Category: Term Sheet
We’re down to our last two sections on a typical VC term sheet. Since they are both things that most entrepreneurs simply live with as part of a financing, we decided to combine them into one post.
The first clause is indemnification and usually looks as follows:
“Indemnification: The bylaws and / or other charter documents of the Company shall limit board member’s liability and exposure to damages to the broadest extent permitted by applicable law. The Company will indemnify board members and will indemnify each Investor for any claims brought against the Investors by any third party (including any other shareholder of the Company) as a result of this financing.”
Given all the shareholder litigation in recent years, there is almost no chance that a company will get funded without indemnifying its directors. The first sentence is simply a contractual obligation between the company and its board. The second sentence – which is occasionally negotiable – indicates the desire for the company to purchase formal liability insurance. One can usually negotiate away insurance in a Series A deal, but for any follow-on financing, the major practice today is to procure director and officer (D&O) insurance.
The next clause – assignment – looks as follows:
“Assignment: Each of the Investors shall be entitled to transfer all or part of its shares of Series A Preferred purchased by it to one or more affiliated partnerships or funds managed by it or any or their respective directors, officers or partners, provided such transferee agrees in writing to be subject to the terms of the Stock Purchase Agreement and related agreements as if it were a purchaser thereunder.”
The assignment provision allows venture funds to transfer between funds and make distributions to their limited partners (their investors). This is something companies must normally live with and is a term that is rarely availed upon by investors.
Neither of these terms should be controversial. The company should be willing to indemnify its directors and will likely need to purchase D&O insurance in order to attract outside board members. The assignment clause simply gives VC firms flexibility over transfers which they require to be able to run their business and – as long as the VC is willing to require that any transferee agrees to be subject to the various financing agreements – the company should be willing to provide for this (although entrepreneurs should be careful not to let the loophole of “assignment without transfer of the obligation under the agreements” occur.)
Earlier this week I did a brief post on the “no shop agreement” that is a common feature in a term sheet. I compared signing a no shop to the construct of serial monogamy in a relationship. I had a couple of comments (one that was intellectual, one that was a little harsher and painted VCs as “duplicitous.”) I was mulling over my obviously (in hindsight to me) asymmetric view when Tom Evslin very clearly and coherently articulated why my analogy was really unilateral monogamy (e.g. the VC isn’t signing up for serial monogamy – only the entrepreneur is.)
Tom – and the comments I received – are correct (although I don’t agree with the generalization that “VCs are duplicitous.”) After reading Tom’s post, I thought about my own behavior (at least my perception of my own behavior) vs. the general case and realized I’ve mixed the two up. I’ve been on the giving and receiving side of unilateral no shops many times and – when on the receiving side – have usually been sensitive to why the other party wouldn’t sign a reciprocal no shop. In most cases, I simply don’t put a lot of weight behind the no shop due to the ability to bind it with time (30 – 45 days), plus whenever I’m on the receiving end, I’ve done my best to test commitment before signing up to do the deal.
In addition to Tom’s post, Rick Segal wrote up his thoughts in a post titled “The Handshake Clause” where he makes the point that his firm doesn’t sign a term sheet until they are committed to doing a deal. His explanation of how he approaches this is useful, but it is important to acknowledge that there is a wide range of behavior among VCs – the group that doesn’t put a term sheet down until they are committed are at one end of the spectrum; the group that puts down a term sheet to try to lock up a deal while they think about whether or not they want to do it is at the other. I’d like to think that we are at the “good” end of this spectrum (e.g. we won’t issue a term sheet unless we are ready to do a deal.) Obviously, your mileage will vary with the VCs you are dealing with – hence the value of doing your own due diligence on your potential future partners.
