Note: This article is the fifth 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.
In the first article in 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 second article in this deal terms series we gave an overview and mapping of all of the key term sheet clauses used by investors to address the concerns in each category. In the third article we dug deeper into the provisions relating to Deal Economics, in the fourth Investor Rights/Protection, and in this article we are going to tackle the Governance, Management and Control category.
Since equity investors have no legal right to be repaid the way a lender does, their only path to repayment is through the success of the company. It is natural for them:
to want to know what’s going on in the company,
to have a say in critical decisions, and
to protect against founder behavior that could be damaging to the company.
There are four principal ways investors implement this: board seats, governance provisions, information rights and founder restrictions.
Investor Board Seats
The investors in a given round will typically negotiate to have a representative join the board either as a full, voting board member, or as an observer with no voting rights. In many cases they will ask for both types of seats. The board seat will typically be combined with governance provisions requiring board or committee approval for a list of important operational activities. These provisions will, in some cases, reserve a veto right for the investor board member on key matters. The investor board seat is usually not term-limited. But, the expectation and custom is that as additional investor directors are added through additional larger rounds of financing, and the board grows unwieldy, that some early investor directors may drop down to being observers, or may roll off the board entirely in the belief that it is best for the company. The right to appoint a board seat is usually part of a section which specifies the structure of the entire board.
Example Termsheet Board Composition Language:
“The Board of Directors shall initially consist of five directors and one observer:
• the Chief Executive Officer of the Company, initially [__________]
• a co-founder of the company, initially [_________]
• one investor representative nominated by [lead investor] and acceptable to the holders of a majority of the Series Seed Stock (the “Series Seed Director”)
• a second investor representative nominated by the holders of Series Seed and acceptable to [lead investor]
• an independent director nominated by the CEO and acceptable to the Series Seed Director.”
Director approval rights will often cover the annual budget and any expenditures not in the budget, any borrowing, or any leases or material contracts. Stockholder approval rights will typically require a significant percentage of stockholders (or a percentage of stockholders in one class) to approve any amendments to the company’s by-laws or charter in a manner adverse to the interests of preferred stockholders, any increases to the number of authorized shares of preferred stock, the authorization of any stock having equal or better rights, the redemption of any stock or payment of any dividends, or the sale, merger or liquidation of the company.
Paired with these board provisions are information rights, which place a requirement that the company regularly share with investors information on the company’s financial and business condition. Although some CEOs will voluntarily update investors as frequently as once a month, most information rights clauses merely obligate the company to provide quarterly management reports with some financial or management dashboard data and to provide detailed annual financials, within a certain period after closing the fiscal year. With very early stage rounds, these financials are often not required to be audited. Later round investors will typically require audits. Investors also reserve the right to inspect the company’s books and records, though this right is afforded them under the law of most states anyway.
Example Termsheet Information Rights Language:
“Series Seed shall have the right to the following information:
• Audited annual financial reports to Investors within 180 days of the end of the fiscal year.
• Monthly unaudited financial summary and “management dashboard” updates on progress and accomplishments against targets in past and next period, in a mutually agreeable form, to Investors by the 15th calendar day of the following month.
• Annual budgets will be supplied to the Board of Directors at a regularly noticed Board meeting, but in no event later than 45 days prior to the beginning of each fiscal year for approval.
• Customary inspection rights.”
To address the risks associated with relying on a small number of key founders to make the company successful, investors will generally insist on a couple important founder-related provisions. The first provision addresses the risk that a key founder will quit her job, leave the company with a huge gap in the team and potentially its know-how, and take a chunk of stock which will dilute the investors and potentially vote against their wishes. To prevent this, investors typically insist on what is called “founder vesting”. The term is actually a misnomer because the stock is already owned by the founder and is therefore not subject to vesting. Instead, these clauses impose a right on the part of the company to “claw-back” (buy back at a low price) some portion of the founder’s stock in the event that she leaves the company in the early critical years. The right may apply to all or merely some of the founder’s stock. It is always designed to phase out over time, so that more and more of the stock returns to being unrestricted each quarter or year. (Therefore it is more accurately thought of as lapsing of restrictions, more than vesting of ownership.)
“Founder vesting” (i) creates a strong financial incentive to remain with the company (ii) avoids a major inequity among the founders who stayed and are working to make their stock valuable (iii) avoids dilution by pulling stock back in, which can be used to pay a hired replacement and (iv) avoids a situation where an angry departed founder controls a large voting block.
Investors will almost universally insist on clauses which forbid departed employees from using the company’s confidential information for any purpose and from attempting to hire away any of its employees for a period of time following their departure. In jurisdictions where it is allowed, investors will often also require that founders as well as other employees sign agreements not to compete with the company in the event that they depart. And depending on the situation, investors will sometimes purchase one or more “key person insurance” policies to hedge the risk of death or illness of an essential founder or employee.
Example Termsheet Founder Vesting Language:
“Common stock owned by any Founder with more than 5% of the outstanding, post-Private Placement equity of the Company will be subject to the right of repurchase by the Company for $0.0001 per share if the Founder’s employment with the Company ceases within the first [four] years following the private placement. Such a right expires over [four] years on a monthly basis after the initial closing of the Private Placement ([2.083%] per month for 48 months).”
Example Termsheet Founder Non-Poaching/Non-Compete Language:
“In addition to standard confidentiality/assignment of inventions agreements, Founders and other key employees to execute agreements [not to compete with the Company or] solicit employees of the Company or its subsidiaries, directly or indirectly, for one year after termination of employment.”
Next in this deal terms series, we’ll look at the clauses in the Exits & Liquidity category.