by David Niebauer
Founders who get their first term sheet proposal are sometimes mystified by the various terms and conditions proposed by their prospective investor. This article assumes a general familiarity with the type of transaction involved and will put attention on the various provisions contained in the typical term sheet. Some provisions are more negotiable, or more easily argued for, than others. We will highlight these points, using the very useful open source legal document model term sheet prepared at the direction of the National Venture Capital Association.
A good starting point is to compare your term sheet with the NVCA’s model. Click here to view the NVCA’s model, then follow along with my comments. My headings track the headings of the NVCA model for easy reference.
OFFERING TERMS
Not much to say here. This section points to one of the most important negotiations, which is price. Oddly, though, if your company is well positioned in a growing field, price will be largely determined by the amount of capital you can realistically use in order to hit major milestone(s). This will determine a) the amount of your raise and b) the type of investor you will need to solicit. From here, it is not uncommon for Founders to negotiate the sale of 20%-30% of the company for the amount raised, and your pre- and post- money valuations flow from there.
CHARTER
Investors like Delaware corporations. The Delaware General Corporation Law (the “DGCL”) is management-friendly and the Delaware courts hear more corporate issues by far than any other jurisdiction. Keep this in mind when you start your company. LLCs are fine for some businesses, but not if you plan to have investors. Avoid Nevada unless you have a really good reason. There are no franchise taxes in Nevada. Other than that, I don’t see any advantage.
Dividends
Not a big negotiation point. Early stage companies almost never pay them. Dividends are a way for your investor to attempt to nickel and dime you, so resist putting an interest type percentage (e.g. “8% per annum, compounded”). The counter argument to a dividend rate request is that the investor is going to make its return on the liquidity event, not from a few points of interest on the money. If all else fails, allow non-cumulative dividends – it’s almost the same as no dividend at all.
Liquidation Preferences
This is probably the most important negotiation point a founder of a company has – and it should be decided up front: will the investor be acquiring “participating” or “non-participating” Preferred stock. “Participating” means that, on the sale of the company, the investor gets its money back, plus interest (if agreed to) and then participates with the Common for the remainder of the sale proceeds. In a “non-participating” scenario, the investor gets to choose – either get its money back plus negotiated interest or convert to Common. Participating Preferred is pretty common and has become the norm, in my experience, but it always strikes me as double dipping. When an investor negotiates an equity position, you should project that into the future to a likely sale or other liquidity event. You will want to know what percentage of the sales price will go to the investor. With participating Preferred, this calculation is skewed. You have to take the investor’s money off the top – the investor is basically getting a greater percentage of the company than its stock position warrants.
A cap is another way to go. The argument here is “don’t get too greedy”. At the end of the day, we will be partners, so let’s structure a deal that reflects that partnership without the financial imbalance.
Voting Rights
Uncontroversial. Yes, the Preferred will vote with the Common and yes Preferred get special preferential voting by statute. You should want a representative of the investor(s) on your Board – this is sometimes more valuable than the money. Keep your Board small and manageable.
Protective Provisions
There are actually two separate protective provisions in this term sheet: here and in the section titled: Matters Requiring Investor Director Approval in the INVESTOR RIGHTS AGREEMENT. The difference is actually meaningful from both an administrative and substantive point of view. This first set of protective provisions is designed to protect the Preferred stockholders as a class. The set requiring investor director approval is focused on operational issues and how the invested money is being spent.
From the company’s point of view it is easier to get the investor director approval than it is to solicit a vote from the Preferred stockholders. Most of the Preferred stockholder protections are afforded by the DGCL. For example, you can’t alter the rights and preferences of the Preferred without stockholder approval. Try to keep these as close to the statute and as relevant as possible.
As for the management protections, you want as few as possible, but from a practical standpoint, you will want your financial partner on board with most management decisions anyway, so don’t worry too much about these. That being said, one thing to be careful of is agreeing to onerous information requirements. See Management and Information Rights in the INVESTOR RIGHTS AGREEMENT section, below.
