* * * * * * * * * *

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)

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

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.

* * * * * * * * * *

In this post we look at when an investor’s preferred stock may or must convert to common stock, and how the conversion ratio may be adjusted in certain circumstances.

Optional Conversion and Mandatory Conversion

Preferred stock typically converts to common stock either:

(a)  at the option of the stockholder (“Optional Conversion”); or

(b)  automatically (i) at the time of the company’s initial public offering (usually subject to the public offering share price being at least X times the per share price paid by the investors) or (ii) if at least X% of the investors agree to convert all preferred stock held by all investors (both (i) and (ii) being “Mandatory Conversion”).

The conversion provisions are important to the investors – who do not want to be forced to convert before it is most advantageous to them – but of little consequence to the company and generally are not the subject of much negotiation, but there are two points worth mentioning. First, for a Mandatory Conversion upon an IPO the threshold public offering price, if there is one, is sometimes a topic of disagreement (typically 3X-5X the original purchase with a higher threshold giving the investors more control over the timing and terms of an IPO), but it is important to keep in mind that investor approval will always be required for an IPO regardless of the threshold (either explicitly or because of the amendments to the corporate charter that will be required before the company goes public). Second, the other issue of some concern to the company is what percentage of investors can compel all investors to convert to common. The company prefers that the percentage required is not so high as to make obtaining approval burdensome. Typically, the percentage required to force conversion is the same as that required to approve matters subject to the investors’ Protective Provisions.

Anti-dilution Provisions

While the timing of conversion is not a very hot topic in negotiating a term sheet, the anti-dilution provision can be if the investors decide to play hardball. The ratio at which preferred stock converts to common stock is initially set at 1:1, but the ratio is typically subject to adjustment in a variety of circumstances. Certain adjustments merely compensate the investor for changes in the company’s capital structure – for instance those caused by a stock split, reverse stock split or stock dividend – without altering the economics of the preferred stock. Other adjustments, however, are intended to protect the investor against dilution caused when the company issues shares at an effective price-per-share lower than the price-per-share paid by the investors (a future financing at a lower price is called a “down-round”). These adjustments are referred to as “price-based” anti-dilution protection.

Price-based anti-dilution protection operates by increasing the number of shares of common stock into which a share of preferred stock converts (i.e. it increases the conversion ratio) and has the effect of causing the company’s common stockholders (who do not have anti-dilution protection) to be diluted twice: once by the issuance of the shares to the new stockholders and a second time as a result of the adjustment to the conversion price of the preferred stock. The anti-dilution protection provisions can, therefore, have a significant economic impact. There are two types of price-based anti-dilution protection typically found in angel and VC financings: full ratchet (very investor favorable) and weighted average (less investor favorable). Note that the third alternative – no price-based anti-dilution protection (company favorable) – is often seen in pre-VC financings, but almost never in VC deals.

Full ratchet anti-dilution adjusts the conversion price of outstanding preferred stock to that of the stock being sold in the new offering, thereby putting the existing investors in the same position they would have been in if they had purchased their shares at the new, lower price per share. This type of anti-dilution protection is extremely favorable to the investor and should be resisted by the company in favor of weighted average anti-dilution. If you receive a term sheet with a full-ratchet anti-dilution provision, it should be a red flag that the rest of the terms may be heavily investor favorable. Fortunately, most investors do not seek to impose full ratchet anti-dilution.

