Term Sheet Tutorial
Term Sheet Tutorial 1
INTRODUCTION TO OTAF’S TERM SHEET TUTORIAL
Many books have been written about angel and VC term sheets. At an early
Summit the ACA held in Kansas City we gave attendees a copy of Alex Wilmerding’s
well known book, Term Sheets & Valuations: An Inside Look at the Intricacies of
Term Sheets & Valuation (Aspatore, 2001).
We based our generic term sheet on this book, which we provide entrepreneurs
whenever we discuss the terms and conditions for our investment in their venture. The
OTAF term sheet is similar to the NVCA term sheet available at:
http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=13
6
Although these are our core documents, we have pasted into this compendium the
occasional article/blog discussing an illuminating term sheet concept or nuance. Please
note: I want to apologize for the sophomoric and profane language prevalent in some
particular bloggers’ posts. I did not feel I should recast their words. The original type
fonts have also been retained.
I encourage you to:
 Consult this compendium whenever you confront a new twist in deal
documents, and
 Send me enhancements and additions as you encounter them
John O. Huston
Manager, Ohio TechAngel Funds
Aug 2010
Term Sheet Tutorial 2
Table of Contents
Term Sheet .......................................................................................................................... 6
The Science & Art of Term Sheet Negotiation ............................................................... 6
Term Sheet: Restriction on Sales, Proprietary Inventions, and Co-Sale Agreement........ 10
Term Sheet: Restriction on Sales, Proprietary Inventions, and Co-Sale Agreement.... 10
Term Sheet: Voting Rights and Employee Pool ............................................................... 12
Term Sheet: Voting Rights and Employee Pool ........................................................... 12
Term Sheet: Option Pool .................................................................................................. 13
Option Pool ................................................................................................................... 13
Option Pool Shuffle ...................................................................................................... 13
Mastering the VC Game: A Venture Capital Insider Reveals How to Get from Start-up
to IPO on Your Terms................................................................................................... 17
Term Sheet: Right of First Refusal ................................................................................... 20
Right of First Refusal .................................................................................................... 20
Term Sheet: Right of First Refusal by Feld Thoughts .................................................. 20
Right of First Offer Versus Right of First Refusal: ...................................................... 21
Term Sheet: Information and Registration Rights ............................................................ 22
Information Rights ........................................................................................................ 22
Term Sheet : Information and Registration Rights by Feld Thoughts .......................... 22
Registration Rights........................................................................................................ 24
Term Sheet: Vesting ......................................................................................................... 27
Term Sheet: Vesting by Feld Thoughts ........................................................................ 27
Vesting of Founders Shares by John Huston ................................................................ 29
Term Sheet: Conditions Precedent to Financing .............................................................. 30
Conditions Precedent .................................................................................................... 30
Term Sheet: Conditions Precedent to Financing by Feld Thought ............................... 30
Term Sheet: Conversion ................................................................................................... 32
Automatic Conversion .................................................................................................. 32
Term Sheet: Conversion by Feld Thought .................................................................... 34
Term Sheet: Redemption Rights ....................................................................................... 36
Redemption ................................................................................................................... 36
Term Sheet: Redemption Rights by Feld Thoughts ...................................................... 36
Term Sheet: Compelled Sale Right................................................................................... 38
Compelled Sale Right ................................................................................................... 38
Term Sheet Tutorial 3
Term Sheet: Dividends ..................................................................................................... 39
Dividend Provisions ...................................................................................................... 39
Term Sheet: Dividends by Feld Thoughts .................................................................... 39
Another Look At Dividends.......................................................................................... 41
Term Sheet: Pay-to-Play ................................................................................................... 42
Term Sheet: Pay-to-Play by Feld Thought ................................................................... 42
Pay To Play ................................................................................................................... 43
Term Sheet: Anti-Dilution ................................................................................................ 44
Anti-dilution Provisions ................................................................................................ 44
Dilution? By Frank Demmler ...................................................................................... 44
Term Sheet : Anti-Dilution by Feld Thoughts .............................................................. 48
Anti-Dilution Protection Key Aspect of Raising Money .............................................. 51
Practical Implications of Anti-Dilution Protection ....................................................... 55
Full Ratchet Anti-Dilution Protection ....................................................................... 58
Weighted Average Anti-Dilution Protection ............................................................ 65
Anti-Dilution Protection Postscript .......................................................................... 71
Protective Covenants ................................................................................................ 75
