine, but don’t get too worked up over the need to obtain approval of the investors’ director(s) for matters that are likely to only arise periodically.

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The next several posts in this series concern the provisions located in the “Investor Rights Agreement,” “Right of First Refusal and Co-Sale Agreement” and “Voting Agreement,” which together give the investors a variety of contractual rights vis-à-vis the company and the company’s other stockholders. While the provisions contained in these three agreements are common to most VC financings, it is important to note that the titles of the agreements and the mix of provisions in each agreement can vary. We begin with the Investor Rights Agreement.

Registration Rights

The Registration Rights provisions in the NVCA term sheet give the investors the right to have the company register their shares with the Securities and Exchange Commission, which is a prerequisite to selling shares in the public markets (i.e. NYSE, Nasdaq, etc.). There are three types of registration rights typically granted to investors: (1) Demand Registration allows the investors to compel registration of their shares after some period of time following the offering, subject to certain conditions; (2) S-3 Registration allows the investors to compel registration at any time if the company meets the eligibility requirements for an “S-3” registration statement (which usually means that the company is already publicly traded); and (3) Piggyback Registration allows the investors to include their shares in any other registration of securities the company undertakes, subject to limitations on the number of shares that can be registered in some circumstances. The remaining Registration Rights provisions in the NVCA term sheet, neither of which is generally the subject of negotiation, are “Expenses,” which compels the company to pay the cost of a registration (which can be significant), and “Lock-up,” whereby the investors agree that they will not sell their shares for a given period of time after the company’s initial public offering.

Of the three types of registration rights, Demand Registration rights are by far the most important because the investors can compel the company to undertake the costly and time-consuming process of an initial public offering. From a strategic standpoint, however, Demand Registration rights are very similar to Redemption Rights: while they give the investors an exit opportunity, in practice they are almost never exercised because if the company has not gone public it is likely because either the company is not ready or the market conditions are not favorable. As with Redemption Rights, Demand Registration rights give the investors leverage against the company that they can use to extract concessions at a later date.

Registration rights are standard in a Series A financing and, as noted above, of limited consequence to the company, so any negotiation is usually best left to after the term sheet is signed. If investors in a pre-Series A financing require registration rights, the company should insist that they agree up-front to subordinate those rights to the registration rights of future venture capital investors. The points that are sometimes negotiated at the term sheet stage are: (1) the threshold percentage of investors required to trigger Demand Registration (see the discussion of voting thresholds in our post on Voting Rights and Protective Provisions); (2) the earliest date the investors may exercise Demand Registration rights (5 years from the date of the financing is typical for a Series A financing, which may be reduced as low as 3 years for later-stage venture rounds); (3) the number of times the investors may exercise Demand Registration rights (typically 1-2 total) and the frequency with which the investors may exercise S-3 Registration rights (typically 1-2 per year); and (4) the minimum aggregate offering price for any Demand Registration (typically the same threshold as would trigger a Mandatory Conversion) or S-3 Registration (should be no less than $1M). Note that the threshold percentage of investors required to trigger S-3 Registration is less important (and typically much lower) than for Demand Registration because the burden on the company is much less.

Finally, it is worth noting that companies are sometimes able to negotiate for S-3 and Piggyback Registration rights for founders and even for other common stockholders, provided that these rights are subordinated to the investors’ registration rights. Without registration rights, common stockholders must wait to sell their shares to the public until either they qualify for an exemption from registration, which usually comes with inconvenient conditions and restrictions, or the Board of Directors decides to register their shares, so obtaining registration rights for some or all of the company’s common stockholders is arguably more important that attempting to restrict the registration rights of the investors.

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With this post we move away from the Charter provisions to discuss the Stock Purchase Agreement (SPA), the primary purpose of which is evident from its title: it is the contract where the investors agree to buy the shares of stock the company is offering to sell. The importance of the SPA, however, lies is in the terms and conditions it places on the financing, which serve primarily to protect the investors.

