It has been a while since I put up a term sheet post so I thought I’d tackle a hard one today. While it’s fun to tease lawyers about math (and – actually – about anything), my co-author on this series Jason Mendelson (a lawyer) often reminds me that lawyers can do basic arithmetic (and occasionally have to resort to algebra). The anti-dilution provision demonstrates this point.
Traditionally, the anti-dilution provision is used to protect investors in the event a company issues equity at a lower valuation then in previous financing rounds. There are two varieties: weighted average anti-dilution and ratchet based anti-dilution. Standard language is as follows:
Anti-dilution Provisions: The conversion price of the Series A Preferred will be subject to a [full ratchet / broad-based / narrow-based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities (other than shares (i) reserved as employee shares described under the Company’s option pool,, (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 anti-dilution rights) at a purchase price less than the applicable conversion price. In the event of an issuance of stock involving tranches or other multiple closings, the antidilution adjustment shall be calculated as if all stock was issued at the first closing. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, combinations, recapitalizations and the like.
Full ratchet means that if the company issues shares at a price lower than the Series A, then the Series A price is effectively reduced to the price of the new issuance. One can get creative and do “partial ratchets” (such as “half ratchets” or “two-thirds ratchets”) which are a less harsh, but rarely seen.
While full ratchets came into vogue in the 2001 – 2003 time frame when down-rounds were all the rage, the most common anti-dilution provision is based on the weighted average concept, which takes into account the magnitude of the lower-priced issuance, not just the actual valuation. In a “full ratchet world” if the company sold one share of its stock to someone for a price lower than the Series A, all of the Series A stock would be repriced to the issuance price. In a “weighted average world,” the number of shares issued at the reduced price are considered in the repricing of the Series A. Mathematically (and this is where the lawyers get to show off their math skills – although you’ll notice there are no exponents or summation signs anywhere) it works like this (note that despite the fact one is buying preferred stock, the calculations are always done in as-if-converted to common stock basis):
NCP = OCP * ((CSO + CSP) / (CSO + CSAP))
- NCP = new conversion price
- OCP = old conversion price
- CSO = common stock outstanding
- CSP = common stock purchasable with consideration received by company (i.e. “what the buyer should have bought if it hadn’t been a ‘down round’ issuance”)
- CSAP = common stock actually purchased in subsequent issuance (i.e., “what the buyer actually bought”)
Recognize that we are determining a “new conversion price” for the Series A Preferred . We are not actually issuing more shares (you can do it this way, but it’s a silly and unnecessarily complicated approach that merely increases the amount the lawyers can bill the company for the financing). Consequently, “anti-dilution provisions” generate a “conversion price adjustment” and the phrases are often used interchangeably.
Got it? I find it’s best to leave the math to the lawyers.
You might note the term “broad-based” in describing weighted average anti-dilution. What makes the provision a broad-based versus narrow-based is the definition of “common stock outstanding” (CSO). A broad-based weighted average provision includes both the company’s common stock outstanding (including all common stock issuable upon conversion of its preferred stock) as well as the number of shares of common stock which could be obtained by converting all other options, rights, and securities (including employee options). A narrow-based provision will not include these other convertible securities and limit the calculation to only currently outstanding securities. The number of shares and how you count them matter – make sure you are agreeing on the same definition (you’ll often find different lawyers arguing over what to include or not include in the definitions – again – this is another common legal fee inflation technique).
In our example language, we’ve included a section which is generally referred to as “anti-dilution carve outs” (the section (other than shares (i) … (iv)). These are the standard exceptions for share granted at lower prices for which anti-dilution does not kick in. Obviously – from a company (and entrepreneur) perspective – more exceptions are better – and most investors will accept these carve-outs without much argument.
One particular item to note is the last carve out: (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their anti-dilution rights. This is a carve out that started appearing recently which we have found to be very helpful in deals where a majority of the Series A investors agree to further fund a company in a follow-on financing, but the price will be lower than the original Series A. In this example, several minority investors signaled they were not planning to invest in the new round, as they would have preferred to “sit back” and increase their ownership stake via the anti-dilution provision. Having the larger investors (the majority of the class) “step up” and vote to carve the financing out of the anti-dilution terms was a huge bonus for the company common holders and employees who would have suffered the dilution of additional anti-dilution from investors who were not continuing to participate in financing the company. This approach encourages the minority investors to participate in the round in order to protect themselves from dilution.
