Note: This article is the third 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 previous article in this deal terms series we explain how the many concepts covered in a typical term sheet can be grouped into four main categories: Deal Economics; Investor Rights/Protection; Governance, Management & Control; and Exits/Liquidity. Here we are going to take a first look at the individual term sheet provisions themselves and make sense of them by assigning them to the categories where they belong. We’ll do this primarily from the investor perspective. In the later installments of this deal terms series we will go deep into issues associated with each individual provision.
When you think about the basic economics of a round of investment, clearly the total size of the round is a key question as is the valuation of the company; specifically, the valuation the investor agrees to before investing. The higher the valuation, the greater the price per share, and the fewer the number of shares (and percentage of the company) will be acquired for a given investment.
A closely linked issue is the size of the option pool - investors want to invest in a company which has the tools necessary to attract and retain talent (i.e. employee stock options) and the investors want the company to establish that pool prior to their investment so that the creation of the pool does not dilute their ownership and raise the effective valuation of the deal.
This category is also where you are going to find discussion of the liquidation preference or repayment priority associated with the shares on offer. Preferred stockholders are always entitled to repayment before common stockholders, but the liquidation preference provision specifies key details: whether they are entitled to more than 1X their original money, or whether they are entitled to participate with common after they have been paid back their original principal.
Dividends are the final item you sometimes see addressed in the deal economics category. It is highly unusual for a startup to agree to regular cash dividends, but accruing dividends or dividends payable in stock are often seen. Dividends function as a way to keep a time clock on the entrepreneurs to make sure there is some compensation for the passing of time.
The most important provision in this category is the anti-dilution provision. This clause prevents the company from diluting investors by selling stock to someone else for a lower price than the earlier investor paid. The anti-dilution clause states that the investors’ stock will be repriced downward (and they will therefore own more shares for their original investment) if stock is offered to others at a lower price. More on this complex clause later.
The anti-dilution provision is strong medicine, but indirect. The other provisions in this category attempt to control behavior more directly. The first is an assertion of the right to approve any material merger, acquisition or liquidation of the company. 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.
Working in parallel are similar provisions controlling transactions involving the company’s stock. The first reserves the right on behalf of investors to participate in any future financings, so that if things are going well, current investors will have the right to invest more. The second relates to secondary stock transactions - stock sold by a founder rather than by the company itself. This provision pairs two sides of the same coin: a right of first refusal (ROFR) and a co-sale right. What these provisions say is that if a founder is selling any of their stock, first, the investors will have a right of first refusal to buy that stock before it is sold to a third party. However, the investors may not want that stock, because things might not be going well, so, second, the investors pair the ROFR with an alternative right: the right to sell a proportionate amount of their stock in any transaction that the founders are able to pull off. This way the investors are covered no matter what the transaction scenario is.
Governance, Management & Control
This category addresses the reality that investors want to know what’s going on in the company, have a say in critical decisions, and want to protect against founder behavior that could be damaging to the company. Thus, the heart of this category is the right to one or more investor board seats, combined with governance provisions requiring board or committee approval for a list of important operational activities (or even in some cases reserving a veto right for the investor board member).
Paired with this in the Governance category is the clause called information rights. These rights involve a requirement that the company regularly share with investors information on the company’s financial and business condition.
The final concepts in this section have to do with managing the risks associated with relying on key founders to make the company successful. The first goes under the misnomer “founder vesting” - it is a misnomer because -it’s actually a right to claw-back some of the founder’s stock in the event that the founder leaves the company in the early critical years. The right phases out over time, so it is really not vesting of ownership, it is lapsing of restrictions. Related to this is the requirement (in jurisdictions permitting it) that founders as well as other employees sign agreements not to compete with the company and/or poach its employees for a period of time following their departure.
Exits & Liquidity
The final category of clauses relates to the control of exits and liquidity; investors want to make sure they maximize the chances of getting their money back in all possible exit scenarios (positive or negative), even if they have to force such a situation to occur.
The key provision to accomplish that is the drag-along provision, which states that if the investors want to sell the company, and they are backed by a certain amount of stockholder support, a small minority cannot block the transaction, but must go along with the majority looking to sell.
This drag-along provision is sometimes accompanied by redemption rights, which allow investors to demand repayment of the money they invested, plus some agreed-upon return, usually during a window of time a few years out from their initial investment. If things are not going well, such a repayment could cause a cash crunch which would have the effect of forcing the company into a sale or recapitalization.
And finally, it is in the exits and liquidity section where you will see registration rights. Registration rights entitle the investors, as part of an IPO, to have their stock registered with the SEC so that they become fully liquid and tradeable after the IPO.
So that concludes a quick initial overview of the key provisions used in each of the four investor “concern categories.” In the next installments in this deal terms series, we will dig deeper into the concepts and nuances involved in each of these provisions.