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.
Earlier 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. Next 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 fourth article we dug deeper into the provisions relating to Deal Economics. Now we are going to tackle the provisions in the Investor Rights/Protection category.
The most important provision in the protection category is the anti-dilution provision. This clause prevents the company from diluting investors by later selling stock to someone else for a lower price than the earlier investor paid. Now, it is true that any issuance of stock is technically going to be dilutive in the simplest sense of the word. This is because it will further divide the pie and lower the original investor’s percentage ownership. But it is not that simple; an issuance at a higher price is merely arithmetic dilution rather than economic dilution. An investor may hold less stock, but (i) that stock has been revalued upwards by the new pricing, and (ii) the company she owns a part of also has more cash on the balance sheet. An issuance at a lower price is the opposite; it is both economically and arithmetically dilutive.
Enter the anti-dilution clause, which has almost magical properties. This clause says that if a round happens at a lower price, the earlier investors purchase price is automatically and retroactively changed, and her original investment is automatically recalculated to a lower price. In effect, she gets more stock for her original investment.
How much is the price changed? Under the terms of the rare, and unreasonably harsh, full-ratchet anti-dilution clause, all of her stock is fully repriced to the new lower price without any regard to the size (i.e. impact) of the offering. Under the terms of the more common and more reasonable “weighted average anti-dilution clause,” the size of the other offering relative to the total capitalization of the company is taken into account in the calculation. As a result, the downward adjustment of her price more closely and proportionally reflects the degree to which she was harmed. Sometimes these calculations will be broad-based. This is where the denominator for the calculation takes in every possible aspect of the company’s capitalization including the option pool or as-converted common numbers after giving effect to various preferences. Sometimes it is more narrowly based and excludes things like the option pool.
Full-ratchet sounds better for the investor, right? Don’t be so sure. Since the economic brunt of anti-dilution clauses are felt by the founders (in the form of reduced ownership percentages), very severe anti-dilution terms can have the effect of nearly completely wiping out the holdings of the founders, thus rendering them absolutely desperate to avoid a down round at any cost. They may resort to taking any inappropriate type of investor they can find. Or if they absolutely cannot avoid a down round, they may no longer be incented to keep working for the company since they will never see a real return. So then to fix that, the investors have to grant them options to keep carrying on. The net result is about as much dilution as they would have experienced with a more reasonable clause in the first place, but with a lot more work, and hard feelings, and without the flexibility of a more moderate clause.
Example Termsheet Anti-Dilution Language (broad-based):
“Weighted average anti-dilution, calculated as follows: in the event that the Company issues additional securities at a purchase price less than the then-current Series Seed Stock conversion price, such conversion price shall be adjusted in accordance with the following formula:
CP2 = CP1 * (A+B) / (A+C)
CP2 = New Series Seed Conversion Price
CP1 = Series Seed Conversion Price in effect immediately prior to new issue
A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding Common Stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)
B = Aggregate consideration received by the Company with respect to the new issue divided by CP1
C = Number of shares of stock issued in the subject transaction.”
The anti-dilution provision is very strong medicine, but it operates automatically, indirectly, and after-the-fact. The other provisions in this Investor Rights/Protection category attempt to control founder behavior more directly and before the fact. The first is an assertion of the right (by the board, or a class of stock, or that class’ director) to approve any change of control or liquidation of the company. These clauses typically require that any merger resulting in an effective change of control of the company, any material acquisition or any liquidation of the company be approved in advance by the shareholders. Because the transaction cannot be done without investor permission, the investors know they will be asked to approve a transaction in advance and can be sure they will not be surprised by a transaction after the fact.
Other control provisions will require approval of:
material (i.e. significant) contracts or leases;
annual spending budgets and exceptions;
changes to the management team;
payment of dividends or redemptions of stock;
assumption of any debt obligations;
changes to the capitalization or authorizations of new classes of stock; or
changes to the charter or bylaws.
In each case the idea being that investors will be at the table and have a say in any important decisions or any decisions which will affect their economic rights directly.
Example Termsheet Control Provisions Language:
“So long as at least 10% of shares of the Series Seed Stock sold in this Private Placement are outstanding, in addition to any other vote or approval required under the Company’s Certificate of Incorporation or By-laws, the Company will not, without the consent of the holders of at least a majority of the Series Seed Stock, either directly or indirectly by amendment, merger, consolidation, or otherwise: [list of prohibited activities; see bullets above for examples].”
Working in parallel are similar provisions controlling transactions not involving the company itself, but involving the company’s stock. The first reserves the right on behalf of investors to participate in any future financings. If things are going well, current investors will have the right to invest more. Sometimes this right is open-ended. Other times each investor’s right is capped at their pro-rata ownership in the company to allow them to maintain their percentage ownership, but no more. Thus, this clause is often referred to as “pro-rata rights.”
Pro-rata rights can be extremely valuable rights to have in super-hot companies, so they can come with some strong provisos. In response to shenanigans where people try to profit unduly off their pro-rata rights by selling them to outsiders looking to gain access to hot deals that would otherwise be closed off, it is increasingly common to see language to ensure that the holder of pro-rata rights does not try to transfer those rights to third parties directly or indirectly through investment vehicles. Pro-rata rights may also be narrowed by calculating them without including any unexercised options or warrants a stockholder owns. Pro-rata rights for earlier shareholders may also be subject to extinguishment if they are not used each round, or they may simply be negotiated away entirely as a condition of later financing rounds.
Example Termsheet Pro-Rata Rights Language:
“Investors will have a right to maintain their pro rata interest in the Company on a fully diluted basis in any subsequent offering of securities. In any subsequent rounds of financing where the round is limited to major investors, the investments of all members [in this investor group] shall be aggregated together for the purposes of calculating whether group members count as a major investor.”
ROFR & Co-Sale Rights
After pro-rata rights to buy more stock issued directly by the company, the second collection of protection rights in this category relates to secondary stock transactions – stock sold by a founder (or major stockholder) rather than by the company itself. This provision pairs two sides of the same coin: a right of first refusal (ROFR) on one side and a co-sale right on the other. Under the terms of these provisions, if a founder or major stockholder is legally permitted to sell any of her stock, first, the investors will have a right of first refusal to buy that stock before it can be sold to a third party. These ROFRs also generally say that if the investors don’t want the stock, the company has a right to exercise the ROFR and buy it. This allows them to increase their position and keep unknown third parties out.
However, the investors may not want that stock, because things might not be going as well as hoped for the company. So, the investors pair the ROFR with an alternative right on the flip side of the coin: investors reserve the right to sell a proportionate amount of their stock as part of any transaction that the founders are able to arrange. This way the investors are covered if things are going well because they can acquire more stock and prevent new investors coming in. And, they are covered if things are going poorly because they can make sure that nobody gets liquidity before them - they get to sell a proportionate amount of their stock to any buyer who can be found.
Example Termsheet ROFR & Co-Sale Rights Language:
“The Company will have a right of first refusal to purchase a proportional part of shares lawfully offered for sale by founders (“Founders”), management of the Company or other shareholders, if a shareholder wishes to sell stock before an initial public offering. If Investors so choose, Investors shall have the right to sell a proportional part of their holdings along with Founders or other shareholders before an initial public offering.”
Next in this deal terms series, we’ll look at the clauses in the Governance, Management & Control category.