Occasionally, anti-dilution will be absent in a Series A term sheet. Investors love precedent (e.g. the new investor says “I want what the last guy got, plus more”). In many cases anti-dilution provisions hurt Series A investors more than prior investors if you assume the Series A price is the low watermark for the company. For instance, if the Series A price is $1.00, the Series B price is $5.00, and the Series C price is $3.00, then the Series B is benefited by an anti-dilution provision at the expense of the Series A. However, our experience is that anti-dilution is usually requested despite this as Series B investors will most likely always ask for it and – since they do – the Series A proactively asks for it anyway.
In addition to economic impacts, anti-dilution provisions can have control impacts. First, the existence of an anti-dilution provision incents the company to issue new rounds of stock at higher valuations because of the ramifications of anti-dilution protection to the common stock holders. In some cases, a company may pass on taking an additional investment at a lower valuation (although practically speaking, this only happens when a company has other alternatives to the financing). Second, a recent phenomenon is to tie anti-dilution calculations to milestones the investors have set for the company resulting in a conversion price adjustment in the case that the company does not meet certain revenue, product development or other business milestones. In this situation, the anti-dilution adjustments occur automatically if the company does not meet in its objectives, unless this is waived by the investor after the fact. This creates a powerful incentive for the company to accomplish its investor-determined goals. We tend to avoid this approach, as blindly hitting pre-determined (at the time of financing) product and sales milestones is not always best for the long-term development of a company, especially if these goals end up creating a diverging set of goals between management and the investors as the business evolves.
Anti-dilution provisions are almost always part of a financing, so understanding the nuances and knowing which aspects to negotiate is an important part of the entrepreneur’s toolkit. We advise you not to get hung up in trying to eliminate anti-dilution provisions – rather focus on (a) minimizing their impact and (b) building value in your company after the financing so they don’t ever come into play.
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.
Every now and then I run into a new VC term in a term sheet that I’ve never seen before. My legs tremble with excitement as I stare at the words to dissect what they mean. On Friday, a long time friend sent me the following new and exciting term.
Compelled Sale Right: So long as VC (together with its permitted transferees) continues to hold at least 10% of the outstanding common shares (on an as-converted basis), and so long as an IPO has not been completed, then, at any time from and after the seventh anniversary of the transaction, if VC or the Company shall receive a bona fide offer from an unaffiliated third party to purchase 100% of the equity of the Company, VC shall have the right to cause each other stockholder to sell such stockholder’s equity securities on the same terms and conditions applicable to VC.
My first reaction was “what the fuck?” My second reaction was “eh – this is just a different twist on redemption rights.” But – then I thought about it some more and thought “you’ve got to be kidding me!”
So – after seven years, if there hasn’t been a liquidity event, a VC that owns at least 10% of the company can force all the other shareholders to sell their shares to an unaffiliated third party. Read it slowly and think about it. Basically, this term gives a minority shareholder the right to sell the company after 7 years, with no input from any other shareholders.
Be forewarned – this is not a nice term.
I’ve written about liquidation preferences (and participating preferred) before, as have most of the other VC bloggers (and several entrepreneur bloggers.) However, for completeness, and since liquidation preferences are the second most important “economic term” (after price), Jason and I decided to write a post on it. Plus – if you read carefully – you might find some new and exciting super-secret VC tricks.
The liquidation preference determines how the pie is shared on a liquidity event. There are two components that make up what most people call the liquidation preference: the actual preference and participation. To be accurate, the term liquidation preference should only pertain to money returned to a particular series of the company’s stock ahead of other series of stock. Consider for instance the following language:
Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
This is the actual preference. In the language above, a certain multiple of the original investment per share is returned to the investor before the common stock receives any consideration. For many years, a “1x” liquidation preference was the standard. Starting in 2001, investors often increased this multiple, sometimes as high as 10x! (Note, that it is mostly back to 1x today.)
The next thing to consider is whether or not the investor shares are participating. Again, note that many people consider the term “liquidation preference” to refer to both the preference and the participation, if any. There are three varieties of participation: full participation, capped participation and non-participating.
Fully participating stock will share in the liquidation proceeds on a pro rata basis with common after payment of the liquidation preference. The provision normally looks like this:
Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.
Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. Sample language is below.
Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.
One interesting thing to note in the section is the actually meaning of the multiple of the Original Purchase Price (the [X]). If the participation multiple is 3 (three times the Original Purchase Price), it would mean that the preferred would stop participation (on a per share basis) once 300% of its original purchase price was returned including any amounts paid out on the liquidation preference. This is not an additional 3x return, rather an addition 2x, assuming the liquidation preference were a 1 times money back return. Perhaps because of this correlation with the actual preference, the term liquidation preference has come to include both the preference and participation terms. If the series is not participating, it will not have a paragraph that looks like the ones above.
Liquidation preferences are usually easy to understand and assess when dealing with a series A term sheet. It gets much more complicated to understand what is going on as a company matures and sells additional series of equity as understanding how liquidation preferences work between the series is often mathematically (and structurally) challenging. As with many VC-related issues, the approach to liquidation preferences among multiple series of stock varies (and is often overly complex for no apparent reason.) There are two primary approaches: (1) The follow-on investors will stack their preferences on top of each other: series B gets its preference first, then series A or (2) The series are equivalent in status (called pari passu – one of the few latin terms lawyers understand) so that series A and B share pro-ratably until the preferences are returned. Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon.
Most professional, reasonable investors will not want to gouge a company with excessive liquidation preferences. The greater the liquidation preference ahead of management and employees, the lower the potential value of the management / employee equity. There’s a fine balance here and each case is situation specific, but a rational investor will want a combination of “the best price” while insuring “maximum motivation” of management and employees. Obviously what happens in the end is a negotiation and depends on the stage of the company, bargaining strength, and existing capital structure, but in general most companies and their investors will reach a reasonable compromise regarding these provisions. Note that investors get either the liquidation preference and participation amounts (if any) or what they would get on a fully converted common holding, at their election; they do not get both (although in the fully participating case, the participation amount is equal to the fully converted common holding amount.)
Since we’ve been talking about liquidation preferences, it’s important to define what a “liquidation” event is. Often, entrepreneurs think of a liquidation as simply a “bad” event – such as a bankruptcy or a wind down. In VC-speak, a liquidation is actually tied to a “liquidity event” where the shareholders receive proceeds for their equity in a company, including mergers, acquisitions, or a change of control of the company. As a result, the liquidation preference section determines allocation of proceeds in both good times and bad. Standard language looks like this:
A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.
Ironically, lawyers don’t necessary agree on a standard definition of the phrase “liquidity event.” Jason once had an entertaining (and unenjoyable) debate during a guest lecture he gave at his alma mater law school with a partner from a major Chicago law firm (who was teaching a venture class that semester) that claimed an initial public offering should be considered a liquidation event. His theory was that an IPO was the same as a merger, that the company was going away, and thus the investors should get their proceeds. Even if such a theory would be accepted by an investment banker who would be willing to take the company public (no chance in our opinion), it makes no sense as an IPO is simply another funding event for the company, not a liquidation of the company. However, in most IPO scenarios, the VCs “preferred stock” is converted to common stock as part of the IPO, eliminating the issue around a liquidity event in the first place.
That’s enough for now – I’m going to go get a drink and have my own personal liquidity event (sorry – the punmaster got control of my keyboard for a moment.)
If you are avid followers of the TV series 24 (as Jason and I are), you’ll recognize that the next item in our term sheet series – Redemption at Option of Investors – has similar characteristics to the regular exchange Jack has with CTU:
CTU Director (any of them – Driscoll, Tony, Ryan, George, Michelle): “Jack – stand down – don’t go in there without backup.”
Jack: (Gruffly, in a hoarse voice) “I gotta go in – there’s no time to wait – if I don’t go, the world will end and my (current babe, hostage, daughter, partner) will die.”
CTU Director: (Mildly panicked) “Jack – wait – it’s too dangerous – I command you – wait.”
Jack: (Insolently) “I gotta go.” (Jack hangs up the phone).
Cut to clock ticking and commercial or teaser for scenes from next week.
Think of the discussion around redemption rights as this scene – utterly predictable and ultimately benign. Jack always goes in. Jack always stops the bad stuff – for the time being. Jack (or the bad guys) always creates a new problem. The CTU director always forgets that Jack disobeyed a direct order shortly after Jack is successful with his latest task.
You are Jack. Your investor is the CTU director. If you ask your CTU director “have you ever actually ever triggered redemption rights?” you will normally get some nervous fidgeting (“wait – it’s too dangerous”), a sheepish “no” followed by a confident “but we have to have them or we won’t do the deal!” (“I command you – wait.”)