Representations and Warranties

The primary way in which the SPA protects investors is through the inclusion of “Representations and Warranties” (R&Ws) about the company’s business. R&Ws are statements about facts existing at the time a contract is signed that are made by one party to induce the other party to enter into the agreement (for a more detailed description of R&Ws, see this post). In a financing, a company is typically required to make R&Ws about everything from the company’s capital structure to its ownership of relevant intellectual property and its compliance with applicable laws to ensure it has disclosed to the investors all information that might materially impact their decision to invest. If any of the R&Ws are later found to be incorrect, the company may be liable to the investors for damages. Note that it is generally accepted that investors will make R&Ws to the Company confirming their eligibility to participate in the offering (usually this means confirming they are “accredited investors”), though these R&Ws are not typically mentioned in the term sheet.

In most financings, the lawyers spend more time negotiating the R&Ws than any other section of the financing documents, but at the term sheet stage the only thing entrepreneurs usually need to worry about is whether and to what extent the company’s founders are being asked to personally make R&Ws about the company’s business. Founders’ R&Ws are most common where the founders are receiving some liquidity in the transaction or where there is particular concern over an important topic of disclosure, such as intellectual property. The principal rationale for requiring founder R&Ws in addition to company R&Ws is economic: any damages paid by the company to compensate the investors also reduce the value of the company, and therefore of the investors’ shares, while damages paid directly by the founders have no impact on the value of the company. In some cases, investors may insist that the founders put some or all of their shares of company stock in escrow as security in case there is a breach of the R&Ws.

There are many ways in which founder R&Ws, and the founders’ liability for breaches of R&Ws, can be limited, for example by: (a) limiting the categories about which the founders are required to make R&Ws, (b) providing that the R&Ws don’t survive (i.e. can’t be enforced) after a certain date (the typical range for drop-dead dates is 6-24 months after the financing) or (c) capping the founders’ liability (often at an amount equal to the value of the founders’ ownership interest in the company). The appropriate type and scope of the limitations is, however, closely tied to the language of the R&Ws to be negotiated by the lawyers, so if an investor insists on providing for founder R&Ws in the term sheet, entrepreneurs are usually best off simply seeking to add language that those R&Ws will be subject to limitations to be negotiated and included in the final transaction documents. Finally, note that founder R&Ws are almost never appropriate beyond a Series A financing.

Conditions to Closing

Conditions to Closing can protect the investors by requiring the completion of certain tasks and/or the occurrence of certain events between the time the SPA is signed and the actual completion of the transaction (called the “closing,” which is when the investors actually pays for their shares). For instance, the SPA may require that as a condition to the investors’ obligation to close, the founders’ must sign non-competition agreements. In practice, however, conditions to closing often never come into play because the parties do not sign the SPA until all of the would-be conditions have already been satisfied, so entrepreneurs should not worry about this provision in the term sheet unless it includes a condition that is clearly outrageous or unlikely to be satisfied (ex. the Cubs winning the World Series).

Counsel and Expenses

This section serves two purposes: (a) to specify which party’s lawyers will initially draft the transaction documents; and (b) to establish the extent to which the company will pay the investors’ legal fees. First, note that any advantage generally conferred by drafting is significantly diminished where, as in a typical Series A financing, the range of terms is fairly well understood and accepted; so if the investors insist that their counsel prepare the initial drafts of the financing documents, it is generally not worth arguing unless you believe it would be significantly more cost effective to have your lawyers draft the documents. Second, company payment of investor legal fees is also standard in venture financings (though not in earlier stage financings), but there are two ways in which companies often seek to limit their responsibility for such fees: by placing a cap on the dollar amount of the fees and/or by limiting or eliminating the obligation to pay fees if the transaction isn’t completed. Avoiding payment of fees if the transaction doesn’t close is typically more important to a company than capping the fees because absent completion of the financing, the company likely will not have sufficient funds available to pay its own lawyers, much less the investors’ lawyers. Even if the company is not required to pay fees if the transaction doesn’t close, however, a fee cap is still a reasonable request and can serve to discourage over-lawyering.