Weighted average anti-dilution reduces the conversion price of outstanding preferred stock in a proportionate manner taking into account both the number of shares being issued and the price per share. In this way the conversion ratio is adjusted to somewhere between the original ratio and the ratio that would apply after full ratchet anti-dilution protection. Weighted average anti-dilution may be either “broad” or “narrow” depending on whether certain derivative securities (such as options and warrants) are included in the calculation of the company’s existing capital, with a “broad” formula resulting in less dilution adjustment (i.e., more company favorable) than a “narrow” formula. The NVCA term sheet presents a typical broad based anti-dilution formula: the number of shares outstanding for purposes of the formula (the “A” variable in the NVCA term sheet) includes not just common stock actually outstanding and common stock issuable on conversion of outstanding preferred stock, but also common stock issuable upon exercise of outstanding options. The formula could be made broader by, for instance, including all shares of common stock that may be issued out of the company’s option pool (not just those covering option already granted). The formula could be made narrower by, for instance, only including common stock issuable upon exercise of outstanding options that have vested. In negotiating the term sheet, remember that while the breadth of a weighted average anti-dilution formula does matter, it is much less important than the choice between weighted average and full ratchet anti-dilution.

Regardless of the type of anti-dilution protection, the Charter typically includes a number of exceptions allowing a company to issue additional shares in specified circumstances without any adjustment to the conversion price of the outstanding preferred stock.  The NVCA term sheet includes standard exceptions for (a) shares issued upon conversion of convertible securities (conversion does not result in further dilution), (b) stock splits, dividends and the like pertaining to the company’s common stock (pro rata adjustments for these events are provided for in the Optional and Mandatory Conversion provisions), (c) equity incentives for employees and others (i.e. shares issued out of the company’s option pool) and (d) shares issued in certain types of transactions. It is also common, and generally good for the company, to include a provision allowing X% of the investors to waive anti-dilution protection on behalf of all investors (again, the percentage required is typically the same as for approving matters subject to the protective provisions or compelling a mandatory conversion).

Of course, the best way to avoid the double-dilution created by anti-dilution provisions is to keep growing the value of your company so the stock price keeps rising. Herein lies an important lesson about negotiating valuation in a financing: a higher valuation increases the probability of a future down-round financing, so it may be better to accept a lower valuation that you are confident you can improve before you’ll next need to raise capital.

* * * * * * * * * *

Voting Rights and Protective Provisions define when investors vote with the other stockholders and when they have the right to a separate vote. Having separate voting rights in certain circumstances is important to investors because it prevents them from being outvoted by other stockholders with competing interests. The circumstances in which investors have the right to a separate vote will typically include at least (a) significant corporate events (ex. a sale of the company) and (b) actions that could adversely affect the rights of the investors (ex. amending the corporate Charter or changing the composition of the Board of Directors2). Sometimes more company-specific protective provisions will be included, such as the sale of a specific division of the company’s business. Note that the scope of the protective provisions should be commensurate with the size of the investment, so angel investors should not necessarily have the right to a separate vote on actions that typically require a separate vote by a VC investor, such as taking on debt or changing the size of the Board of Directors.

Most of the time you should not expend any energy fretting over the protective provisions, but do watch out for two things. First, make sure the percentage required to approve any action subject to the protective provisions is not so high as to make obtaining approval burdensome. Typically the threshold should be high enough so that approval of the lead investor(s) is always necessary, but not so high that a minor investor has a block. This becomes ever more important as the number of investors grows. Second, be sure the protective provisions don’t unduly inhibit the company’s freedom of action by requiring stockholder approval for routine matters. The Protective Provisions should protect the investors, not give them an additional means of controlling the company. If the investors are seeking a stockholder vote for day-to-day decisions, suggest instead that such decisions be made by the Board including the director(s) appointed by the investors. For a discussion of matters that typically require approval of the investors’ director(s), see this post.

* * * * * * * * * *

We continue our discussion of the Charter provisions with the liquidation preference, which is the most important economic term in the term sheet after the valuation because it establishes the relative rights of the investors and the common stockholders with respect to assets available for distribution when the company winds up its business. While the term “liquidation preference” suggests the provision applies only if the company goes belly-up, in reality there is likely to be little to fight over if this happens. The real impact of the liquidation preference comes into play when there is a “Deemed Liquidation Event,” such as an acquisition by another company, which generates cash or other assets (ex. stock of the acquiring company) to be divided among the stockholders.