As I mulled this over, I came up with a couple of examples in the past 10 years where the no shop had any meaningful impact on a deal in which I was involved. I could come up with an edge case for each situation, but this was a small number vs. the number of deals I’ve been involved in. In addition, when I thought about the situations where I was a VC and was negatively impacted by not having a no shop (e.g. a company we had agreed with on a term sheet went and did something else) or where I was on the receiving end of a no shop and was negatively impacted by it (e.g. an acquirer tied me up but then ultimately didn’t close on the deal), I actually didn’t feel particularly bad about either of the situations since there was both logic associated with the outcome and grace exhibited by the participants. Following are two examples:
- We signed a term sheet to invest in company X. We didn’t include a no shop in the term sheet – I don’t think there was a particular reason why. We were working to close the investment (I think we were 15 days into a 30–ish day process) and had legal docs going back and forth. One of the founders called us and said that they had just received an offer to be acquired and they wanted to pursue it. We told them no problem – we’d still be there to do the deal if it didn’t come together. We were very open with them about the pros and cons of doing the deal from our perspective and – given the economics – encouraged them to pursue it (it was a great deal for them.) They ended up closing the deal and – as a token – gave us a small amount of equity in the company for our efforts (totally unexpected and unnecessary, but appreciated.)
- I was an existing investor in a company that was in the process of closing an outside led round at a significant step up in valuation. The company was under a no shop agreement with the new VC. Within a week of closing, we received an acquisition overture from one of the strategic investors in the company. We immediately told the new lead investor about it who graciously agreed to suspend the no shop and wait to see whether we wanted to move forward with the acquisition or the financing. We negotiated with the acquirer for several weeks, checking regularly with the new potential investor to make sure they were still interested in closing the round if we chose not to pursue the acquisition. They were incredibly supportive and patient. The company covered their legal fees up to that point (unprompted – although it was probably in the term sheet that we’d cover them – I can’t recall.) We ended up moving forward with the acquisition; the new investor was disappointed in the outcome but happy and supportive of what we did.
As I said earlier, these are edge cases – in almost all of my experiences the no shop ended up being irrelevant. But – as both of these example show – the quality and the character of the people involved made all the difference. Near the end of his post, Tom makes the point that it’s “good negotiating advice to make sure that every clause which can be mutual is mutual.” I completely agree.
As an entrepreneur, the way to get the best deal for a round of financing is to have multiple options. If you’ve been a studious reader of our term sheet series, you are painfully aware that there are many other terms – beside price – that help define what “the best deal” actually is. However, there comes a point in time where you have to choose your investor and shift from “search for an investor” mode to “close the deal” mode. Part of this involves choosing your lead investor and negotiating the final term sheet with him.
A “no shop agreement” is almost always part of this final term sheet. Think of it as serial monogamy – your new investor to be doesn’t want you running around behind his back just as you are about to get hitched. A typical no shop agreement is as follows:
“No Shop Agreement: The Company agrees to work in good faith expeditiously towards a closing. The Company and the Founders agree that they will not, directly or indirectly, (i) take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company, or (ii) enter into any discussions, negotiations or execute any agreement related to any of the foregoing, and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing. Should both parties agree that definitive documents shall not be executed pursuant to this term sheet, then the Company shall have no further obligations under this section.”
At some level the no shop agreement – like serial monogamy – is more of an emotional commitment; it’s very hard to “enforce a no shop agreement” in a financing, but if you get caught cheating, your financing will probably go the same way as the analogous situation when the groom or the bride to be gets caught in a compromising situation.
At some level, the no shop agreement reinforces the handshake that says “ok – let’s get a deal done – no more fooling around looking for a better / different one.” In all cases, the entrepreneur should bound the no shop by a time period – usually 45 to 60 days is plenty (and you can occasionally get a VC to agree to a 30 day no shop.) This makes the commitment bi-directional – you agree not to shop the deal; the VC agrees to get things done within a reasonable time frame.