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The NVCA model term sheet includes a typical Redemption Rights provision entitling investors to require the company to repurchase all of the outstanding shares of stock held by the investors at a certain point in the future (typically five years from the date of a Series A financing, give or take a year or two). The redemption price is typically the original price paid by the investors plus any accrued and unpaid dividends. Exercising Redemption Rights usually requires approval of at least X% of the investors, where the applicable percentage is generally the same as that required to approve actions under the Series A Protective Provisions, though sometimes the presumption is flipped such that redemption is required unless at least X% of the investors waive it (called “mandatory” Redemption Rights).

Redemption Rights are important to investors because they provide an exit in the event the company turns out to be successful enough to survive, but not successful enough to go public or be acquired by the time the investors need liquidity (remember that VC funds have a limited lifespan). In practice, however, Redemption Rights are almost never exercised because even if the company is still around (and has not gone public) when the Redemption Rights mature, it probably does not have sufficient cash available to repurchase the investors’ shares. Investors will often insist that the Charter provide for penalties if the company fails to redeem the investors’ shares when the Redemption Right is exercised – for instance, the conversion ratio may be increased (see our post on Conversion) or the investors may obtain the right to elect a majority of the company’s Board of Directors until all the investors’ shares are redeemed – but even the penalties are sometimes not enforced if the investors believe doing so would only further harm the company’s prospects.  The most important impact of the Redemption Rights (and any associated penalties), therefore, is that it gives the investors leverage to extract concessions from the company. For instance, the investors may use the threat of exercising their Redemption Rights to compel reluctant founders to take the company public or accept an acquisition offer.

Redemption Rights are typical in Series A financings (though not in earlier seed financings) and entrepreneurs should focus on minimizing their impact rather than eliminating them altogether. The impact of Redemption Rights can be reduced by (a) pushing for optional rather than mandatory Redemption Rights, (b) lengthening the time before the rights mature (beware of anything in the term sheet that accelerates maturity in certain circumstances, such as a material change in the company’s business), (c) providing that any payout in a redemption is made over a lengthy period of time (preferably at least 3 years) and (d) ensuring that the consequences of failing to redeem the investors’ shares are not too draconian (for instance, where the investors earn interest on the unpaid amounts until redemption while still also accruing dividends on the unredeemed shares).

Finally, it is worth noting that on occasion the company can negotiate for a Redemption Right of its own, entitling it to call (i.e. require the sale back to the company of) the investors’ shares at a future date, though the redemption price will necessarily be higher than for an investor Redemption Right.

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The Pay-to-Play provision is another term that can have significant economic impact on the investors and the company, and it dovetails nicely from the discussion of Anti-dilution Provisions in our last post because in a down-round financing (where the company’s valuation is lower than in the prior round) it helps mitigate the negative impact of anti-dilution protections. A Pay-to-Play provision provides that any investor failing to fully exercise her “Preemptive Rights” to participate in a future financing will have some or all of her shares of preferred stock converted into common stock or into another class of preferred stock with lesser rights (losing her anti-dilution protection and other rights in the process).

A Pay-to-Play is clearly company-favorable because it penalizes investors who do not pony-up when the company needs more funding, but it also has positive consequences for those investors who do invest in future rounds because it prevents other investors from free-riding. Lead investors are often willing to accept a Pay-to-Play provision (and some even prefer to include one) where there is a syndicate of smaller investors who the lead investor wants to ensure will continue to play ball, particularly if the lead investor has the voting power to block any future financing where it does not want the Pay-to-Play to apply (see our earlier post on Voting Rights and Protective Provisions). Smaller investors, by contrast, are most likely to object to a Pay-to-Play.

Note that although the NVCA’s model term sheet only applies the Pay-to-Play to a “down-round” financing (where the company’s valuation is lower than in the prior round), it can be applied to “up” rounds as well, though investors are usually much more willing to participate when the company’s valuation is on the rise.