The model term sheet includes three alternative provisions for the liquidation preference. They are (1) non-participating preferred stock (most company favorable), (2) participating preferred stock (most investor favorable) and (3) participating preferred stock with a cap. In all three alternatives, preferred stockholders are entitled to receive a “preference” – typically some multiple of their original investment (1x-3x) plus any accrued and unpaid dividends – before any payment is made to the common stockholders. “Participating” preferred stockholders are also entitled, after payment of their preference amount, to share with the common stockholders, on an as-converted-to-common basis, in the distribution of any remaining proceeds (this is called “double dipping”). If there is a right to participate with the common, the right may be capped at a multiple of the preferred stockholders original investment. It is important to note that investors will always have the option to convert their preferred stock to common stock if it would result in a larger payout, which could be the case with non-participating preferred and participating preferred with a cap if the amount available for distribution exceeds the preference amount or the cap, as applicable. Thus, investors will never receive less in liquidation than they would have if they simply owned common stock.

As with dividends, the economic impact of the preference and the participation rights depends on the company’s eventual fate. When evaluating a term sheet, it’s a good idea to do some quick math to determine what the different groups of stockholders (common and preferred) would take home if the company were sold for different values (for this exercise, assume the entire proceeds of the sale go to the stockholders). Then see how changing the proposed preference and participation rights impacts these results.

Entrepreneurs should note that investors may find it counterproductive to impose a very investor-favorable liquidation preference on a company for two reasons. First, it reduces the founders’ economic incentive to build the business. Second, later investors will likely want similar terms, which would leave the earlier investors negatively impacted by the same terms they imposed on the company. Don’t be afraid to raise these points (particularly the first one) in negotiating the liquidation preference, but also be prepared to make tradeoffs: if your potential investors insist on having a participation right, focus on pushing down the liquidation preference and adding a cap on participation; if the potential investors want a big liquidation preference (say, 5x), say no to participation.

* * * * * * * * * *

The operative provisions in the NVCA’s model term sheet are grouped according to the NVCA model financing document in which they are found, beginning with the Charter, which defines the rights and preferences of the shares being purchased in the financing. The next several posts in this series deal with the terms in Charter.

Dividends

Dividend provisions are often overlooked by entrepreneurs, but can have a significant effect on the economics of a financing. The model term sheet includes two alternative dividend provisions, one providing that dividends will be paid only when also paid to the common stock (company favorable), and the other providing for “accruing” dividends on the preferred stock (investor favorable). In the second alternative, the more company favorable formulation provides that the preferred stockholders have a right to receive a dividend “only when and if declared by the Board.” If this language is not included, the right to receive dividends is not contingent on Board approval and unpaid dividends simply remain as obligations of the company to the investors.

It is important to note that in practice even accruing dividends not requiring Board approval are never (in this blogger’s experience) actually paid out in cash unless and until the company liquidates (and then only if there’s enough cash available, which there often is not); rather, typically they eventually convert to common stock when the underlying preferred stock converts (we’ll discuss conversion in a later post). Like interest on a debt, accruing dividends may “compound” periodically, meaning dividends accrue on dividends. The more frequently dividends compound, the faster they accrue.

The economic impact of dividends is most significant to the entrepreneur (and to the investor) if the company is eventually sold for a modest amount. If a company is wildly successful, the value of the accrued dividends relative to the rest of the company will be trivial, and if a company fails there won’t be any money to pay the dividend on liquidation. Between these extremes, however, dividends can take a significant bite out of an entrepreneur’s payout when a company is sold. Since few companies become wildly successful, entrepreneurs should try to eliminate accruing dividends, or at least reduce their effect by (a) keeping the dividend rate low (5-10% is the standard range in normal economic times), (b) insisting that the dividends do not compound and/or (c) providing that the dividends do not begin to accrue until some time in the future (typically 1-3 years from the date of the financing).

