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The terms we’ve chosen to designate as “other” are not any less likely to show up on your term sheet than the “essential” terms above. The difference is that the terms in this section have layers of complexity that most founders will need their lawyers to take the lead on or explain to them. You should be able to talk to a friend at a party about essential terms like pro rata rights; but if you can’t casually chat about anti-dilution, don’t worry about it. You’ll communicate closely with your lawyer about any issues they see in the term sheet related to these terms, and you can and should use this section as a reference when you get off the phone with your counsel.
Major Investor Clause
Some founders choose to include a major investor clause, which defines what the company considers to be a “major investor” based on an amount invested, or by number of shares purchased.
The major investor clause matters because, if included, the company can reserve rights and provisions for major investors only. Typical terms that the company will reserve for major investors include information rights, pro rata rights, co-sale rights, and the right of first refusal.
If you include a major investor clause, make the threshold an amount that will limit the number of investors who earn the designation. Even if you’re raising a $1M party round, the threshold could be $100K or $200K, as a carrot for larger checks.
Beyond an incentive for larger checks, major investor thresholds are beneficial because they reduce the number of investors you have to coordinate or negotiate with during subsequent rounds of funding regarding pro rata rights, or in a situation where someone wants to sell their stock and the ROFR and co-sale agreements are triggered. Granting information rights, pro rata rights, rights of first refusal, and co-sale rights to every investor has consequences you should be aware of before making a decision.
See the pro rata section for more on reserving pro rata rights for major investors.
Mark Suster recommends at least reserving information rights for major investors, citing a particularly egregious breach of trust he witnessed as an investor. Suster writes, “I know the temptation is to trust every investor—large and small—who gave you money when you were an early-stage startup. The reality is that you cannot. Major investor clauses exist for a reason. Protect your financial information wisely.” For another take, angel investor and co-author of The Startup Playbook, Will Herman, describes the major investor clause—particularly when it reserves pro rata rights—as unfair to angel investors and other early investors who took the first risks on the company.
DefinitionAnti-dilution provisions in a term sheet adjust the number of common shares into which preferred shares convert in the event of a down round or other stock dilution. The purpose of these provisions is to protect investors’ stock ownership percentage in a company.
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When negotiating anti-dilution clauses, lawyers may not get into the details of how anti-dilution works. They should, however, advise you to request contingencies to anti-dilution clauses. These contingencies allow space—or “carve-outs”—for founders to get around the clause in certain standard circumstances, like issuing shares in an acquisition, offering options for employees, or taking on venture debt that allows you to do those things without triggering anti-dilution.
DefinitionFull ratchet anti-dilution is a form of anti-dilution that adjusts the rate at which convertible preferred stock can be exchanged for common stock to reflect the lower price of shares issued in a down round. This adjustment recalculates the number of shares of common stock into which each share of preferred stock is convertible by dividing the price per share when the preferred stock was purchased by the price per share of common stock in the down round.* Full ratchet anti-dilution provisions benefit investors over founders because of the disparity they create between the values of common and preferred stock,* and they are relatively rare compared to weighted average anti-dilution provisions, which create less disparity.
If you raised an investment at $5 per share in one round, then raised a later round at $1 per share, each share of convertible preferred stock protected by full ratchet anti-dilution in the earlier round would be convertible into five shares of common stock. Those additional shares have to come from somewhere, which is what makes this approach controversial.
DefinitionWeighted average anti-dilution is a form of anti-dilution that uses a relative (weighted) formula in a down round or other stock dilution to decrease the price at which preferred stock can convert into common stock. This form of anti-dilution takes into account not only the new price per share but also the extent of the would-be dilution. As a result of its relative formula, weighted average anti-dilution produces a smaller adjustment than full ratchet anti-dilution* and is accordingly the more founder-friendly option.*
The formula for weighted average anti-dilution compares:
the amount of money previously raised by the company and the price per share at which it was raised, with
the amount of money currently being raised by the company in a down round or other stock dilution, and the price per share at which this new money is raised.