Jason and I are planning to finish strong with some serious stuff in our term sheet series, but we figured we’d put one more term in that has us sniggling whenever we see it (a “sniggle” is a combination “sneer-giggle” – sort of like how I reacted to Kidman / Ferrell in Bewitched last night). The last sniggle term is as follows:
“Initial Public Offering Shares Purchase: In the event that the Company shall consummate a Qualified IPO, the Company shall use its best efforts to cause the managing underwriter or underwriters of such IPO to offer to [investors] the right to purchase at least (5%) of any shares issued under a “friends and family” or “directed shares” program in connection with such Qualified IPO. Notwithstanding the foregoing, all action taken pursuant to this Section shall be made in accordance with all federal and state securities laws, including, without limitation, Rule 134 of the Securities Act of 1933, as amended, and all applicable rules and regulations promulgated by the National Association of Securities Dealers, Inc. and other such self-regulating organizations.”
We firmly put this in the “nice problem to have” category. This term really blossomed in the late 1990’s when anything that was VC funded was positioned as a company that would shortly go public. However, most investment bankers will push back on this term if the IPO is going to be a success as they want to get stock into the hands institutional investors (e.g. “their clients”). If the VCs get this push back, they are usually so giddy with joy that the company is going public that they don’t argue with the bankers. Ironically, if the VC doesn’t get this push back (or even worse, get a call near the end of the IPO road show) where the bankers are asking the VC to buy shares in the offering, the VC usually panics (because it means it’s no longer a hot deal) and does whatever he can not to have to buy into the offering.
Sniggle. Our recommendation – don’t worry about this one or spend lawyer time on it.
I’m going to keep tonight’s term sheet post short and sweet, especially since I’m still reeling from the horrifyingly bad War of the World movie I just saw. Jason and I are almost done with the term sheet series (yeah, we know we keep promising that) but – like the Spielberg tragicomedy I just watched, it’s not over until it’s over (sorry – that cliche just snuck its way in – I was helpless against it – the aliens made me do it.)
Occasionally a term sheet will have – buried near the back – a short clause concerning “founders activities.” It usually looks something like:
“Founders Activities: Each of the Founders shall devote 100% of his professional time to the Company. Any other professional activities will require the approval of the Board of Directors.”
This should be no surprise to a founder that your friendly neighborhood VC wants you to be spending 100% (actually 120%) of your time and attention on your company. If this paragraph sneaks its way into the term sheet, the VC has either been recently burned or is suspicious and / or concerned that one or more of the founders may be working on something besides the company in question.
Of course, this is a classic no-win situation for a founder. If you are actually working on something else at the same time and don’t disclose it, you are violating the terms of the agreement (and – breaching trust before you get started – not a good thing as it’ll eventually come to light.) If you do disclose it – or push back on this clause (hence signaling that you are working on something else), you’ll reinforce the concern that the VC has. So – tread carefully here. Our recommendation – unless of course you are working on something else – is simply to agree to this (why wouldn’t you, unless you don’t believe in the thing you are asking the VC to fund?)
In situations where I’ve worked with a founder that already has other obligations or commitments, I’ve always appreciated him being up front with me early in the process. I’ve usually been able to work these situations out in a way that causes everyone to be happy and – in the cases where I can’t get there – I’m glad that the issue came up early so that I didn’t waste my time or the enterpreneurs’ time.
While there are situations where VCs get comfortable with entrepreneurs working on multiple companies simultaneously (usually with very experienced entrepreneurs or in situations where the VC and the entrepreneur have worked together in the past), they are the exception, not the norm.
I had good intentions earlier this week to try to crank out the balance of the term sheet series, but it turned into a busy week. Since I’m still muddling through the set of terms that either don’t matter much and/or are hard to negotiate away (e.g. chose you battles wisely), I didn’t expect anyone would be waiting on the edge of their seats for these. However, for completeness, it’s worth going through the stuff that shows up on the last few pages of a standard VC term sheet. Jason and I aren’t quite done, but with this post, we are one (tedious) step closer.
Almost every term sheet we’ve ever seen has a “Restrictions on Sales” clause in it that looks something like:
“Restrictions on Sales: The Company’s Bylaws shall contain a right of first refusal on all transfers of Common Stock, subject to normal exceptions. If the Company elects not to exercise its right, the Company shall assign its right to the Investors.”