* * * * * * * * * *

Introductory Paragraph

The introductory paragraph in the NVCA’s model term sheet is important because it makes clear that, for the most part, the term sheet does not create any legally binding obligations. Entrepreneurs must recognize that a term sheet is an agreement to try to reach an agreement, and therefore only a steppingstone (albeit an important one) on the path to financing. However, while the terms of an eventual financing may vary from those outlined in the term sheet, the term sheet is the first place lawyers on both sides will look to when preparing the actual financing documents. Any deviation from the term sheet must be justified; for instance, by a revelation about the company discovered during the investors’ due diligence.

Note that the introductory paragraph excludes the “No Shop/Confidentiality” and “Counsel and Expenses” provisions from the non-binding caveat.

Offering Terms

The “Offering Terms” section of the NVCA’s model term sheet summarizes the key economic provisions of the financing. This section is fairly self-explanatory, so we will limit our discussion to three points.

First, sometimes the investment will be divided into tranches spread across two or more Closing Dates, and later tranches may be subject to the company achieving certain milestones. If milestones are included, it is important that they be clearly defined and, if achievement or failure of a milestone cannot be objectively determined (i.e. is open to interpretation), that the mechanism for determining if/when the milestone is achieved also be clearly defined. Typically, determining if a milestone is achieved will fall to the investors, so it is in the company’s best interest to ensure the milestones are sufficiently well defined to minimize the investors’ discretion.

Second, the employee option pool is typically set at 15-20% of a company’s fully-diluted post-money capitalization at the time of a Series A financing, though it is sometimes set as low as 10% or as high as 25%. The principal factor in determining the size of the pool should be the need to incentivize current and future employees, so a company with a strong core team already in place should not need as large a pool as a company that expects to hire a new CEO in the near future. If the pool seems large, your investors may have a different expectation about the future growth of the company and you should raise your concerns with your invstors. The goal should be to establish a pool that is the right size to meet the company’s needs for the foreseeable future.

Third, it is also important to note how the pre- and post-money valuations of the company are impacted by the employee option pool. The NVCA model term sheet treats the option pool as part of the post-money valuation, but investors will sometimes include the option pool (or a proposed increase in an existing option pool) in the company’s pre-money valuation. This results in an illusory increase in the pre-money valuation, which the guys at Venture Hacks have dubbed the “Option Pool Shuffle.” There is nothing inherently wrong with including an option pool in the pre-money valuation, but it is important for entrepreneurs to understand that doing so has real economic impact. To illustrate, consider a pre-money valuation of $5 million that does not include an option pool and a pre-money valuation of $6 million that includes an option pool equal to 20% of the company’s fully-diluted capital. In the latter case, the option pool accounts for $1.2 million of the valuation, making the effective pre-money valuation only $4.8 million. Check out the Venture Hacks article for a more in-depth discussion of the impacts of the Option Pool Shuffle.

Although the specific language in early-stage financing documents can vary considerably depending on, among other things, the investor (angel, VC or someone else) and the company’s stage of development, the universe of possible terms is actually fairly well established. It is therefore possible, with an understanding of these basic terms, to form your own conclusions about a term sheet. For these posts we will use the model Term Sheet available from the National Venture Capital Association (NVCA) website as our guide because it covers most of the terms you would expect to see in a term sheet for an early stage equity financing (for a discussion of convertible debt, see this post), and it also includes some helpful annotations. We encourage you to download the NVCA Term Sheet here and follow along as we go through each section.

As an aside, there has been a lot of chatter recently about the sample early-stage financing documents put out by Fenwick & West, TechStars (by Cooley), Y Combinator (by Wilson Sonsini) and the Founders Institute (also by Wilson Sonsini). We do not want to rehash the pros and cons of form documents or go into the specifics of these four sets of models (for that we recommend you read the analysis already put out by Yokum Taku of Wilson Sonsini and Ryan Roberts, aka The Startup Lawyer, who together have said all we would care to say on those topics).