Term Sheet: Protective Provisions .................................................................................... 76
Protective Provisions .................................................................................................... 76
Term Sheet: Protective Provisions by Feld Thoughts .................................................. 76
Term Sheet: Board of Directors ........................................................................................ 79
Board Composition and Meetings ................................................................................ 79
Term Sheet: Board of Members by Feld Thoughts ...................................................... 79
Special Board Approval ................................................................................................ 80
Term Sheet: Preferred Stock ............................................................................................. 81
Preferred Stock.............................................................................................................. 81
How preferred stock terms can affect valuation – a scenario ....................................... 81
What’s so preferable about preferred stock? ................................................................ 82
Overview of preferred stock ..................................................................................... 82
Anti-dilution protection ............................................................................................ 83
Control ...................................................................................................................... 85
Advice to Entrepreneurs ........................................................................................... 85
Term Sheet: Liquidation Preference ................................................................................. 86
Liquidation .................................................................................................................... 86
Term Sheet Tutorial 4
Term Sheet: Liquidation Preference ............................................................................. 86
Participating Preferences by Feld Thoughts ................................................................. 87
Term Sheet: Liquidation Preference by Feld Thoughts ................................................ 90
Liquidation Preferences: What They Really Do ........................................................... 92
Term sheet overview: Liquidation Preference .............................................................. 94
Liquidation Amount ...................................................................................................... 95
Participation .................................................................................................................. 95
Limits On Participations (Three Alternative Examples) .............................................. 96
Term Sheet: Price .............................................................................................................. 98
Term Sheet: Price by Feld Thoughts ............................................................................ 98
Terminology.................................................................................................................... 100
The Off Road Investor ................................................................................................ 100
Equity vs. Convertible Note ........................................................................................... 101
Convertible notes ........................................................................................................ 101
The Conundrum of Convertible Notes ........................................................................ 101
Rationale for a convertible Note ............................................................................. 101
Standard features of a convertible note ................................................................... 102
Potential flaws of a convertible note ....................................................................... 103
Appropriate Use of Convertible Notes ................................................................... 105
Advice to entrepreneurs .......................................................................................... 105
Watch Out Angels When Buying Notes From An Llc: .............................................. 105
Financing......................................................................................................................... 106
Revenue Participation Certificates: Should I consider this alternative? .................... 106
Valuation ......................................................................................................................... 109
How VCs Calculate Valuation (And How It's Different From The Way Founders Do
It) ................................................................................................................................. 109
Appendix A ..................................................................................................................... 110
Founders Shares Issues ............................................................................................... 110
Examples of legal wording from the two most popular model term sheet sources: ... 114
Brad Feld: Term Sheet - Vesting ................................................................................ 114
Optimum Share and Option Vesting by Basil Peters .................................................. 118
Founders' Equity By Mary Beth Kerrigan and Shannon Zollo ................................... 120
Vesting of Founders’ Stock: Beyond the Basics......................................................... 122
The term sheet tango ................................................................................................... 125
What should the vesting terms of founder stock be before a venture financing? ....... 125
Term Sheet Tutorial 5
Vesting Founders Stock with a Vesting Schedule | Startup Lawyer........................... 127
Get vested for time served .......................................................................................... 127
Supersize your vesting with these microhacks ........................................................... 134
What entrepreneurs need to know about Founders’ Stock ......................................... 135
Ted Wang: Fenwick & West...................................................................................... 139
Vesting Imposed On Founder Stock In Connection with Financing--Section 83(b)
Election Required? ...................................................................................................... 140
Note to Founders: Have Vesting ................................................................................. 141
Three Questions - Part ll ............................................................................................. 143
The Making of a Winning Term Sheet: Understanding What Founders Want - Part II.