Management / founders rarely argue against this as it helps control the shareholder base of the company which usually benefits all the existing shareholders (except possibly the one who wants to bail out of their private stock.) However, we’ve found that the lawyers will often spend time arguing how to implement this particular clause. Some lawyers feel that putting this provision in the bylaws is the wrong way to go and prefer to include such a provision in each of the company’s option agreements, plans and stock sales. Personally, we find it much easier to include in the bylaws.
Next up is the ubiquitous proprietary information and inventions agreement clause.
“Proprietary Information and Inventions Agreement: Each current and former officer, employee and consultant of the Company shall enter into an acceptable proprietary information and inventions agreement.”
This paragraph benefits both the company and investors and is simply a mechanism that investors use to get the company to legally stand behind the representation that it owns its intellectual property. Many pre-Series A companies have issues surrounding this, especially if the company hasn’t had great legal representation prior to its first venture round. We’ve also run into plenty of situations (including several of ours – oops!) where companies are loose about this between financings and – while a financing is a good time to clean this up – it’s often annoying to previously hired employees who are now told “hey – you need to sign this since we need it for the venture financing.” It’s even more important in the sale of a company, as the buyer will always insist on clear ownership of the IP. Our best advice here is that companies should build these agreements into their hiring process from the very beginning (with the advice from a good law firm) so that there are never any issues around this, as VCs will always insist on it.
Finally, a co-sale agreement is pretty standard fare as well.
“Co-Sale Agreement: The shares of the Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange their stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis. This right of co-sale shall not apply to and shall terminate upon a Qualified IPO.”
If you are a founder, you are probably asking why we did not include the co-sale section in the “really matter section.” The chance of keeping this provision out of a financing is close to zero, so we don’t think it’s worth the battle to fight it. Notice that this only matters while the company is private – if the company goes public, this clause no longer applies.
Jason and I are feeling the need for closure on our term sheet series as we’ve started gearing up on our next series (M&A). So – we’re going to knock out the balance of the standard term sheet terms this week. We’re still in the “terms that don’t matter much zone” so we’re including Voting Rights and Employee Pool for completeness.
“Voting Rights: The Series A Preferred will vote together with the Common Stock and not as a separate class except as specifically provided herein or as otherwise required by law. The Common Stock may be increased or decreased by the vote of holders of a majority of the Common Stock and Series A Preferred voting together on an as if converted basis, and without a separate class vote. Each share of Series A Preferred shall have a number of votes equal to the number of shares of Common Stock then issuable upon conversion of such share of Series A Preferred.”
Most of the time voting rights are simply an “FYI” section as all the heavy rights are contained in other sections such as the protective provisions.
“Employee Pool: Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants. The term “Employee Pool” shall include both shares reserved for issuance as stated above, as well as current options outstanding, which aggregate amount is approximately __% of the Company’s fully diluted capital stock following the issuance of its Series A Preferred.”
The employee pool section is a separate section in order to clarify the capital structure and specifically call out the percentage of the company that will be allocated to the option pool associated with the financing. Since a cap table is almost always included with the term sheet, this section is redundant, but exists so there is no confusion about the size of the option pool.
Today’s “term that doesn’t matter much” from our term sheet series is the Right of First Refusal. When we say “it doesn’t matter much”, we really mean “don’t bother trying to negotiate it away – the VCs will insist on it.” Following is the standard language:
“Right of First Refusal: Investors who purchase at least (____) shares of Series A Preferred (a “Major Investor”) shall have the right in the event the Company proposes to offer equity securities to any person (other than the shares (i) reserved as employee shares described under “Employee Pool” below, (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their right of first refusal) to purchase [X times] their pro rata portion of such shares. Any securities not subscribed for by an eligible Investor may be reallocated among the other eligible Investors. Such right of first refusal will terminate upon a Qualified IPO. For purposes of this right of first refusal, an Investor’s pro rata right shall be equal to the ratio of (a) the number of shares of common stock (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) held by such Investor immediately prior to the issuance of such equity securities to (b) the total number of share of common stock outstanding (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) immediately prior to the issuance of such equity securities.”
