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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
The term sheet for a preferred stock offering will contain the following key elements:
The type of security (for example, series A convertible preferred stock). (Note that the word “convertible” here refers to the fact that the preferred converts to common.)
The amount of money being raised in the round (referred to as an “offering”).
A summary of the cap table post investment. Because the cap table represents the ownership of the company, it is really useful to have a summary cap table in the term sheet, so that there are no surprises on either side as the deal comes together. Everyone has a clear picture of what they are going to end up with.
The preferred stock term sheet will also contain a list of preferences for the preferred stockholders, discussed in this section.
A liquidation preference entitles the holder of the security with the liquidation preference to be paid before other stockholders on a sale of the company or all of its assets.
exampleFor example, suppose you invest in Series A Preferred Stock at $1 per share, and the Series A Preferred Stock has a 1X liquidation preference. On the sale of the company, after the payment of creditors (lenders), the Series A Preferred stockholders would get paid back their $1 per share liquidation preference before the common stockholders received anything.
Liquidation preferences come in a variety of different flavors. A preferred stock might have a liquidation multiple. In this case, the Series A Preferred might have the right to receive twice its purchase price per share (a 2X liquidation preference) before any other stockholder is entitled to receive any liquidation proceeds.
Another critical characteristic of each liquidation preference is whether the preferred is “participating” or “nonparticipating” preferred.
Non-participating preferred stock is preferred stock that entitles the holder on a liquidation to receive the greater of either (i) its liquidation preference, or (ii) what the preferred stock would receive if it converted to common stock.
Participating preferred stock is preferred stock that entitles the holder to a return of its liquidation preference, and then to participate with the common stock on an as-converted to common stock basis.
exampleFor example, suppose you invest $1M in non-participating Series A Preferred Stock with a 1X liquidation preference, for a post-closing ownership of 10% of the company and a post-money valuation of $10M (the company has 9M shares of common outstanding in this example). If the company is sold for:
$1M, you would be entitled to all of the liquidation proceeds. There would be nothing left for the founders and earlier investors.
$3M, you would receive the first $1M, and the common would get the remaining $2M; you would only get your money back.
$100M, you would forgo your $1M liquidation preference, and either convert to 10% of the issued and outstanding common stock or be treated as if you had converted, and receive $10M on the sale.
exampleNow let’s look at the same example above, with a participating preferred stock, with a 1X liquidation preference. If the company is sold for:
$1M, you would be entitled to all of the liquidation proceeds.
$3M, you would get the first $1M, and then 10% of the remaining proceeds (10% x $2M = $200K) for a total of $1.2M.
$100M, you would get your $1M liquidation preference, and then your 10% share of $99M, for a total of $10.9M.
exampleUsing the same example, if there were no liquidation preference, the outcomes are very different.
If the company is sold for:
$1M, you would get only $100K back, a 90% loss on your investment.
$3M, you would get $300K, a 70% loss on your investment.
$100M, you would get $10M.
As you can see, the liquidation preference—and especially the participating preference—is very important to achieving a positive ROI if the company is not acquired for a very large multiple of its post-money valuation.
Anti-dilution protection, or, more precisely, purchase price anti-dilution adjustment protection, refers to provisions of stock, most typically preferred stock, that automatically adjust the conversion ratio of the stock to greater than 1:1 if the company sells shares in the future at a price less than what the investor paid.
confusionAnti-dilution adjustment protection typically only comes with preferred stock, but it is possible (though very rare) under corporate law to make it part of any type of stock, including a subclass of common stock, for example.
Preferred stock starts out as convertible into common stock on a 1:1 basis. However, if the company issues shares of stock in a financing at a lower price than you paid, the anti-dilution conversion adjustment protection may be triggered. If it is triggered, you become entitled to more than one share of common stock on conversion of each share of your preferred stock.
exampleYou buy Series A Preferred Stock at $1 per share with anti-dilution protection. The company later sells Series B Preferred Stock at $0.50 per share. Your shares of preferred stock would become convertible into more than one share of common stock. The exact ratio at which your preferred would convert into common depends on what type of anti-dilution protection you have.
confusion Anti-dilution protection is a typical preferred stock preference but it is not included in all preferred stock. For example, Series Seed Preferred Stock typically does not have it. Instead, the Series Seed Preferred Stock terms say that on the company’s next round of preferred stock, if that round has anti-dilution adjustment protection, at that time the Series Seed will be conferred those rights as well.
importantIf the valuation of the company and its stock is increasing with each successive round of funding, anti-dilution adjustment provisions are not triggered. If, however, the company needs to raise money at a lower valuation for whatever reason (called a down round), the anti-dilution protection could be valuable. The anti-dilution clause is intended to prevent the prior investors from getting too badly diluted by the new money coming in at a lower valuation. However, if the company is really struggling to raise new money, a new investor coming in can essentially dictate terms, which may mean that you have to negotiate away some or all of this protection to close the deal (the golden rule again)—but at least you have some say in the matter.