B = number of new shares that would have been issued if the conversion price before the dilution (CP1) applied
C = number of new shares actually issued
danger If you are looking at a weighted average anti-dilution provision, pay close attention to the way the calculation is described. Different versions of this provision can especially vary in terms of how they calculate the number of shares before the down round or other stock dilution (variable A above).
important We strongly recommend consulting an attorney about any anti-dilution provisions you have been presented with or are considering. These calculations can get extremely complicated, and they can have serious downstream consequences.
Conditions precedent to financing is legalese for “these things have to happen before this deal is actually binding,” which should be a reminder that term sheets are usually not legally binding documents. This part of the term sheet can range in size, may include several items, and, as Brad Feld writes, “if you can dream it, it has probably been done.” Common items include, per Brad Feld:
“approval by investors’ partnerships”
“rights offering to be completed by company”
“employment agreements signed by founders as acceptable to investors.”
Drag-along agreements are important in the event of an acquisition. Under Delaware law, the general standard is that a majority of the outstanding shares have to vote in favor of an acquisition—common and preferred voting together, a majority of the stockholders have to vote in favor of selling the company. At the time of an acquisition, however, almost every acquirer will require a supermajority (usually 85–95% of stockholders) to vote in favor of the deal. A simple majority of 51% leaves the acquirer open to the risk of 49% of the company opposing the deal and creating trouble through lawsuits.
DefinitionDrag-along agreements (or the drag-along provision) require certain minority shareholders to comply with a transaction approved by a specified majority percentage of shareholders.* In the context of venture capital term sheets, VCs are often majority shareholders while founders are minority shareholders.* Transactions that commonly trigger drag-along agreements include a sale of the company to, or a merger with, another entity.
While drag-along agreements are primarily designed to protect majority shareholder rights and make companies more attractive for acquisition, they also benefit minority shareholders by ensuring they receive the same transaction terms as the majority shareholder(s).* However, founders should be careful with drag-along agreements because investors can use these agreements against them.
Since founders usually hold common stock and investors typically hold preferred, founders should make sure the triggers to drag include:
A majority board vote.
A majority of the preferred vote.
A majority of the common vote.
caution Some investors try to remove the third provision, arguing that founders control the board, therefore protecting holders of common stock. The trouble with this is that the founders may lose control of the board at some point, and it will be very hard to then insert a new trigger to drag based on a majority of common shareholders’ votes.
TechCrunch details another provision founders can negotiate for when it comes to drag-alongs: common shareholders can require preferred shareholders to vote for liquidation if the sale would return them a certain multiple—say 3X—of their investment.
Definition A dividend is a distribution of a company’s profit to shareholders. Preferred stock pays predetermined dividends,* while a company’s board of directors must authorize any dividends to holders of common stock.* Many established public companies and some private companies pay dividends on common stock, but this is rare among startups and companies focused on rapid growth.* Startups rarely pay dividends on common stock because they generally prefer to reinvest their profits into expanding the business.
caution Companies backed by traditional venture capital firms will almost certainly not ever issue dividends. Because of this, most founders don’t negotiate on dividend rights in term sheets. Venture capitalists are looking for fund-returning results, not 6–8% dividends. Negotiating on dividend terms at the Series A can be hazardous, as the company may inadvertently signal that they’re interested in becoming a cash-flow positive dividend-distributing business, not a venture-scale fund returner.
Dividends come in two major types: non-cumulative dividends and cumulative dividends.
A non-cumulative dividend can be declared by the board and distributed to shareholders at any time. They are most common in venture-backed companies. Non-cumulative dividends are sometimes referred to as “if, when and as” or “when, as and if” dividends. This comes straight from the language you’ll find in term sheets related to dividends: “…if, when and as declared by the Board.” Some non-cumulative dividends require the company to pay some percentage to preferred stockholders before any dividend is issued to common stockholders, which can become onerous if a venture-backed company should switch strategies to become a cash-flow positive dividend-distributing business.
A cumulative dividend accrues at roughly 6–8% annually to be paid out on M&A or an IPO and are essentially a guaranteed return on investment. They are much more common in private equity or hedge-fund style investments.
