How do founder concerns and investor concerns translate into actual deal terms? We know they need to be allocated appropriately between the parties, but what tools are used to actually make the puzzle pieces fit together? Let's look at the individual term sheet provisions used to address the key concerns and try to make sense of them by organizing them into the categories where they belong.
Category 1: Deal Economics Provisions
Think about the basic economics of a round of investment. Clearly the provisions relating to the total size of the round and the valuation of the company are fundamental. The higher the valuation, the greater the price per share, and the fewer the number of shares (and percentage of the company) will be acquired for a given investment.
A closely linked term is the size of the option pool. Investors want to invest in a company which has the tools necessary to attract and retain talent (i.e. employee stock options) and the investors want the company to establish that pool prior to their investment; otherwise, the creation of the pool will dilute their ownership and raise the effective valuation of the deal.
The deal economics category also includes the liquidation preference, or repayment priority, associated with the offered shares. Preferred stockholders are always entitled to repayment before common stockholders. The liquidation preference provision specifies key details such as whether preferred stockholders are entitled to more than just the customary 1X of their original money, and whether they are entitled to participate with common shareholders after they have been paid back their original principal. Liquidation preference clauses generally give the preferred holders a choice of taking their preference or converting to common stock. Depending on how the liquidation preference is structured, and what the exit price is, sometimes it is better to take the preference and sometimes it is better to convert to common stock.
Dividends are the final item addressed in this category. It is highly unusual for a startup to agree to regular cash dividends, but accruing dividends or dividends payable in stock are seen in some deals. Dividends function as a way to keep a time clock on the entrepreneurs to make sure there is some compensation for the passing of time.
Category 2: Investor Rights/Protection Provisions
The most important topic in this category is the anti-dilution provision. This clause prevents the company from economically diluting investors by selling stock to someone else for a lower price than the earlier investors paid (arithmetic dilution from sales at higher price is not addressed by anti-dilution clauses). It states that in the event of a lower-priced offering, the investors' stock will automatically and retro-actively be re-priced downward (and they will therefore own more shares for their original investment).
The anti-dilution provision is strong medicine, but indirect and automatic. The other provisions in this category attempt to protect investors more directly. The first is an assertion of the right to approve any material merger, acquisition or liquidation of the company. This approval right means that a transaction cannot be completed without investor permission. This ensures that the investors will not be surprised by a transaction after the fact.
Working in parallel are similar provisions that control transactions involving the company's stock. The first reserves the right on behalf of investors to approve of and participate in any future financings. This means that if things are going well, current investors will have the right to invest more. The second relates to secondary stock transactions - stock sold by a founder rather than by the company itself. This provision pairs together two opposing sides of the same coin: a right of first refusal (ROFR)and a co-sale right. These provisions give the investors (or the company) a right of first refusal to buy any stock that a founder may choose to sell before it can be sold to a third party. However, the investors may not want that stock (for example, when things are not going well). This is why investors pair the ROFR provision with an alternative right: the right to sell a proportionate amount of their own stock in any transaction that the founders are able to pull off. This protects the investors regardless of what the transaction scenario is.
Category 3: Governance, Management & Control Provisions
This category addresses three basic realities: investors want to know what's going on in the company, have a say in critical decisions, and protect against founder actions that could damage the company. At the heart of this category is the right to one or more investor board seats, combined with governance provisions requiring board or committee approval for a list of important operational activities (or even in some cases reserving a veto right for the investor board member).
Paired with board seats is a clause called information rights. These rights involve a requirement that the company regularly share with investors information on the company's financial and business condition.
The final clauses in this category focus on managing the risks associated with relying on key founders to make the company successful. The first is called "founder vesting." The term is a misnomer because it is actually a right to claw-back some of the founder's stock in the event that the founder leaves the company in the early critical years. The right phases out over time, so it is really not about vesting of ownership, it is lapsing of restrictions. Related to this is the requirement that founders as well as other employees sign agreements not to use its confidential information, solicit its customers, poach its employees, or compete with the company (in jurisdictions permitting this), for a period of time following their departure.
Category 4: Exits & Liquidity Provisions
This category of clauses relates to the control of exits and liquidity. Investors want to make sure they maximize the chances of getting their money back in all possible exit scenarios (positive or negative), even if they have to force such an event to occur. The primary way this is accomplished is through the "drag-along" provision, which states that if the investors want to sell the company, and they are backed by a certain amount of stockholder support, a small minority cannot block the transaction, but must go along with the majority looking to sell.
The drag-along provision is sometimes accompanied by redemption rights, which allow investors to demand repayment of the money they invested, plus some agreed-upon return, usually during a window of time a few years out from their initial investment. If things within the company are not going well, such a repayment could cause a cash crunch which would have the effect of forcing the company into a sale or recapitalization.
Finally, registration rights are included in the exits and liquidity category. Registration rights entitle the investors, as part of an IPO, to have their stock registered with the SEC so that they become fully liquid and tradeable after the IPO.
Clearly, the road to fair deal terms requires a deep understanding of the complex issues fueling both founder and investor concerns. Making sense of these issues is far easier when they are considered in context, and this can be achieved when the key provisions used in each of the four investor "concern categories" are mapped out together in their respective categories.
Next up we'll explore smart approaches for reaching fair compromises when drafting and negotiating these provisions. Stay tuned to this series for upcoming installments.