Vesting Acceleration, Reallocation of Founder's Stock, Option Pool Dilution and
Founder Liquidity ....................................................................................................... 144
What is an 83(b) election and how does it work in practice? ..................................... 150
Term Sheet Tutorial 6
TERM SHEET
The Science & Art of Term Sheet Negotiation
January 17, 2008
By the time I was in the 9th grade, I had been playing chess for a few years (as in I
knew the rules) but I didn't play seriously and more often than not I lost. Then one
day at the library (remember, pre-internet) I happened to find a book on chess. So I
read the book and almost
overnight I became one of the chess
"stars" in high school. In one of the funnier incidents, I started playing chess during
lunch hour and was "hustling" money which on one occasion resulted in a kid pulling
a knife on me after I relieved him of a few bucks. True story.
What was it in that book that allowed me to take advantage of the situation? Well,
there was a lot of basic stuff, some general rules and even some strategy, however,
the most useful bit of information, initially, was a table on the relative value of
pieces. You know, a pawn is worth 1, a knight/bishop 3, rook 5, a queen 9 and the
king "infinite" unless it's the endgame then it's more like a 4. Experienced players
have a "feel" for this from many games played and they can also break the "rules"
by, for example, sacrificing a queen for a rook to get better position. But these are
all things learned from experience and best not tried by a novice. If you are new to
the game, you have no idea. When you are starting out, having some rules of
thumb can make all the difference between winning and getting hustled.
What does this have to do with negotiating term sheets? Well, I think a lot of
newbies get hustled when negotiating term sheets because they don't know the
relative importance of the various terms. Have you heard the joke about the VC who
says, "I'll let you pick the pre money valuation if I get to pick the terms?" My goal
here is to provide a framework that gives relative value of various terms on a term
sheet and allows you to compare them on two dimensions: economics and control
(or as my friend Noam Wasserman likes to say, "rich" versus "king"). In the same
way that a chess grand master doesn't need rules of thumb from someone else, if
you're a seasoned negotiator of term sheets then this is probably equally useless.
And no, this is not based on any academic or scientific study. It's based on my own
experience and, more importantly, that of a few other experts like Dave Kimelberg
(Softbank's GC).
In my view there are 12 important terms on a typical Series A / B term sheet. Yes
there are other terms and yes sometimes they are important, but if you go with the
thesis of keep it simple, then 12 is the magic number. In terms of rating, the
rich/king differentiation is important as different people are after different things so
depending upon your motivation you may be inclined to pay more attention to one
Term Sheet Tutorial 7
column than the other. So without further adieu, below is a table showing them as
well as the relative importance:
Term
1. Investment / price
2. Board of directors
3. Option pool refresh
4. Preemptive rights
5. Andi-dilution protection
6. Registration rights
7. Drag along rights
8. Right of first refusal / co-sale
9. Dividend right
10. Liquidation preference
11. Protective provisions
12. Redemption
Rich
10
10
1
5
1
1
5
5
7
1
King
8
3
1
5
8
-
Here a 10 means it is really important to get as favorable a result as possible on this
term, a 1 means it is not so important and a "-" means it doesn't apply (i.e. a zero).
The cool thing about having something like this is you can use it as a tool to compare
term sheets (provided you can determine how favorable or unfavorable each
individual term is...more on that below).
The next part of this post is to provide a range of typical results for each term which
will give you a means to rank each term in each term sheet with a "1,3 or 5" where 1
is "unfavorable", 3 is "fair" and 5 is "favorable." If you aren't already familiar with
the terms in a term sheet, you should check out the model term sheet (basically a
template) put together by the National Venture Capital Association. They have other
model agreements too, but you will see with the term sheet that they include various
options, some discussed here. Below is a scale for each of the 12 key terms across
the two dimensions:
1. Investment/price. I think there are two ways you can rank price. One is to rate it
relative to your expectation and another is to rate it relative to similar companies
(in terms of stage, geography, sector, etc.). If you don't have comparables, you
can fairly easily get them, for example Dow Jones puts out a quarterly survey of
VC deal terms which includes pre-money valuation (send me an email if you want
a copy). If you're less than 80% of your benchmark, that's probably unfavorable,
if you are within +/- 20% than that's fair and if you're over 120%, then it's
favorable.
2. Board of directors. This term comes down to simple math. If you give up and
don't have control of the board, that's unfavorable, if it's tied, call it fair and if you
control it, that is quite favorable. BTW, the reason I didn't rate the board control a
"10" on the "king" scale is because even when you give up control, your board
members are bound by fiduciary obligations to the firm, i.e. they can't do
whatever they want.