Definition A pay-to-play provision in a term sheet requires investors to participate, at the company’s request, in subsequent financing rounds on a pro rata basis. If an investor does not participate when requested, they face consequences that can range from losing some privileges like anti-dilution protections to having their preferred stock wholesale converted to common stock.
Pay-to-play provisions are extremely rare in technology investment deals. But they are absolutely common in biotechnology or life sciences deals because those types of companies require such a large amount of capital to get a product to market. Early investors in biotechnology or life sciences companies need to be prepared to pony up cash in future financings and go the distance.
Definition A registration rights provision in a term sheet allows an investor to require a company to register the investor’s shares with the SEC when certain conditions are met, ensuring that the investor has the opportunity to sell their shares in the public market. Commonly listed conditions are: a certain period of time passing after the initial investment or an IPO; the company qualifying for a simplified registration; and/or the company registering other shares for public sale.* Registration rights are desirable to investors because the SEC’s Rule 144 limits the sale of a company’s stock to 1% of the total outstanding shares in a three-month period but only applies to unregistered stock.*
Registering shares is usually seen as a good thing for both a company’s management and investors. When a company goes public, large investors like Fidelity and T. Rowe Price may buy up large positions and hold them. This means the company’s stock is not widely available for purchase on the open market and can lead to volatility. When a large investor is able to sell a meaningful position after the lockup period, this increases the number of shares available for trading, which can reduce volatility. Again, good for everybody.
Usually, if big investors want liquidity near an IPO, there will be a separate conversation between management and investors as to how to make this happen outside of registration rights.
danger In extremely rare cases, registration rights can be used to force a company to go public. This is sometimes referred to as demanded registration rights. It’s so rare, in fact, that we could only find one modern example of this happening, between IVP and Applied Medical Corporation in 2012.** In this case, IVP was granted registration rights that they used to force Applied Medical to go public so they could get liquidity. A forced IPO cuts off opportunity for other forms of exit such as a sale and can greatly damage the company if the timing is wrong.
Restrictions on Sales
Term sheets may specify various restrictions on sales (ROS or transfer restrictions). Types of restrictions include: preventing stockholders from selling within a certain time period or until a certain valuation has been reached; subjecting sales of stock to consent by the board of directors and/or other stockholders; giving some stockholders right of first refusal on the sale of others’ stock; incorporating a co-sale agreement; and simply prohibiting the sale of stock altogether. These restrictions may appear in a clause titled Restrictions on Sales or under other headings.
Definition A redemption rights provision in a term sheet requires the company to buy back the investor’s preferred shares at a specified time, upon a specific occurrence, or at the investor’s request.* Typical provisions stipulate that a certain amount of time must pass after the original financing and, if redemption is not mandatory, the holders of a specified percentage of the relevant preferred stock series must vote in favor for redemption to occur. Redemption may take place in a single transaction or installments.* Redemption rights protect investors in the case that a company becomes profitable but not big enough to be an IPO or acquisition candidate.*
danger One version of redemption rights that is particularly dangerous is an “adverse change redemption” clause, which Brad Feld recommends never agreeing to.* This clause gives investors the option to request redemption if there are any significant changes to the company’s prospects. Since it’s usually vaguely worded, this clause gives investors the power to force the company to pay them for their shares in a wide range of scenarios based on arbitrary judgment.
Right of First Refusal and Co-Sale Agreement
The right of first refusal and the co-sale agreement govern how and to whom founders and employees can sell their stock.
Definition A right of first refusal (ROFR) provision in a term sheet gives the company and/or the investor the option to purchase shares from founders or other major common shareholders before they are sold to a third party. If the company or investor exercises this right, the sale must be on the same terms offered by the third party. Some term sheets first give the option to the company, then to the investor,* while others simply give the option to the investor.* If there are multiple venture capital investors, the ROFR provision typically specifies that each has the option to purchase a pro rata portion of the shares being sold.*
Definition A co-sale agreement (co-sale rights or tag-along provision) in a term sheet gives one group of stockholders the right to sell their shares when another group does so, and under the same conditions. In venture capital deals, these clauses are typically used to ensure that investors will be able to participate on a pro rata basis in any sales made by founders or other stockholders who pass a specified ownership percentage threshold.