There are a few different types of anti-dilution adjustment protection:
Broad-based, weighted average anti-dilution adjustment
Full ratchet anti-dilution adjustment protection
Narrow-based, weighted average anti-dilution adjustment protection.
Broad-based weighted average anti-dilution protection is the friendliest anti-dilution protection for founders
Broad-based weighted average anti-dilution protection is a type of purchase price anti-dilution protection that has the effect of adjusting the conversion price of a class or series of preferred stock entitled to the protection if the company subsequently raises money by selling shares at a lower price per share than the price per share paid. This type of repricing takes into account the amount of shares the company sold at the lower price. The more the company raises at the lower your conversion price becomes.
The formula for broad-based weighted average anti-dilution, from NVCA, is:
⚖️legaleseFor purposes of the foregoing formula, the following definitions shall apply:
(a) “CP2” shall mean the Series A Conversion Price in effect immediately after such issue of Additional Shares of Common Stock
(b) “CP1” shall mean the Series A Conversion Price in effect immediately prior to such issue of Additional Shares of Common Stock;
(c) “A” shall mean the number of shares of Common Stock outstanding immediately prior to such issue of Additional Shares of Common Stock (treating for this purpose as outstanding all shares of Common Stock issuable upon exercise of Options outstanding immediately prior to such issue or upon conversion or exchange of Convertible Securities (including the Series A Preferred Stock) outstanding (assuming exercise of any outstanding Options therefor) immediately prior to such issue);
(d) “B” shall mean the number of shares of Common Stock that would have been issued if such Additional Shares of Common Stock had been issued at a price per share equal to CP1 (determined by dividing the aggregate consideration received by the Corporation in respect of such issue by CP1); and
(e) “C” shall mean the number of such Additional Shares of Common Stock issued in such transaction.
How broad an anti-dilution adjustment is depends on what is included in the “A.” Typically you include issued and outstanding options in the “A.” We have included an §interactive spreadsheet for you to play with these formulas.
Full ratchet anti-dilution adjustment protection (or full ratchet) refers to a method of purchase price anti-dilution protection in which an adjustment is triggered upon the sale of stock at a lower price. Full ratchet rights entitle the holder to have their conversion adjustment formula reset in order to give them the number of common shares that they would have received had they purchased their shares at the lower price.
With full ratchet protection, if the company sells shares at a price per share that is lower than you paid, your purchase price gets adjusted to the new, lower price, regardless of how many shares are sold at the lower price. Even one share sold at a lower price triggers the adjustment in the price you paid for all of your shares.
In a narrow-based purchase price anti-dilution formula, the investors receive more shares on an as converted to common stock basis than with broad-based protection because in narrow-based you do not count the issued and outstanding options in “A” in the formula above, only the issued and outstanding stock. This results in a lower conversion price, making it less friendly to founders than broad-based. Narrow-based anti-dilution results in a greater adjustment than broad-based, weighted average anti-dilution adjustment provisions, but less than full ratchet adjustment provisions.
Preferred stock usually has a dividend preference, which means that dividends cannot be paid on the common stock unless a dividend is first paid on the preferred stock. A dividend preference might say that the preferred stock is entitled to a certain percentage dividend—say, 8% of the purchase price of the stock, per year, noncumulative, “as, if and when” declared by the board. The preference would go on to say that no dividends may be declared on the common unless and until the preferred dividend is paid.
If the preferred stock is participating preferred, the dividend preference would also dictate that after payment of the preferred dividend, the preferred would participate with the common on any dividend paid on the common stock on an as-converted to common stock basis. For example:
⚖️legaleseHolders of the Series A Preferred shall also participate pro rata on an as-converted basis with respect to dividends, if any, declared with respect to the Common Stock.
If the preferred stock is not participating (meaning, it is not entitled to its liquidation preference and to participate alongside the common, it is only entitled to either its liquidation preference or to participate alongside the common), there is no need for the language immediately above, and in fact its presence would not be appropriate.
Dividends can also be “cumulative.”
A cumulative dividend would accumulate every year, year over year, but be paid only “as and when” declared by the board. Cumulative dividends would be paid on liquidation, if not paid before. Cumulative dividends can be economically harsh on founders and junior investors and are not common in competitive deals.