Term Sheet Tutorial 8
3. Option pool refresh. Often time this will show up as a separate term in the term
sheet, however it is actually just another bite at the apple in terms of price.
Traditionally there is a refresh pre-deal so that after the round the company can
execute on its hiring plan without needing to expand the pool for 12-18 months.
You will have to develop your hiring budget if you haven't already. Given that
benchmark and your hiring equity budget, I'd say less than 12 months is
favorable, 12-18 months is fair and more than 18 months is unfavorable.
4. Preemptive rights. As you know, preemptive rights give your investor the right
to invest in future rounds. This is of moderate economic value, however you are
giving up some control of future financings. There is remarkably little variation
in how this term gets negotiated, probably because of its relatively low
importance in the grand scheme. I'm told the only area that gets negotiated is
whether the investor has an "overallotment right" whereby they can take a portion
or all of the pro rata of another investor in the same series who didn't participate.
That said, unless something unusual is in your term sheet, it's probably a 3 for
both rich and king.
5. Anti-dilution protection. Anti-dilution is a pretty important economic term. In
terms of the range of possibilities, no anti-dilution would be a 5, broad-based
weighted average would be a 3 and full-ratchet would be a 1. I think the vast
majority of deals end up as broad-based weighted average. Very few deals avoid
it altogether, but it can be done, particularly in later stage or very hot deals.
6. Registration rights. Reg rights have some economic value and in theory you do
give up some control, but in reality they're close to worthless. You can push on
these and most investors will give in when pressed. You can negotiate when the
right kicks in and cutbacks. But bear in mind that investors will love it if you
waste time negotiating this because it is not an important term. Unless something
unusual is going on, I'd rate this a 3 on both dimensions.
7. Drag along rights. Most deals include drag along rights and like many of the
other terms, the key is in the voting thresholds. I rated this a 1/5 on the rich/king
scale. In terms of economics the issue is with regard to a sale of the company
where the preferred stock, because of special rights, is indifferent to a deal that
would be better for Common. However, the bigger issue is on the control side of
the equation where you could get dragged into a sale that you don't want to do.
So in terms of rating both the economic and control sides, I would say that if the
thresholds are such that a single investor can unilateral drag along, that's a 1, if it
takes 2 or more investors that's a 3 and if it takes investors plus either a neutral
party or Common (you) then it's a 5.
8. Right of first refusal / co-sale. I rated this a 5 because this is essentially a "lockup" on the founders stock which seriously affects liquidity and thus value. It
doesn't really affect control issues. If you read the actual section of the stock
purchase agreement that describes this term it's several pages of bureaucratic
procedures for a sale that in the real world you can't imagine ever occurring
(which they don't). As a result, the only real counter party for selling common
stock is the other investors or the company with the investors approval and they're
all quite likely to low ball. Unfortunately, I've never heard of avoiding this term
completely, so in terms of how to rate it, I'd say that if you can negotiate a right to
Term Sheet Tutorial 9
sell some portion (say 20% on an annual basis) you're at a 5 otherwise if it's a
standard lockup then you're at 3.
9. Dividend right. I rate this a 5 on the economic scale. In terms of the range, there
is no dividend which is a 5, then there is a simple interest dividend which I'd say
is a 3 and a 5 would be a compounding dividend. For some reason, the dividend
rate has been 8% ever since I've seen term sheets. You can negotiate the rate, but
the bigger battle is whether you pay a dividend and how the rate compounds.
10. Liquidation preference. This is a very important economic term that doesn't
have any importance in terms of control. The issue here is during a sale, how do
investors get paid out. I'd say about 1/3 of deals have a preference at 1X but no
participation, another 1/3 have a preference with a cap and participation and the
balance a preference with no cap plus participation and that's pretty much how I'd
rate it, i.e. 5 for 1X preference/no participation, 3 if with a cap in the 2-4X range
and 1 if with no cap and participation.
11. Protective provisions. This is very important from a control perspective but not
so economically. While there are a ton of these protective provisions, the key
ones relate to sale/merger of the company and future rounds of financing. As
with other control rights, the key is in the voting thresholds so I'd assess this the
same as 7 (drag along rights).