There are two things to pay attention to in this term that can be negotiated. First, the share threshold that defines a “Major Investor” can be defined. It’s often convenient – especially if you have a large number of small investors – not to have to give this right to them. However, since in future rounds, you are typically interested in getting as much participation as you can, it’s not worth struggling with this too much.
A more important thing to look for is to see if there is a a multiple on the purchase rights (e.g. the “X times” listed above). This is an excessive ask – especially early in the financing life cycle of a company – and can almost always be negotiated to 1x.
As with “other terms that don’t matter much”, you shouldn’t let your lawyer over engineer these. If you feel the need to negotiate, focus on the share threshold and the multiple on the purchase rights.
When Jason and I last wrote about term sheets, Jack was still trying to save the world (surprise – he did) and we dealt with a meaty and important issue – vesting. For completeness (and because all good “series” deserve to be finished off), we’re tackling the terms that rarely matter in the next couple of posts. Today we’re starting with Information Rights and Registration Rights.
You might ask, “If these terms rarely matter, why bother?” Well – you’ll end up having to deal with them in a VC term sheet, so you might as well (a) be exposed to them and (b) hear that they don’t matter much. Of course, from a VC perspective, “doesn’t matter much” means “Mr. Entrepreneur, please don’t pay much attention to these terms – just accept them as is.” Specifically, if one of these terms is being hotly negotiated by an investor or company, that time (and lawyer money) is most likely being wasted.
First up is Information Rights – the typical clause follows:
“Information Rights: So long as an Investor continues to hold shares of Series A Preferred or Common Stock issued upon conversion of the Series A Preferred, the Company shall deliver to the Investor the Company’s annual budget, as well as audited annual and unaudited quarterly financial statements. Furthermore, as soon as reasonably possible, the Company shall furnish a report to each Investor comparing each annual budget to such financial statements. Each Investor shall also be entitled to standard inspection and visitation rights. These provisions shall terminate upon a Qualified IPO.”
Information rights are generally something companies are stuck with in order to get investment capital. The only variation one sees is putting a threshold on the number of shares held (some finite number vs. “any”) for investors to continue to enjoy these rights.
Registration Rights are more tedious and tend to take up a page or more of the term sheet. The typical clause(s) follows:
“Registration Rights: Demand Rights: If Investors holding more than 50% of the outstanding shares of Series A Preferred, including Common Stock issued on conversion of Series A Preferred (“Registrable Securities”), or a lesser percentage if the anticipated aggregate offering price to the public is not less than $5,000,000, request that the Company file a Registration Statement, the Company will use its best efforts to cause such shares to be registered; provided, however, that the Company shall not be obligated to effect any such registration prior to the [third] anniversary of the Closing. The Company shall have the right to delay such registration under certain circumstances for one period not in excess of ninety (90) days in any twelve (12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand right provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty (180) day period commencing with the date of the Company’s initial public offering, or (ii) if it delivers notice to the holders of the Registrable Securities within thirty (30) days of any registration request of its intent to file a registration statement for such initial public offering within ninety (90) days.
Company Registration: The Investors shall be entitled to “piggy-back” registration rights on all registrations of the Company or on any demand registrations of any other investor subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered pro rata in view of market conditions. If the Investors are so limited, however, no party shall sell shares in such registration other than the Company or the Investor, if any, invoking the demand registration. Unless the registration is with respect to the Company’s initial public offering, in no event shall the shares to be sold by the Investors be reduced below 30% of the total amount of securities included in the registration. No shareholder of the Company shall be granted piggyback registration rights which would reduce the number of shares includable by the holders of the Registrable Securities in such registration without the consent of the holders of at least a majority of the Registrable Securities.
S-3 Rights: Investors shall be entitled to unlimited demand registrations on Form S-3 (if available to the Company) so long as such registered offerings are not less than $1,000,000.
