Completing your initial equity financing with outside investors is likely to be one of your first experiences in financing your company. Typically, these financings are done with a venture capital firm (“VC”) or with angel investors, and the company sells Series A Preferred Stock. In most cases, a company will send its business plan to potential investors, after which one or more of those investors will show interest in the company, spend time with the founders to understand their business and strategy, and perform some due diligence on the technology involved. During this process, the investors will determine their comfort level with the company’s management team. If multiple investors are interested, the investors will likely select one VC or angel to be the lead investor. The lead investor will then negotiate the transaction documents on behalf of all other investors.
If after conducting their due diligence the investors wish to make an investment, they will present the company with a term sheet outlining the basic parameters of the transaction. The term sheet will be negotiated and signed, then final documentation will be prepared for a closing and funding of the transaction. As part of the process, the VC’s attorneys will want to do legal due diligence on the company. Among other matters, they will confirm that stock reflected on the capitalization table has been properly authorized and issued, that the company owns the intellectual property necessary to the operation of the business, and that the company’s material contracts are in order.
Some of the primary negotiating points in the Series A Preferred Stock financing are as follows:
A proper valuation is difficult to ascertain; in truth, there is no way to determine a start-up company’s value with any real precision. A company may wish to seek non-legal assistance in determining its valuation in order to be able to negotiate this point more effectively.
Amount to be Invested
The investors will determine the amount that they will invest in the company. However, this amount is often driven by the company’s planned use of proceeds and the valuation enhancement it intends to achieve. Based on this amount, the company valuation, and the number of shares outstanding, the parties will set a purchase price per share and the number of shares of Series A Preferred Stock that they will acquire.
The term sheet may or may not provide that dividends will accumulate and be paid on the Series A Preferred Stock. It may also provide that dividends may be paid in cash or in stock. Additionally, it will typically provide that dividends will not be paid on the common stock without the consent of the holders of the preferred stock. Dividends may be cumulative or non-cumulative. (Cumulative dividends are due in following years if the company does not have surplus from which to pay them in a particular year. Non-cumulative dividends are never required to be paid if the company does not have sufficient surplus to pay them in the year they accrue.)
The term sheet will almost always provide that if the company is liquidated, after all debts have been paid, the holders of the Series A Preferred Stock will get the amount that they invested back (together with accrued but unpaid dividends, if the investors have cumulative dividends) before any payments are made to the holders of the common stock. It may also provide that the holders of common stock are then entitled to a certain amount per share. Once these amounts have been paid, any remaining amounts are either paid to the holders of the preferred stock and the common stock (in the case of “participating” preferred stock), or exclusively to the holders of the common stock (in the case of “nonparticipating” preferred stocks).
The term sheet will address the conversion rights of the Series A Preferred Stock. While Series A Preferred Stock has a preferential position with respect to shares of common stock, there are certain instances where the investors will want to convert their shares to common stock (e.g., in connection with an initial public offering (“IPO”)). In this regard, the Series A Preferred Stock is convertible initially on a one-to-one basis, subject to anti-dilution protection. Typically, the investors will have the right to convert shares of Series A Preferred Stock at any time, and the Series A Preferred Stock will automatically convert immediately prior to an IPO or the vote of a specified percentage of the Series A Preferred Stock.
The investors will want assurance that their interest in the company will not be subject to unreasonable dilution. In particular, they will want protection if the company issues shares at a lower price per share than the investors are paying. These protective provisions are usually built into the rate at which the preferred stock is convertible into common stock. Typically the preferred stock is initially convertible into common stock on a one-to-one basis. If stock is later issued at a lower price per share than the investors have paid, the conversion ratio shifts in favor of the investors. These provisions are called “weighted average ratchet” provisions. Weighted average ratchet provisions may be “narrow-based,” which is more favorable to the investors, or “broad-based,” which is more favorable to the company. The difference between the two lies in what shares are included in the formula that determines the investor’s conversion ratio adjustment. If a broader base of shares is included, the adjustment in favor of the investor will typically be a smaller one. The least favorable type of ratchet provision to the founders is the “absolute” or “full ratchet” (as opposed to the weighted average ratchet), which provides for an automatic increase in the conversion ratio as if the investors had purchased all of their shares for the same price per share as the lower price at which the shares are currently being offered.
The term sheet may provide that if the company has not had an IPO or been sold within a certain number of years, the investor can require the company to redeem the preferred stock for an amount equal to the amount paid for the stock, plus dividends if the term sheet provides for cumulative dividends. Payments are typically made over a number of years.
The term sheet will almost always provide that the shares received by the investor will be registered by the company with the Securities and Exchange Commission (“SEC”). This is necessary because shares received in a VC transaction are “restricted shares.” The investor cannot sell restricted shares on the open market, even after the company’s IPO, unless they are registered or an exemption from registration is available. The registration rights may be “demand” and/or “piggyback” rights. Demand registration rights allow investors to require a registration of their shares, whether or not the company is already public or engaged in a registration. Piggyback (also sometimes called “incidental”) registration rights allow investors to require that they be included in a registration that the company is conducting. Investors will typically get both demand and piggyback registration rights, but the number of registrations they are entitled to is often the subject of negotiation.
Right of First Refusal; Preemptive Rights
The term sheet often gives the investors the right to invest in the company’s future financings in preference to other investors the company may want to bring in as shareholders. The company will want to take care that the right of first refusal does not apply to strategic investors. However, the investor will want the right (called a “preemptive right”), if shares are issued in a strategic investment, to acquire the number of shares necessary to maintain its percentage ownership in the company, at the same price as the strategic investor is paying. Naturally, this will often lead to valuation issues, and the documents will address the method of valuing the price that a strategic investor has paid for its shares.
Voting Rights of Series A Preferred
The term sheet will provide the voting rights of the Series A Preferred Stock. Typically, the Series A Preferred Stock will carry a number of votes equal to the number of shares of common stock issuable on conversion, and the Series A Preferred Stock and common stock will vote together as a class (except in certain instances). At least initially, the Series A Preferred Stock will vote on a one-for-one basis with the holders of common stock.
In many instances, the vote or consent of the holders of the Series A Preferred Stock is required before the company may take certain actions, including a sale of the company’s assets, a merger or consolidation, a change in the terms of the company’s charter or bylaws, and a change in the terms of the Series A Preferred Stock. These protective provisions permit the holders of Series A Preferred Stock to vote as a class to approve any extraordinary corporate action that might harm their investment.
The term sheet often gives the investors co-sale rights. That is, if a founder or other significant shareholder is selling his shares in the company, the investors will have the right to participate in that sale on the same terms.
The term sheet typically provides investors with drag-along rights. Drag-along rights are designed to protect the majority shareholder or shareholders: specifically, if a specified percentage of shareholders vote to effect a change of control in the company, the remaining shareholders may be compelled to join in the deal. The compelled shareholders must generally be provided the same deal terms (price, conditions, etc.) as the majority shareholders. Drag-along rights may also carry further stipulations, including limits on disproportionate indemnification rights against particular shareholders.
Rights Relating to the Founders
The term sheet will sometimes require that the founders agree to have their shares vest over some period of time, and that the founders agree to sign non-competition agreements which will extend for one to two years following the term of their employment with the company.
The investors may want at least one seat on the board of directors and may want to add several independent directors to the board. They will require board meetings be held either monthly or quarterly. They may also require board control or the right to put the company up for sale if the company does not meet certain predetermined goals. The investors will want to approve major transactions, increases in executive salaries, annual budgets, and other matters relating to the business of the company.
The investors will want to receive monthly or quarterly financial statements, an executive summary signed by the company’s CEO relating to the business of the company, and visitation and inspection rights.
Payment of Fees
The term sheet generally requires that the company pay the investor’s legal fees and other expenses. If the term sheet so requires, the company should be able to negotiate a cap on this amount.
The term sheet will usually require that the company agree not to discuss alternative investments with any other investor for a period of roughly 30 to 60 days after the term sheet is signed. Following the signing of the term sheet, attorneys will draft a full set of documents to be negotiated between the company and the VC and their counsel. Funding occurs when this set of documents is finalized and signed.