Conversion and Anti-Dilution Protection
Preferred stock has substantial rights, preferences and privileges over Common stock. The company would be better off with one class of Common and no Preferred. So optional conversion is not an issue. It is also typical for all Preferred to convert at an IPO and if a certain percentage of Preferred holders want to convert. Keep the percentage as close to a majority as possible.
Anti-dilution protections are built in to the conversion ratio of the Preferred. Initially it’s 1:1. This can (and should) adjust if the company sells its equity at a valuation lower than agreed to with the investor. Try to stick with a “typical” weighted-average adjustment. The formula is probably not necessary in the term sheet. A “full-ratchet” adjustment will adjust the conversion ratio down to the lower price and will result in the investor receiving more shares when the Preferred is converted to Common.
One pitfall I often see Founders run into is making agreements with co-founders, employees, investors and others based on a percentage of the company. The problem with this approach is that the percentage changes based on what shares are counted. The term “fully diluted” attempts to take into account all options, warrants and agreements to issue shares in the future, but this is misleading because many options and warrants are never exercised.
An anti-dilution feature that is pegged on a percentage will get everyone in trouble, so avoid it. Stick with a weighted average adjustment and then work to increase the value of the company.
Pay-to-Play
Conceptually, a pay-to-play provision benefits both the company and the investor group. It encourages investors to step up and support the company and works to counter-balance the effects of some investors refusing to participate in a down round.
No one likes to think that the company will lose value so there is often a disinclination to include such a provision. Unless an investor sees itself as a strong lead, willing to support the company through thick and thin, an investor may only focus on the chance of losing rights and therefore opt to omit a pay-to-play.
In the end, pay-to-play was created by sophisticated investors wanting to exert some control over a disparate investor group. If your investor doesn’t want it, it’s probably not something to fall on your sword about.
Redemption
Avoid it. The investment is not a loan and it shouldn’t be treated like a loan. The argument against redemption is that you, as Founder, are looking for a financial partner – someone who will work with the company to and through a liquidity event, where everyone prospers. A redemption provision pits the investor and the company against one another and starts the relationship off on the wrong dynamic.
If you are forced into a redemption provision, put it out as far as possible in the future. Also, use it to trade on some other rights, such as the protective provisions and/or make the Preferred non-participating (see above).
STOCK PURCHASE AGREEMENT
Much of the Stock Purchase Agreement is boiler-plate, so don’t sweat the language too much. Avoid giving personal representations and warranties unless you are taking cash out of the deal.
Start working on your exceptions to the representations and warranties. I can’t emphasize this enough. For liability purposes, you want to disclose EVERYTHING, and the way to do it is in a detailed Schedule of Exceptions (sometimes called a Disclosure Schedule). Memories fade very quickly, so put everything in writing. This is where Founders should focus most of their work in the time between signing the term sheet to the closing.
Ah, yes, legal fees. The company nearly always pays legal fees for a deal that closes. It doesn’t seem to make sense because in every other way your investor will be urging you to cut expenses. The reason for the attorney fee provision is the way investment funds are structured and the way investor’s compensation is calculated.
The amount of fees should be limited, however. At this writing, I would say never go over $15,000 for investors’ counsel, and expect to pay about that for company counsel. Agree to use the NVCA open source legal documents as a starting place and have company counsel prepare the first set of documents, using the term sheet as a guide. If company counsel is worth their salt, there should be few changes to the documents after the initial drafting and therefore little time and effort wasted.
INVESTOR RIGHTS AGREEMENT
Registration Rights
Back in the day when there was an IPO market, the registration rights provisions had more meaning. Make sure the investors’ demand rights are triggered after the company’s IPO: the decision to go public should be made by the Board, not the investors.
The anticipated size of the company will help determine what dollar amounts trigger which registrations. Founders should be included in any piggy-back rights.
Management and Information Rights
Be careful about the information rights being too onerous. I have seen founders saddled with monthly budget and financial statement obligations, which make it very hard for them to get other work done. Yes, management should report to the board in an ongoing fashion and the reports should be formal enough to allow for real planning. Think through what it will take to comply with the information rights and carve them back where necessary.