Redemption rights usually look something like:
“Redemption at Option of Investors: At the election of the holders of at least majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.”
There is some rationale for redemption rights. First, there is the “fear” (on the VCs part) that a company will become successful enough to be an on-going business, but not quite successful enough to go public or be acquired. In this case, redemption rights were invented to allow the investor a guaranteed exit path. However, any company that is around for a while as a going concern that is not an attractive IPO or acquisition candidate will not generally have the cash to pay out redemption rights.
The second reason for redemption rights pertains to the life span of venture funds. The average venture fund has a 10 years life span to conduct its business. If a VC makes an investment in year 5 of the fund, it might be important for that fund manager to secure redemption rights in order to have a liquidity path before his fund must wind down. As with the previous case, whether or not the company has the ability to pay is another matter.
Often, companies will claim that redemption rights create a liability on their balance sheet and can make certain business optics more difficult. In the past few years, accountants have begun to argue more strongly that redeemable preferred stock is a liability on the balance sheet, not an equity feature. Unless the redeemable preferred stock is mandatorily redeemable, this is not the case and most experienced accountants will be able to recognize the difference.
There is one form of redemption that we have seen in the past few years and we view as overreaching – the adverse change redemption. We recommend you never agree to the following which has recently crept into terms sheets.
“Adverse Change Redemption: Should the Company experience a material adverse change to its prospects, business or financial position, the holders of at least majority of the Series A Preferred shall have the option to commit the Company to immediately redeem the outstanding Series A Preferred. Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.”
This is just too vague, too punitive, and shifts an inappropriate amount of control to the investors based on an arbitrary judgment. If this term is being proposed and you are getting pushback on eliminating it, make sure you are speaking to a professional investor and not a loan shark.
In our experience – just like Jack’s behavior – redemption rights are well understood by the market and should not create a problem, except in a theoretical argument between lawyers or accountants.
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.
There’s nothing like a solid week of vacation with no phone, email, or blogs to get the writing juices rolling again. Of course, now that I’m through my email, I only have 8200 blog posts to read to catch up – thank god for jet lag – wait, what am I saying?
In our term sheet series, Jason Mendelson and I have been focusing first on “the terms that really matter.” We are down to the last one – the pay-to-play provision. At the turn of the century, a pay-to-play provision was rarely seen. After the bubble burst in 2001, it became ubiquitous. Interesting, this is a term that most companies and their investors can agree on if they approach it from the right perspective.
In a pay-to-play provision, an investor must keep “paying” (participating pro ratably in future financings) in order to keep “playing”(not have his preferred stock converted to common stock) in the company. Sample language follows:
“Pay-to-Play: In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated above under “Right of First Refusal” below will be converted into Common Stock.
[(Version 2, which is not quite as aggressive): If any holder of Series A Preferred Stock fails to participate in the next Qualified Financing, (as defined below), on a pro rata basis (according to its total equity ownership immediately before such financing) of their Series A Preferred investment, then such holder will have the Series A Preferred Stock it owns converted into Common Stock of the Company. If such holder participates in the next Qualified Financing but not to the full extent of its pro rata share, then only a percentage of its Series A Preferred Stock will be converted into Common Stock (under the same terms as in the preceding sentence), with such percentage being equal to the percent of its pro rata contribution that it failed to contribute.]
A Qualified Financing is the next round of financing after the Series A financing by the Company that is approved by the Board of Directors who determine in good faith that such portion must be purchased pro rata among the stockholders of the Company subject to this provision. Such determination will be made regardless of whether the price is higher or lower than any series of Preferred Stock.
When determining the number of shares held by an Investor or whether this “Pay-to-Play” provision has been satisfied, all shares held by or purchased in the Qualified Financing by affiliated investment funds shall be aggregated. An Investor shall be entitled to assign its rights to participate in this financing and future financings to its affiliated funds and to investors in the Investor and/or its affiliated funds, including funds which are not current stockholders of the Company.”