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one special counsel of the selling shareholders not to exceed $25,000).
Transfer of Rights: The registration rights may be transferred to (i) any partner, member or retired partner or member or affiliated fund of any holder which is a partnership, (ii) any member or former member of any holder which is a limited liability company, (iii) any family member or trust for the benefit of any individual holder, or (iv) any transferee satisfies the criteria to be a Major Investor (as defined below); provided the Company is given written notice thereof.
Lock-Up Provision: Each Investor agrees that it will not sell its shares for a period to be specified by the managing underwriter (but not to exceed 180 days) following the effective date of the Company’s initial public offering; provided that all officers, directors, and other 1% shareholders are similarly bound. Such lock-up agreement shall provide that any discretionary waiver or termination of the restrictions of such agreements by the Company or representatives of underwriters shall apply to Major Investors, pro rata, based on the number of shares held.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to registration rights as are reasonable, including cross-indemnification, the period of time in which the Registration Statement shall be kept effective, and underwriting arrangements. The Company shall not require the opinion of Investor’s counsel before authorizing the transfer of stock or the removal of Rule 144 legends for routine sales under Rule 144 or for distribution to partners or members of Investors.”
Registration rights are also something the company will have to offer to investors. What is most interesting about this section is that lawyers seem genetically incapable of leaving this section untouched and always end up “negotiating something.” Perhaps because this provision is so long in length, they feel the need to keep their pens warm while reading. We find it humorous (so long as we aren’t the ones paying the legal fees), because in the end, the modifications are generally innocuous and besides, if you ever get to the point where registration rights come into play (e.g. an IPO), the investment bankers of the company are going to have a major hand in deciding how the deal is going to be structured, regardless of the contract the company entered into years before when it did an early private financing.
When Jason and I last wrote on the mythical term sheet, we were working our way through the terms that “can matter.” The last one on our list is vesting, and we approach it with one eyebrow raised understanding the impact of this term is crucial for all founders of an early stage company.
While vesting is a simple concept, it can have profound and unexpected implications. Typically, stock and options will vest over four years – which means that you have to be around for four years to own all of your stock or options (for the rest of this post, I’ll simply refer to the equity as “stock” although exactly the same logic applies to options.) If you leave the company earlier than the four year period, the vesting formula applies and you only get a percentage of your stock. As a result, many entrepreneurs view vesting as a way for VCs to “control them, their involvement, and their ownership in a company” which, while it can be true, is only a part of the story.
A typical stock vesting clause looks as follows:
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors, consultants and other service providers will be subject to vesting provisions below unless different vesting is approved by the majority (including at least one director designated by the Investors) consent of the Board of Directors (the “Required Approval”): 25% to vest at the end of the first year following such issuance, with the remaining 75% to vest monthly over the next three years. The repurchase option shall provide that upon termination of the employment of the shareholder, with or without cause, the Company or its assignee (to the extent permissible under applicable securities law qualification) retains the option to repurchase at the lower of cost or the current fair market value any unvested shares held by such shareholder. Any issuance of shares in excess of the Employee Pool not approved by the Required Approval will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the Investors’ first offer rights.
The outstanding Common Stock currently held by _________ and ___________ (the “Founders”) will be subject to similar vesting terms provided that the Founders shall be credited with [one year] of vesting as of the Closing, with their remaining unvested shares to vest monthly over three years.
Industry standard vesting for early stage companies is a one year cliff and monthly thereafter for a total of 4 years. This means that if you leave before the first year is up, you don’t vest any of your stock. After a year, you have vested 25% (that’s the “cliff”). Then – you begin vesting monthly (or quarterly, or annually) over the remaining period. So – if you have a monthly vest with a one year cliff and you leave the company after 18 months, you’ll have vested 37.25% of your stock.
