Note: This article is the last in an ongoing series on Early-Stage Deal Terms. To learn more about navigating term sheets and investment documents, download this free eBook today Understanding Early-Stage Deal Terms or purchase our books at Amazon.com.
At the beginning of this deal terms series, we observed that the concepts covered in a typical term sheet can be grouped into four main categories of investor concerns: Deal Economics; Investor Rights/Protection; Governance, Management & Control; and Exits/Liquidity. In the next articles we gave an overview and mapping of all of the key term sheet clauses used by investors to address the concerns in each category and we dug deeper into the provisions relating to Deal Economics, Investor Rights/Protection and Governance, Management and Control. In this last article we are going to finish off the series by looking at the provisions relating to Exits and Liquidity.
Sometimes more euphemistically called “bring-along rights,” these clauses serve a very important purpose in marginal exit scenarios. These clauses require that when a transaction amounting to a change of control of the company is proposed, and a majority of the preferred stock and a majority of the common stock are in favor of it, all stockholders have to vote in favor of it. The purpose of this should be pretty obvious: not allowing a minority of stockholders (for example, a sentimental founder, or a more optimistic and aggressive roll-the-dice investor) to block a transaction desired by a majority.
In clear-cut grand-slam scenarios this type of coercion isn’t necessary. But how often do those scenarios occur? In most cases, it is much less clear whether the wiser course is to press ahead or whether to throw in the towel and sell. If you allowed group indecision to reign, nothing would ever get decided, and mediocre windows of opportunity would close, typically leaving even worse ones to follow. So even if it leads to results that are less than investors hoped, biasing things with a hair trigger toward liquidity ensures that at least investors don’t waffle and end up with nothing. In effect, drag along clauses ensure that investors will make what are sometimes called type 2 errors (failing to invest in something great or in this case, selling too early) rather than the far more painful type 1 error (investing in something worthless, or in this case failing to sell something worthless when you had the chance.)
Example Termsheet Drag-Along Language:
“With respect to any transaction resulting in a “Change in Control” of the Company which transaction is approved by (i) holders of a majority of the holders of Series Seed Stock and (ii) the holders of a majority of the Series Seed Stock and the Common Stock, voting together as a single class, all stockholders will agree to (a) vote all shares to approve such transaction, and (b) execute such other documentation and otherwise participate as is necessary to effectuate the transaction in such transaction. For purposes of these Drag Along Rights, the term “Change in Control” shall mean any sale of all or substantially all of the assets of the Company, or any sale, exchange, merger, conveyance or other disposition of securities of the Company in which more than 50% of the voting power of the Company is transferred.”
Registration rights address what happens with an investor’s stock in the event of an IPO. IPOs are an expensive process that accomplish two fundamentally separate things: (i) registering the company itself as a public reporting company under the rules established by the Securities Exchange Act of 1934 and (ii) registering the stock actually being offered to the public under the rules of the Securities Act of 1933 so that the stock is freely tradeable without restriction. All investors who make it to the IPO promised land obviously want their stock to be registered and freely tradeable (so that it is not subject to holding periods and volume limitations), but the greater the number of different blocks of stock that need to be registered, the more complicated and expensive the offering is. This is especially true with secondary shares being offered by investors rather than primary shares being offered directly by the company.
Back in the good old days (i.e. prior to about 2002), registration rights were a very important part of an early stage investment term sheet. A lot has changed since then; IPOs are a much less common method of exit for a number of reasons. So to most practitioners it seems silly to negotiate rights in a very early round that would only be used many years and many rounds of financing later, if they are even used at all. As a result, if registration rights are even included in an angel term sheet these days, they are watered down to the point of saying “we will get customary piggy-back rights” (i.e. registered secondary stock on top of the primary stock) or “if later preferred stock investors get them, we will get them on the same terms too.” Footnote: if the new Reg A+ rules really catch on in a broad way and Reg A+ mini-IPOs become a common phenomenon, some new variation on registration rights might return to being a hotter topic in angel term sheets.
Example Termsheet Registration Rights Language (pragmatic):
“The Company will covenant not to grant Registration Rights to any person or entity unless such rights also include the Series Seed Stock on a pari passu basis.”
Another term you don’t see as often in pure angel deals these days is the redemption rights clause. This clause specifies that investors have a right to demand redemption of their stock during a specific window of time. These can be a very important tool for structured VC funds who are on a ten or twelve year time clock. This is because they allow the VC to get their money back and return it to their limited partners during the planned life of the fund. Of course, the way they do that in many cases is like a huge time bomb that creates a liquidity crisis for a fast-growing company. Management is forced to either sell the company in a non-optimized way, or stick remaining shareholders with a hasty and sub-optimal financing.
When angels do see these rights, it is usually in hybrid angel/VC rounds and they typically specify that the company will pay the redeeming party the greater of (i) fair market value or (ii) the original purchase price plus an interest rate in the 5-10% range. Redemption rights clauses can be softened in a number of ways; the opening of the window can be conditioned on certain events or set to start five or more years out, they can specify that the company has several years to get the redemption done, or that the company only has to redeem a certain fraction of the stock each year for several years.
Regardless of how they are set up, they are generally a clause that angels want to try and stay away from if they can - they do catalyze actions, but not always good ones, and often to the benefit of some stockholders over others.
Example Termsheet Redemption Rights Language:
“Unless prohibited by the law governing distributions to stockholders, the Series Seed shall be redeemable at the option of holders of at least % of the Series Seed commencing any time after the [fifth] anniversary of the Closing, at a price equal to the Original Purchase Price plus all accrued but unpaid dividends. Redemption shall occur in [three] equal annual portions. Upon a redemption request from the holders of the required percentage of the Series Seed, all Series Seed shares shall be redeemed.”
This article concludes our deal terms series in which we talked about the main categories of investor concerns, gave an overview and mapping of all of the key term sheet clauses used by investors to address the concerns in each category, and then went back and went through each of the clauses in detail. If you have enjoyed it and want more, be sure to check out our Angel 101 and Angel 201 series.