12. Redemption. Finally, we get to number twelve, redemption rights. This is an
almost worthless economic right. I've never seen or heard of this being exercised
and most investors will acquiesce if you push on this. Unless you see something
unusual, I'd rate this a 3.
Ultimately the individual rating combined with the overall importance of each term
will allow you to create a weighted average total for each term sheet on both the rich
and king dimensions. While you wouldn't want to make a decision to take an
investment on this alone, it will give you a basic idea of where the strengths and
weaknesses of particular term sheets lie. It also gives some tips for negotiating. For
example, you don't want to waste your time negotiating redemption rights and
attorney's fees and instead, you want to go to the core of what's important to you on
the rich/king scale.
Term Sheet Tutorial 10
TERM SHEET: RESTRICTION ON SALES, PROPRIETARY INVENTIONS, AND CO-SALE
AGREEMENT
Term Sheet: Restriction on Sales, Proprietary Inventions, and
Co-Sale Agreement
I had good intentions earlier this week to try to crank out the balance of the term sheet series, but
it turned into a busy week. Since I’m still muddling through the set of terms that either don’t
matter much and/or are hard to negotiate away (e.g. chose you battles wisely), I didn’t expect
anyone would be waiting on the edge of their seats for these. However, for completeness, it’s worth
going through the stuff that shows up on the last few pages of a standard VC term sheet. Jason
and I aren’t quite done, but with this post, we are one (tedious) step closer.
Almost every term sheet we’ve ever seen has a “Restrictions on Sales” clause in it that looks
something like:
“Restrictions on Sales: The Company’s Bylaws shall contain a right of first refusal on all transfers of
Common Stock, subject to normal exceptions. If the Company elects not to exercise its right, the
Company shall assign its right to the Investors.”
Management / founders rarely argue against this as it helps control the shareholder base of the
company which usually benefits all the existing shareholders (except possibly the one who wants to
bail out of their private stock.) However, we’ve found that the lawyers will often spend time
arguing how to implement this particular clause. Some lawyers feel that putting this provision in
the bylaws is the wrong way to go and prefer to include such a provision in each of the company’s
option agreements, plans and stock sales. Personally, we find it much easier to include in the
bylaws.
Next up is the ubiquitous proprietary information and inventions agreement clause.
“Proprietary Information and Inventions Agreement: Each current and former officer, employee and
consultant of the Company shall enter into an acceptable proprietary information and inventions
agreement.”
This paragraph benefits both the company and investors and is simply a mechanism that investors
use to get the company to legally stand behind the representation that it owns its intellectual
property. Many pre-Series A companies have issues surrounding this, especially if the company
hasn’t had great legal representation prior to its first venture round. We’ve also run into plenty of
situations (including several of ours – oops!) where companies are loose about this between
financings and - while a financing is a good time to clean this up – it’s often annoying to previously
hired employees who are now told “hey – you need to sign this since we need it for the venture
financing.” It’s even more important in the sale of a company, as the buyer will always insist on
clear ownership of the IP. Our best advice here is that companies should build these agreements
Term Sheet Tutorial 11
into their hiring process from the very beginning (with the advice from a good law firm) so that
there are never any issues around this, as VCs will always insist on it.
Finally, a co-sale agreement is pretty standard fare as well.
“Co-Sale Agreement: The shares of the Company’s securities held by the Founders shall be made
subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that
the Founders may not sell, transfer or exchange their stock unless each Investor has an opportunity
to participate in the sale on a pro-rata basis. This right of co-sale shall not apply to and shall
terminate upon a Qualified IPO.”
If you are a founder, you are probably asking why we did not include the co-sale section in the
“really matter section.” The chance of keeping this provision out of a financing is close to zero, so
we don’t think it’s worth the battle to fight it. Notice that this only matters while the company is
private – if the company goes public, this clause no longer applies.
Term Sheet Tutorial 12
TERM SHEET: VOTING RIGHTS AND EMPLOYEE POOL
Term Sheet: Voting Rights and Employee Pool
July 05, 2005
Jason and I are feeling the need for closure on our term sheet series as we’ve started gearing up on
our next series (M&A). So – we’re going to knock out the balance of the standard term sheet terms
this week. We’re still in the “terms that don’t matter much zone” so we’re including Voting Rights
and Employee Pool for completeness.
“Voting Rights: The Series A Preferred will vote together with the Common Stock and not as a
separate class except as specifically provided herein or as otherwise required by law. The Common
Stock may be increased or decreased by the vote of holders of a majority of the Common Stock and
Series A Preferred voting together on an as if converted basis, and without a separate class vote.
Each share of Series A Preferred shall have a number of votes equal to the number of shares of
Common Stock then issuable upon conversion of such share of Series A Preferred.”
Most of the time voting rights are simply an “FYI” section as all the heavy rights are contained in
other sections such as the protective provisions.
“Employee Pool: Prior to the Closing, the Company will reserve shares of its Common Stock so that
__% of its fully diluted capital stock following the issuance of its Series A Preferred is available for
future issuances to directors, officers, employees and consultants. The term “Employee Pool” shall
include both shares reserved for issuance as stated above, as well as current options outstanding,
which aggregate amount is approximately __% of the Company’s fully diluted capital stock
following the issuance of its Series A Preferred.”
The employee pool section is a separate section in order to clarify the capital structure and
specifically call out the percentage of the company that will be allocated to the option pool
associated with the financing. Since a cap table is almost always included with the term sheet, this
section is redundant, but exists so there is no confusion about the size of the option pool.
Term Sheet Tutorial 13
TERM SHEET: OPTION POOL
Option Pool
Note: Watch out for those who try to slip in the option pool after the pre-money
valuation has been established, thereby diluting the series A preferred holders.
This will automatically increase the pre-money valuation by diluting the series A!
The term sheet must stipulate that the pre-money valuation is on a fully diluted
basis (after taking into consideration the option pool).!!!
Before discussing the Option Pool Shuffle, it is helpful to review how VC’s look at
valuation, versus the first time entrepreneur.
Option Pool Shuffle
You have successfully negotiated a $2M investment on a $8M pre-money valuation
by pitting the famous Blue Shirt Capital against Herd Mentality Management.
Triumphant, you return to your company’s tastefully decorated loft or bombed-out
garage to tell the team that their hard work has created $8M of value.
Your teammates ask what their shares are worth. You explain that the company
currently has 6M shares outstanding so the investors must be valuing the company’s
stock at $1.33/share:
$8M pre-money ÷ 6M existing shares = $1.33/share.
Later that evening you review the term sheet from Blue Shirt. It states that the
share price is $1.00… this must be a mistake! Reading on, the term sheet states,
“The $8 million pre-money valuation includes an option pool equal to 20% of the
post-financing fully diluted capitalization.”
You call your lawyer: “What the fuck?!”
As your lawyer explains that the so-called pre-money valuation always includes a
large unallocated option pool for new employees, your stomach sinks. You feel duped
and are left wondering, “How am I going to explain this to the team?”
If you don’t keep your eyes on the option pool, your investors will slip it in the premoney and cost you millions of dollars of effective valuation. Don’t lose this game.
The option pool lowers your effective valuation.
Your investors offered you a $8M pre-money valuation. What they really meant was,
Term Sheet Tutorial 14
“We think your company is worth $6M. But let’s create $2M worth of new options,
add that to the value of your company, and call their sum your $8M ‘pre-money
valuation’.”
For all of you MIT and IIT students out there:
$6M effective valuation + $2M new options + $2M cash = $10M post
or
60% effective valuation + 20% new options + 20% cash = 100% total.
Slipping the option pool in the pre-money lowers your effective valuation to $6M. The
actual value of the company you have built is $6M, not $8M. Likewise, the new
options lower your company’s share price from $1.33/share to $1.00/share:
$8M pre ÷ (6M existing shares + 2M new options) = $1/share.
Update: Check out our $9 cap table which calculates the effect of the option pool
shuffle on your effective valuation.
The shuffle puts pre-money into your investor’s pocket.
Proper respect must go out to the brainiac who invented the option pool shuffle.
Putting the option pool in the pre-money benefits the investors in three different
ways!
First, the option pool only dilutes the common stockholders. If it came out of the
post-money, the option pool would dilute the common and preferred shareholders
proportionally.