Co-sale rights are typically paired with the right of first refusal. Co-sale rights will assume that ROFR rights haven’t been exercised, and only kick in after ROFR rights have been passed.
important Note that ROFR and co-sale rights may be reserved for major investors.
Definition The no-shop agreement (no-shop clause or no-shop provision) in a term sheet is a confidentiality agreement prohibiting founders from using the term sheet to solicit offers from other potential investors.
Including the no-shop agreement means investors don’t want you using the terms of their deal to gain leverage with another firm—allowing it will let investors know you’re pursuing this term sheet in good faith.
Management Rights Letter
Definition A management rights letter is a statement from a company that outlines the extent of an investor’s power to review and influence how the company operates. Term sheets may specify that the company provide this letter when the financing deal is closing and/or at the investor’s request.
Pension funds are subject to heightened rules for fund management under the Employee Retirement Income Security Act (ERISA), which protects individuals’ retirement and health savings, and they may act as limited partners in venture capital funds. When this happens, venture capital funds run the risk of also being subjected to the ERISA rules. To avoid this, they often seek management rights letters to support a claim that they should be exempt from ERISA.*
Definition An assignment provision in a term sheet specifies that the investor may transfer some or all of their shares to a partner or closely related entity. This provision allows investors to move shares between funds and make distributions to their limited partners.*
danger Many standard assignment provisions require the recipient of the transferred shares to agree to the same terms as the investor. Founders should be wary of an assignment clause if it does not include this requirement or, even worse, if it uses language that explicitly allows assignment without the recipient taking on the investor’s obligations under the original investment agreement(s).
You may also see the word assign, or assignment, elsewhere in the term sheet. In these cases, it refers to any situation in which one individual or entity transfers a right to another.*
Definition An indemnification provision in a term sheet is a commitment by the company to defend and compensate board members in the event of litigation and/or settlement relating to the venture capital financing or the directors work on the company’s board. Indemnification provisions may also include a requirement that the company provide insurance for its directors to cover these costs.
danger Founders and investors should be aware that many states’ corporate laws do not allow companies to indemnify their directors for intentional misconduct. This can include acting in bad faith, acting in a manner that cannot reasonably be considered to be in the company’s best interest, and acting unlawfully while knowing their conduct was unlawful.* Venture capital firms and the board members they designate may be particularly vulnerable to claims that they have a conflict of interest with holders of common stock because of their own interests as holders of preferred stock, and companies generally cannot indemnify board members for this type of misconduct.*
IPO Participation Rights
Definition An IPO participation rights (or initial public offering shares purchase) provision in a term sheet specifies a minimum percentage of shares that the investor may have the option to purchase in the event of an IPO. Some term sheets state that the investor must have this option if the company IPOs, while others simply require the company to do everything in its power to provide the option.*
danger Investors may like to see an IPO participation rights clause in a term sheet because it signals the company is headed toward an IPO,* but this clause can cause trouble with the SEC if the participation rights are granted too close in time to the IPO. Before a public offering, a company’s shares are not registered with the SEC and Section 5 of the Securities Act of 1933, as amended, prohibits selling or offering to sell unregistered securities unless an exemption applies. To stay on the right side of the SEC, founders and investors may consider including language that grants IPO participation rights only “if permissible under the securities laws.”*
important If a term sheet is going to include an IPO participation rights provision, founders should generally prefer the “best efforts” provision that stops short of mandating that the investors must have the option to purchase the specified percentage of shares. This is because a company works with other entities, such as investment banks, when preparing an IPO, and the company does not have complete control over how shares will be distributed.*
Definition A founders’ activities provision in a term sheet specifies that founders must spend 100% of their professional time on the company. If a founder wishes to work on another project, they must get approval from the company’s board. This provision may also require a founder who leaves the company but retains shares with voting rights to use their vote(s) to match the balance of votes cast by other shareholders. In effect, this would prevent a founder who leaves from continuing to make decisions for the company.