Some terms are more important than others. Here, we look at the most important ones.
Convertible note: discounts and caps
Convertible notes are often the investment vehicle of choice in angel and seed financings, as well as when insiders invest in a bridge round intended to bridge the company to its next full funding round. A cap specifies the maximum valuation at which the note converts into equity. A discount specifies that whatever the price per share is determined to be at the next priced funding round, the percent discount will be applied to convert the note into equity.
If a convertible note includes both a discount and a cap, then the note will specify that the note will convert by whichever method (discount or cap) maximizes the number of shares received by the investor after conversion of the note into equity. A discount in the 20% range is typical and appropriate. The cap is often a key negotiation point between investor and management.
Management should push hard to keep the cap high enough to allow for reasonable valuation growth between the convertible note investment and the next priced round investment. A low cap can unfairly dilute common shareholders in the next round and can influence the new investor to want to keep the round’s valuation at or near the cap, sometimes artificially limiting pre-money valuation.
In a priced equity round, a liquidation preference confers to an investor the first right to proceeds upon company liquidation. This includes a merger or sale of the company. Proceeds may be cash or stock in an acquirer, or other property. A 1X liquidation preference means the preferred investor gets amount of its investment back first, before others share in distributions. A 2X liquidation preference means preferred investor gets 2X the amount of its investment back first. Under normal circumstances, management should push hard for 1X liquidation preference.
Participation (participating liquidation preference)
Participation is a very important term, often misunderstood. There are three types of participation: full participation, capped participation, and no participation. The first is worst.
In the case of full participation, after preferred investors get their liquidation preference of 1x, 2x or more back, these investors then also share on an as-converted basis (as if converted into common stock) in subsequent distributions. For the preferred investor, this is like having your cake and eating it too. It means that the investor always gets more than their pro rata conversion to common. They get that plus their liquidation preference. If terms include full participation, it’s a sign of significant investor leverage — a sign that common has a weak hand. In such a situation, a liquidation preference of greater than 1X would be highly punitive to common and is almost never done.
In capped participation, the sharing on an as-converted basis (as if converted into common stock) ceases once a specified multiple return is reached. For example, a 2x cap means that once the investor has received participation equal to the investment, then that investor ceases to receive proceeds. So the investor must decide whether it’s more financially advantageous to stay as preferred and receive the liquidation preference and capped participation right, or to convert into common and receive an uncapped return.
For the common shareholder (and, usually management), no participation is best. Here, the preferred investor has a choice — either to receive the liquidation preference or convert into common and be treated like all common shareholders. So when the company valuation is determined in a liquidity event, the preferred investor calculates whether it’s more financially favorable to convert preferred shares to common and receive the proceeds equal to the percentage owned, or to receive the liquidation preference payout.
If management has leverage, it should push hard for no participation — full participation should only be accepted if there is no funding alternative. Even capped participation is indicative of limited management leverage. In today’s environment, non-participating liquidation is the standard, and if participation is participating, it is almost always capped.
One reason participation is best to be avoided is that its effects linger. Once you give it to one series of preferred, subsequent rounds will demand it. The effect of these growing preferences is such that as you approach exit, the exit price must be more and more massive for common shares to be in the money. The more employees realize they are with a company that has no viable path to common participation, the more flight risk your company will face.
Anti-dilution provisions provide investors downside protection in the event of a down round. There are three broad types of anti-dilution provisions: full ratchet, narrow-based weighted average, and broad-based weighted average. The first is worst.
A full ratchet anti-dilution provision reduces the preferred investor’s conversion price to common down to the lowest price at which the stock is issued after the date of the preferred investor’s investment, without regard to the number of shares issued in the subsequent investment (the down round). Full ratchet is a draconian provision, and management should only allow it if there is no alternative funding path available for the company.
In a narrow-based weighted average anti-dilution provision, the issuance is weighted just against the outstanding shares, not the convertible shares. This is punitive to common. If your investor insists on anti-dilution protection, you should push for a broad-based weighted average approach.
A broad-based weighted-average anti-dilution provision takes into account both the price per share, and the number of shares issued in the round as compared to the total shares. Such a provision stipulates that the issuance will be weighted against the fully diluted shares of the company (i.e. under the assumption that all preferred shares, options, warrants, etc. have been converted to common). It is the most favorable form of anti-dilution for common shareholders.
The no-shop clause stipulates that once the term sheet is signed, the company cannot hold discussions with other VCs regarding funding until diligence is complete and the investment closes, or the investor walks away. A no shop clause is almost always included in a final, signed term sheet. It makes sense, if and only if the likelihood of a final closed investment round is very high. There can be nothing worse for management than to have signed a term sheet, shut off all other VC conversations, and then in diligence have the VC walk away. Not only is it very hard to restart the pipeline, but you now need to overcome the skepticism new VCs will have as a result of the previous VC walking away post-term sheet.
This is why it’s so important to negotiate all material terms at the term sheet stage. Don’t push the tough conversations into the definitive documents stage — deal with them in the term sheet negotiations.
Conditions precedent to a financing
These terms specify the key categories of work that must be completed prior to close of financing. They usually include:
- Completion of final definitive documents (the detailed legalese)
- Completion of due diligence (to confirm management claims and company’s current technical, legal and financial status)
- A management rights letter (the right of inspection of the books, etc.)
- A detailed budget submitted by management for the next 12 months
A number of items are red flags, and should not be listed in these conditions. For instance, don’t sign a term sheet where the investor imposes a condition requiring approval by an investment committee or by the investor partnership. Investor approval should be complete prior to signing of term sheet. Another item that should be negotiated before signing of the term sheet is employment agreements. All key management compensation issues should be figured out before signing of the term sheet (at least at a high level).
These provisions ensure that certain actions being pursued by management (which often holds a majority of total outstanding shares) can be vetoed if the percentage of preferred shareholders voting for the action is insufficient. Decisions that are covered by such provisions may include:
- A sale of the company
- Changes in the total number of authorized shares (either preferred or common)
- Changes to the articles of incorporation or bylaws
- The issuance of new preferred shares
- The purchase or sale of preferred or common shares
- Increasing or decreasing the size of the board
- Declaring a dividend
- Significant changes to the company’s product offerings
- Compensation changes for top management
- Incurring loans over a certain threshold
- Acquisition of another company
Many of these are reasonable requirements. But management should pay close attention to the thresholds, and make sure you are not excessively constrained in the decision flexibility you have, especially in areas such as product, compensation and financing.
Right of first refusal and co-sale
In the event management seeks to sell some of its shares, the right of first refusal provision stipulates that the company — and then the VC investor — first have a right to buy the shares, at the price set by an outside investor. The outside investor cannot purchase the shares unless both the company and the VC have refused the investment.
The co-sale provision stipulates that an existing investor can sell shares on the same terms as management, on a pro-rata basis.
These are problematic terms. The right of first refusal impedes the ability of management to find an outside investor. No outside investor will put time and energy into evaluating an investment, knowing that there is a significant likelihood that investment will be denied them by action of the company or an investor. And the co-sale agreement may also impede the ability of management to sell a part of their holdings, by complicating the sale itself and increasing the number of shares being sold.
It’s not uncommon for the journey from company inception to final exit to take seven years or more. Management should negotiate flexibility to sell some shares prior to an exit — to help pay for that new home, or college for the kids — with rules that balance the needs of management and institutional investors.
Acceleration of Options
In negotiating management compensation, a key item will be the right to accelerate the vesting of options in a change of control event. If management has enough leverage, you should negotiate for “single trigger” acceleration of options. This means that in the event of a change of control, all of your options immediately vest. A backup alternative is “double trigger” acceleration — in which automatic vesting occurs only in the event of both a change of control and termination of employment.
VCs often demand the right to force common shareholders (and minority preferred investors) to vote their shares in favor of a sale or merger in the event that the board approves the sale or merger. This “drag along” right occurs once a defined percentage of the preferred investor class votes in favor of the transaction.
In term sheet negotiations, depending upon the make-up of the investors, the VC may seek the drag-along trigger point at 50% of preferred investor class shares. Management may wish to negotiate the trigger point higher — such as a supermajority trigger point requirement of ⅔ of all preferred investor class shares.
If your leverage is significant enough, you could ask for a requirement that a majority of common shareholders must also agree to the drag along. But you need to factor into your analysis that preferred shares can convert to common shares. You might instead negotiate a minimum price to trigger the drag-along — such as twice the liquidation preference. This ensures the sale can’t be forced unless common shareholders participate in the proceeds. Preferred investors will want a trigger point that gives them a reasonable return as well.
A pay-to-play provision incents investors to participate in future investments, at least pro rata. With a pay-to-play provision in place, an existing investor who does not participate pro rata in a later investment loses certain rights — such as participation, liquidation preference, anti-dilution rights or board control rights. This is often achieved by forcing the investor to convert to common in the event the investor does not invest in the next round.
Management should work to include a pay-to-play provision in the term sheet, at least for major investors, and at least in a down round situation. Angel and seed investors are usually excluded from this requirement.
This provision ensures that you have investors who are in for the long haul and will continue to support the company — assuming other investors are willing to do so. If an investor resists pay-to-play, it’s legitimate for you to then question any rights they may seek regarding anti-dilution: why should an investor get the protective benefit of an anti-dilution provision in a down round, when they won’t commit to supporting the company in such situations?
In later-stage rounds (B and beyond), especially in down round scenarios, new investors may impose negative terms on previous investors. These may include:
- A lower price than previous rounds
- A requirement to restructure previous liquidation preferences, participation rights, anti-dilution rights, etc.
- A pay to play provision, which stipulates that the investment must include pro rata participation of previous investors or certain negative consequences will be incurred
This is especially likely to happen when the new investor knows or she has significant leverage and the company has limited options. Even negatively affected previous investors may be willing to accept the terms if they conclude that turning down the investment leads to even worse consequences.
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