Right to Participate Pro Rata in Future Rounds
This is a standard provision and should be the investors’ primary anti-dilution protection. If the company sells more stock, each investor must buy in to protect its equity position. Expect all stockholders to be made a party to this agreement unless you have an unusually large number of stockolders.
Matters Requiring Investor Director Approval
We discussed these provisions in the context of the protective provisions contained in the company’s Charter. Keep the matters requiring investor director approval focused on management issues and how proceeds of the financing are going to be spent. To the extent that you can move protective provisions from the Charter to the Investor Rights Agreement, you will be better off. Its easier to get a board member to approve than to have to solicit votes from each and every holder of Preferred stock. Restrictions are restrictions, so try to eliminate ones that seem to be over-reaching.
The remaining provisions in the Investor Rights Agreement are non-controversial. Non-competes are generally not enforceable in California and other states, except in limited circumstances, so you can push back on that. You will want confidentiality and assignment of invention agreements with all employees and consultants, especially if your company has meaningful intellectual property. D&O insurance can get expensive, so you might want to get a price quote to help decide whether and when it becomes necessary.
The option pool, assuming you intend to use options to incent employees, should be set at around 25%-30% on a fully-diluted basis. It’s good to have uniform vesting. Resist attempts to force company buy-back of shares of terminated employees. It lessens the value of the options and could be seen as bad faith on the part of the company – once an option has vested, the employee is entitled to the shares, including any upside after employment is terminated.
RIGHT OF FIRST REFUSAL/RIGHT OF CO-SALE
These are standard restrictions on founders’ shares and should probably be accepted. As a practical matter, it will be difficult if not impossible for a Founder to sell shares to a third party with these restrictions in place, and that is the point. Founders should view their investors as partners – everyone gets paid on a liquidity event; no one gets paid before then.
VOTING AGREEMENT
Its important to have an agreement on how the Board is composed and how directors are elected. I have no problem with that.
On the other hand, the Drag Along and Sale Right should be eliminated. The reason for the investors attempting to include Drag Along provisions is to force an exit on terms that satisfy their requirements. However, such an exit may be premature for the company, and there may be only enough money to pay back the investors, not enough for the Founders and the Common holders. If investors have 50% of the voting power, they can force a sale under the DGCL, but the company will have to provide appraisal rights to any objecting shareholder and pay the fair value for shares under the procedures established by the statute. My argument here is that, if the price if fair, most Founders and Common holders will go along with the deal. If the price is not fair, they should be afforded the basic right to make it fair under the DGCL. In either case, insisting on Drag Along rights seems like bullying to me, so I try to resist it.
As for the investors’ ability to force a sale, same arguments apply. If the deal is only good for the goose and not good for the gander, it is not a good deal. The DGCL has certain minimum minority stockholder protections. Let’s not eliminate even those basic protections on the alter of investor returns.
OTHER MATTERS
Founders’ Stock
The investor wants Founders’ stock to vest, and there is good reason for this. One of the worst things for a start-up company is to have a number of stockholders who are not actively involved in building the business. From the company’s point of view, ALL employees and Founders should vest in.
Founders might argue that they have already contributed significant value by forming the company and by achieving other significant milestones, and these arguments should shorten the vesting term.
At a minimum, Founders should insist on acceleration of vesting in the event of termination without cause.
No Shop/Confidentiality
Obviously, it would be better not to have a No Shop provision. The best position to be in is to have multiple investors bidding for the right to invest in your company. If you have legitimate other leads, you might soften this provision by agreeing to work in good faith to close the transaction, but giving yourself the freedom to speak with other potential investors until the deal is done. On the other hand, if you have a high level of confidence that your investor will come through, it would be bad form to be soliciting others while finalizing the terms. No one wants to be stood up at the alter.
Breakup fees are unusual and I would not attempt to negotiate them unless you have a legitimate competing offer that you believe is likely.
As for confidentiality provisions – same points. No one wants to be a stalking horse. If you can avoid them, all the better, but its best to keep things close to the vest until the deal is done.
David Niebauer is a corporate and transaction attorney, located in San Francisco, whose practice is focused on financing transactions, M&A and cleantech. www.davidniebauer.com