We believe this is good for the company and its investors as it causes the investors “stand up” and agree to support the company during its lifecycle at the time of the investment. If they do not, the stock they have is converted from preferred to common and they lose the rights associated with the preferred stock. When our co-investors push back on this term, we ask: “Why? Are you not going to fund the company in the future if other investors agree to?” Remember, this is not a lifetime guarantee of investment, rather if other prior investors decide to invest in future rounds in the company, there will be a strong incentive for all of the prior investors to invest or subject themselves to total or partial conversion of their holdings to common stock. A pay-to-play term insures that all the investors agree in advance to the “rules of engagement” concerning participating in future financings.
The pay-to-play provision impacts the economics of the deal by reducing liquidation preferences for the non-participating investors. It also impacts the control of the deal, as it reshuffles the future preferred shareholder base by insuring only the committed investors continue to have preferred stock (and the corresponding rights).
When companies are doing well, the pay-to-play provision is often waived, as a new investor wants to take a large part of the new round. This is a good problem for a company to have, as it typically means there is an up-round financing, existing investors can help drive company-friendly terms in the new round, and the investor syndicate increases in strength by virtue of new capital (and – presumably – another helpful co-investor) in the deal.
While lots of VCs posture during term sheet negotiations by saying “that is non-negotiable”, terms rarely are (as you’ve likely inferred from previous posts on term sheets be me and Jason.) Occasionally, a term will actually be non-negotiable. In all the VC deals we’ve ever seen, the preferred has the right – at any time – to convert its stake into common. Following is the standard language:
“Conversion: The holders of the Series A Preferred shall have the right to convert the Series A Preferred, at any time, into shares of Common Stock. The initial conversion rate shall be 1:1, subject to adjustment as provided below.”
This allows the buyer of preferred to convert to common should he determine on a liquidation that he is better off getting paid on a pro rata common basis rather than accepting the liquidation preference and participating amount. It can also be used in certain extreme circumstances whereby the preferred wants to control a vote of the common on a certain issue. Do note, however, that once converted, there is no provision for “re-converting” back to preferred.
A more interesting term is the automatic conversion, especially since it has several components that are negotiable.
“Automatic Conversion: All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price, upon the closing of a firmly underwritten public offering of shares of Common Stock of the Company at a per share price not less than [three] times the Original Purchase Price (as adjusted for stock splits, dividends and the like) per share and for a total offering of not less than [$15] million (before deduction of underwriters commissions and expenses) (a “Qualified IPO”). All, or a portion of, each share of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price in the event that the holders of at least a majority of the outstanding Series A Preferred consent to such conversion.”
In an IPO of a venture-backed company, the investment bankers will want to see everyone convert into common stock at the time of the IPO (it is extremely rare for a venture backed company to go public with multiple classes of stock – it happens – but it’s rare). The thresholds of the automatic conversion are critical to negotiate – as the entrepreneur; you want them lower to insure more flexibility while your investors will want them higher to give them more control over the timing and terms of an IPO.
Regardless of the actual thresholds, one thing of crucial importance is to never allow investors to negotiate different automatic conversion terms for different series of preferred stock. There are many horror stories of companies on the brink of going public and having one class of preferred stockholders that have a threshold above what the proposed offering would consummate and therefore these stockholders have an effective veto right on the offering. We strongly recommend that – at each financing – you equalize the automatic conversion threshold among all series of stock.
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.
Jason and I hope you enjoyed reading our term sheet series at least as much as we enjoyed writing it. While we won’t be competing with our friend Jack Bauer for any drama awards (I tried to make it 24 posts, but could only get to 20), we’ve tried to take a balanced and pragmatic approach to explaining the mysterious “VC term sheet.” Remember – we’re not lawyers (ok – Jason is) and this isn’t legal advice so you should not rely on it for anything, yada yada standard disclaimers follow. In other words, use at your own risk.
For ease of reference, following are the various sections (linked to their corresponding post) that we covered.
- Liquidation Preference
- Board of Directors
- Protective Provisions
- Drag Along
- Redemption Rights
- Conditions Precedent to Financing
- Information Rights
- Registration Rights
- Right of First Refusal
- Voting Rights
- Employee Pool
- Restriction on Sales
- Proprietary Information and Inventions Agreement
- Co-Sale Agreement
- Founders Activities
- Initial Public Offering Shares Purchase
- No Shop Agreement (also Unilateral or Serial Monogamy)
If you have any questions, comments, or suggestions for things we missed, email me anytime. We have had numerous requests for republishing this content – if you are interested, please contact me. We’re usually happy to oblige – we just want to make sure we know about it. Until next season …