Often, founders will get somewhat different vesting provisions than the balance of the employee base. A common term is the second paragraph above, where the founders receive one year of vesting credit at the closing and then vest the balance of their stock over the remaining 36 months. This type of vesting arrangement is typical in cases where the founders have started the company a year or more earlier then the VC investment and want to get some credit for existing time served.
Unvested stock typically “disappears into the ether” when someone leaves the company. The equity doesn’t get reallocated – rather it gets “reabsorbed” – and everyone (VCs, stock, and option holders) all benefit ratably from the increase in ownership (or – more literally – the reverse dilution.”) In the case of founders stock, the unvested stuff just vanishes. In the case of unvested employee options, it usually goes back into the option pool to be reissued to future employees.
A key component of vesting is defining what happens (if anything) to vesting schedules upon a merger. “Single trigger” acceleration refers to automatic accelerated vesting upon a merger. “Double trigger” refers to two events needing to take place before accelerated vesting (e.g., a merger plus the act of being fired by the acquiring company.) Double trigger is much more common than single trigger. Acceleration on change of control is often a contentious point of negotiation between founders and VCs, as the founders will want to “get all their stock in a transaction – hey, we earned it!” and VCs will want to minimize the impact of the outstanding equity on their share of the purchase price. Most acquires will want there to be some forward looking incentive for founders, management, and employees, so they usually either prefer some unvested equity (to help incent folks to stick around for a period of time post acquisition) or they’ll include a separate management retention incentive as part of the deal value, which comes off the top, reducing the consideration that gets allocated to the equity ownership in the company. This often frustrates VCs (yeah – I hear you chuckling “haha – so what?”) since it puts them at cross-purposes with management in the M&A negotiation (everyone should be negotiating to maximize the value for all shareholders, not just specifically for themselves.) Although the actual legal language is not very interesting, it is included below.
In the event of a merger, consolidation, sale of assets or other change of control of the Company and should an Employee be terminated without cause within one year after such event, such person shall be entitled to [one year] of additional vesting. Other than the foregoing, there shall be no accelerated vesting in any event.”
Structuring acceleration on change of control terms used to be a huge deal in the 1990’s when “pooling of interests” was an accepted form of accounting treatment as there were significant constraints on any modifications to vesting agreements. Pooling was abolished in early 2000 and – under purchase accounting – there is no meaningful accounting impact in a merger of changing the vesting arrangements (including accelerating vesting). As a result, we usually recommend a balanced approach to acceleration (double trigger, one year acceleration) and recognize that in an M&A transaction, this will often be negotiated by all parties. Recognize that many VCs have a distinct point of view on this (e.g. some folks will NEVER do a deal with single trigger acceleration; some folks don’t care one way or the other) – make sure you are not negotiating against and “point of principle” on this one as VCs will often say “that’s how it is an we won’t do anything different.”
Recognize that vesting works for the founders as well as the VCs. I’ve been involved in a number of situations where one or more founders didn’t work out and the other founders wanted them to leave the company. If there had been no vesting provisions, the person who didn’t make it would have walked away with all their stock and the remaining founders would have had no differential ownership going forward. By vesting each founder, there is a clear incentive to work your hardest and participate constructively in the team, beyond the elusive founders “moral imperative.” Obviously, the same rule applies to employees – since equity is compensation and should be earned over time, vesting is the mechanism to insure the equity is earned over time.
Of course, time has a huge impact on the relevancy of vesting. In the late 1990’s, when companies often reached an exit event within two years of being founded, the vesting provisions – especially acceleration clauses – mattered a huge amount to the founders. Today – as we are back in a normal market where the typical gestation period of an early stage company is five to seven years, most people (especially founders and early employees) that stay with a company will be fully (or mostly) vested at the time of an exit event.
While it’s easy to set vesting up as a contentious issue between founders and VCs, we recommend the founding entrepreneurs view vesting as an overall “alignment tool” – for themselves, their co-founders, early employees, and future employees. Anyone who has experienced an unfair vesting situation will have strong feelings about it – we believe fairness, a balanced approach, and consistency is the key to making vesting provisions work long term in a company.