For most startup and early-stage companies, dividends are not paid. However, the language remains in investment documents to protect the preference of the preferred stock over the common. One scenario preferred stock investors are protecting themselves from is the following: The company grows slowly but is cash flow positive. The founders treat it as a lifestyle business and pay themselves out a dividend to the common stock without paying a dividend to the preferred stock.
The voting rights of stockholders come into play whenever the company is taking an action that requires stockholder approval. The typical items that require stockholder approval include, among other things: the election of directors; an increase in the company’s equity incentive or stock option plan share reserve; an amendment to the company’s charter (other than purely a change of the company’s name).
Preferred stock usually votes on an as-converted to common stock basis. Meaning, it votes just like common stockholders. It also usually, but not always, has additional, special voting rights known as protective provisions.
Voting rights are part of the company charter.
Protective provisions are provisions in a set of investment documents which require the separate approval of a particular class of investor before the company can take certain actions. For example, the separate approval of holders of a majority of the Series A Preferred Stock might be required before the company can undergo a sale transaction.
It is not a requirement that protective provisions appear in a charter filed with the Secretary of State. It is the most common place for them to appear, but they can also appear in an agreement signed by the company. For example, suppose you were investing in common stock, but wanted protective provisions. In that instance, you could put the protective provisions in a side letter agreement with the company, or in an Investor Rights Agreement.
The Series Seed term sheet includes the following pretty typical protective provisions:
⚖️legaleseVotes together with the Common Stock on all matters on an as‑converted basis. Approval of a majority of the Preferred Stock required to (i) adversely change rights of the Preferred Stock; (ii) change the authorized number of shares; (iii) authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock; (iv) redeem or repurchase any shares (other than pursuant to the Company’s right of repurchase at original cost); (v) declare or pay any dividend; (vi) change the number of directors; or (vii) liquidate or dissolve, including any change of control.
Below is a list of the types of items that may be listed in the protective provisions:
amendments to the charter or bylaws
changes to the terms of the preferred stock
the issuance of a series of preferred stock that is on a parity to or senior to the preferred stock
a sale of all or substantially all of the assets of the company
the entry into an exclusive license for the company’s intellectual property
a change to the size of the company’s board of directors
the authorization or payment of a dividend
the incurrence of debt above a certain amount.
Other open source documents that include protective provisions include:
Redemption rights (or put right) are the rights to have your shares redeemed or repurchased by the company, usually after a period of time has passed (3-7 years). It is also possible to prepare these provisions to allow redemption in the event the company fails to reach a milestone, or breaches a covenant.
caution Be aware, however, that even if you have redemption rights, if a company is insolvent it will not be able to legally satisfy a redemption demand. Under most states’ corporate laws, corporations are disallowed from redeeming shares when the corporation is insolvent either on a balance sheet or ability to pay its debts as they come due, and directors are personally liable if they authorize a redemption when the corporation is insolvent.
Redemption rights are not common in angel deals.* However, they can be appropriate and a good mechanism to employ if a business has the danger of becoming a lifestyle business for the entrepreneur. If you want to put redemption rights in place, in order to avoid a lifestyle business outcome, you will probably also want to put in place covenants, such as restrictions on founder salaries—perhaps subject to the approval of a compensation committee composed entirely of independent directors—to ensure that the redemption rights will have value and are enforceable when they come due.
Pro rata rights (or pro rata) in a term sheet or side letter guarantee an investor the opportunity to invest an amount in subsequent funding rounds that maintains their ownership percentage.
You will want to try to negotiate for pro rata rights. If a company is doing well, you will want to own as much of it as possible. Some founders include a major investor clause in the term sheet, which reserves certain rights and privileges to those they deem “major investors.” Whether to grant pro rata rights to all investors or only those above a major investor threshold is a tricky decision.
When companies use a major investor threshold to determine who gets pro rata rights and who does not, angel investors usually don’t make the cut. Angels hate this because it limits their ability to gain more ownership in a company they see themselves as having spotted and supported early on. VCs want the threshold because they don’t want to share pro rata rights with a larger group of investors. This is a major source of conflict between angel investors and VCs.*
Pro rata rights, when they appear in an angel round, typically show up in a preferred stock financing. But they can appear elsewhere.
The topics below are important elements of a preferred stock financing. These issues may or may not be represented in the term sheet.
In early-stage company financings, preferred stock is almost always convertible into common stock at the option of the holder. It is also typically converted automatically upon an event such as an initial public offering that meets a certain size, or upon the election of a majority (sometimes supermajority) of the preferred stock to convert to common. This clause in the term sheet will typically specify the conversion ratio of preferred stock into common stock (always at a 1:1 ratio) and any events or other provisions that would impact that conversion ratio. For example, take a look at the Series Seed Term Sheet, which says: