Startup 101 - Lesson 3: More Concepts in Term Sheets

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In this series, I will be posting articles on Venture Financing, and in particular, how as a startup founder you will navigate the landscape. The posts will be a concicse summary of the book that inspires me, Venture Deals by Brad Feld which is the best-seller on startups and entrepreneurship. The authors are venture capitalists, and give you the insight on how venture firms think.

In the first post, I outlined the various players in a venture deal, before navigating through what is a Term Sheet. We continue on with Brad Fel's advise in this post as we are Getting to Know the Terms of the Term Sheets. In particular we look at various concepts worth understanding as an entrepreneur, most notably:-

  • Composition of the board of directors;
  • Protective Provisions and Drag-Along Agreements;
  • Conversions and Dividens;
  • Redemption Rights;
  • Information & Registration Rights;
  • Right of First Refusal;
  • Voting Rights and more.

This is a long post, but hopefully it will be of use to you. I will be skimming a lot of the areas, which is why I recommend reading Venture Deals by Brad Feld when you get the chance.

Electing the Board of Directors

An important aspect that gets set during the creation of the Term Sheets is the voting mechanism and composition of the board of directors. The entrepreneur's task is to properly balance the ratio of founders, investors and outside representations (mentors) on the board.

This is set in the board of directors clause which sets the number of directors on the board, as well as it's composition, along with how the voting structure, how many members specific classes of stock holders can elect to the company's board (preferred stock versus common stock) . The founders need to decide whether each person on the board shall have one vote, or based on share ownership proportionality, or common-as-converted basis.

Brad Felds provides a great example of scenarios founders would be in, during the early-stage board compision, and finding the right balance. What's important to remember is, you don't want too many people on the board, especially outsiders who arent investors or founders because your sway may be compromised.

It is common for VCs to ask that one of the board members serve as the then-serving CEO, and it's preferrably that it's not one of the founders, but someone that is voted in by the common-stock holders. An ideal-balanced board would have the same number of seats for VCs as the CEO and founders combined.

Protective Provisions

These are veto rights investors will have on certain actions by the company, and whilst they are powerful they can also be destructive. Standardized now, protective provisions are supposed to protect investors from actions that the company may do that may compromise their economic position.

Usually set in the Term Sheet, the protective provision would require that at least a majority of Series A Preferred shall be required for actions such as:

  • Mergers;
  • Recapitalization;
  • Alteration of rights, preferences or priviliges of Series A;
  • Increase or decrease of Common or Preferred Stock; or
  • Re-classification of new classes of series of shares.

Once again, Brad Felds in this chapter provides excellent resource on analyzing each of these provisions and helping you assess what's fair and what's not common, as well as whether to negotiate for Series A and Series B to vote as one on protective provisions or to have separate provisioning.

Protective Provisions can also protect the entrepreneurs, in the instance where the company is in the process of being acquired, investors can block the sale and thus use this as a leverage when negotiating with a buyer to increase the price high enough to get the investor's consent on the deal.

Drag-Along Agreement

Drag-along agreements gives some of the investors the ability to 'drag' or force all of the investors and founders to do a sale of the company, regardless of how the rest of the board feels. This was something that was common according to Fels around the internet bubble burst when liquidation was abudant, and is a very complicated thing to understand. It mostly depends on the founder and his or her ownership percentage whether it matters to negotiate against or not.

Conversions & Dividends

Conversions

Conversions are one of those things that are generally non-negotiable, whereby holders of Series A Preferred have ther ight to convert their Series A preferred stock at any time into common stock, at an initial rate of 1:1 (commonly, along with some adjustments). This protective measurement ensures initial investors can benefit during liquidation on an as-converted common basis for their stock.

You would hear the term Automatic Conversion which means Series A Preferred will automatically convert ot Common Stock at an applicable price 'upon closing say during an IPO. Commonly you would have a conversion ratio of no less than 3 times the original price per share when an offering of no less than $X (like $15m). During an IPO investment bankers prefer to see all stock converted to common.

The author recommends that founders try to negotiate that automatic conversion should be the same regardless of what series of preferred stock is held, to save the complexities of having to deal with each series individually.

Dividends

This would mean for instance that holders of Series A Preferred would normally be entitled to receive non-cumulative dividends in preference to any dividend given to Common Stock, at rate of (say 8 percent) of Original Purchase Price per annum. These are great carrots to dangle at investors early on, as they won't usually see sweet returns for a while, but once they do, the dividends will certainly pay more handsomly for the Series A Preferred holders.

There are a few downsides to these, besids complex accounting erffort, and can put a company unknowingly into the realm of insolvency.

Redemption Rights

As another form of downside protection, are redemption rights, which requires the company re-buy their shares after a period of time, to put back into the company. An exercise that is rarely included, or actioned by investors. The premise of this provision is to protect investors from a company that is loosing momentum and attractiveness and most likely will not be making it to IPO.

This is further complicaed by the fact that companies will rarely have the capital to buy the shares back, which makes this a very bad deal for entrepreneurs to normally take. They aren't the norm either.

Information Rights

Another term found in a term sheet is information rights, which defines the scope of information the VC has access to legally, as well as the time frame in which the company is required to divulge such information.

“If you care about information rights for your shareholders, you are nuts. You should run a transparent organization as much as possible in the twenty-first century. If you can't commit to sending your shareholders a budget and financial statements, you shouldn't take on outside investors. If you are of the paranoid mind-set (which I generally applaud), feel free to insist on a strict confidentiality clause to accompany your information rights.” (Excerpt From: Brad Feld. “Venture Deals.”)

Registration Rights

Registration Rights provides investors with the rights to register their shares in an IPO scenario, and probably one of the most complicated sections of the term sheet. This forces a company to register common stock shares so that investors can sell them to the public.

This is something founders don't appreciate as it can force an IPO even if the founders don't feel the company is ready to go public yet, which may artificially lower the share values prematurely. This is something that investors would rarely exercise, and hopefully something that would not be on the term sheet,

Whether the company needs to use “best” efforts or “commercially reasonable” efforts to effect a registration. Investors ask for “best” efforts, which may require registration irrespective of costs or effort disproportionate to benefit. However, some commentators suggest that there is no real difference between any of these standards. (source: http://www.startupcompanylawyer.com/2007/08/12/what-are-demand-registration-rights/)

Right of First Refusal

This gives investors the right to buy shares during a future financing, and usually is termed as a pro-rata right and something a lot of investors insist on. Based on a share threhshold, its important to make sure they dont insist on something like X times listed price for purchase right in the future. It's also vital in the term sheet you define what a major investor is, and to give it to the major investor, not all of the shareholders, and make it only valid if they play in subsequent rounds.

Brad Feld](https://itunes.apple.com/us/book/venture-deals/id588203579?mt=11) served me well in referencing the different players on the startup scene, how to look and treat each of the players, and what to look out for.

In the next installment, I will be diving into the Capitalization table, which always comes attached to the term sheet and is no less important to understand. Stay tuned.