Second, the option pool eats into the pre-money more than it would seem. It seems
smaller than it is because it is expressed as a percentage of the post-money even
though it is allocated from the pre-money. In our example, the new option pool is
20% of the post-money but 25% of the pre-money:
$2M new options ÷ $8M pre-money= 25%.
Third, if you sell the company before the Series B, all un-issued and un-vested
options will be cancelled. This reverse dilution benefits all classes of stock
proportionally even though the common stock holders paid for all of the initial
dilution in the first place! In other words, when you exit, some of your pre-money
valuation goes into the investor’s pocket.
More likely, you will raise a Series B before you sell the company. In that case, you
and the Series A investors will have to play option pool shuffle against the Series B
investors. However, all the unused options that you paid for in the Series A will go
into the Series B option pool. This allows your existing investors to avoid playing the
game and, once again, avoid dilution at your expense.
Term Sheet Tutorial 15
Solution: Use a hiring plan to size the option pool.
You can beat the game by creating the smallest option pool possible. First, ask your
investors why they think the option pool should be 20% of the post-money.
Reasonable responses include
1. “That should cover us for the next 12-18 months.”
2. “That should cover us until the next financing.”
3. “It’s standard,” is not a reasonable answer. (We’ll cover your response in a future
hack.)
Next, make a hiring plan for the next 12 months. Add up the options you need to
give to the new hires. Almost certainly, the total will be much less than 20% of the
post-money. Now present the plan to your investors:
“We only need a 10% option pool to cover us for the next 12 months. By your
reasoning we only need to create a 10% option pool.”
Reducing the option pool from 20% to 10% increases the company’s effective
valuation from $6M to $7M:
$7M effective valuation + $1M new options + $2M cash = $10M post
or
70% effective valuation + 10% new options + 20% cash = 100% total
A few hours of work creating a hiring plan increases your share price by 17% to
$1.17:
$7M effective valuation ÷ 6M existing shares = $1.17/share.
How do you create an option pool from a hiring plan? #
To allocate the option pool from the hiring plan, use these current ranges for option
grants in Silicon Valley:
Title
Range (%)
CEO
5 – 10
COO
2–5
VP
1–2
Independent Board Member
1
Term Sheet Tutorial 16
Director
0.4 – 1.25
Lead Engineer
0.5 – 1
5+ years experience Engineer
0.33 – 0.66
Manager or Junior Engineer
0.2 – 0.33
These are rough ranges – not bell curves – for new hires once a company has raised
its Series A. Option grants go down as the company gets closer to its Series B, starts
making money, and otherwise reduces risk.
The top end of these ranges are for proven elite contributors. Most option grants are
near the bottom of the ranges. Many factors affect option allocations including the
quality of the existing team, the size of the opportunity, and the experience of the
new hire.
If your company already has a CEO in place, you should be able to reduce the option
pool to about 10% of the post-money. If the company needs to hire a new CEO
soon, you should be able to reduce the option pool to about 15% of the post-money.
Bring up your hiring plan before you discuss valuation.
Discuss your hiring plan with your prospective investors before you discuss valuation
and the option pool. They may offer the truism that “you can’t hire good people as
fast as you think.” You should respond, “Okay, let’s slow down the hiring plan… (and
shrink the option pool).”
You have to play option pool shuffle.
The only way to win at option pool shuffle is to not play at all. Put the option pool in
the post-money instead of the pre-money. This benefits you and your investors
because it aligns your interests with respect to the hiring plan and the size of the
option pool.
Still, don’t try to put the option pool in the post-money. We’ve tried – it doesn’t
work.
Your investor’s norm is that the option pool goes in the pre-money. When your
opponent has different norms than you do, you either have to attack his norms or
ask for an exception based on the facts of your case. Both straits are difficult to
navigate.
Instead, skillful negotiators use their opponent’s standards and norms to advance
their own arguments. Fancy negotiators call this normative leverage. You apply
normative leverage in the option pool shuffle by using a hiring plan to justify a small
option pool.
Term Sheet Tutorial 17
You can’t avoid playing option pool shuffle. But you can track the pre-money as it
gets shuffled into the option pool and back into the investor’s pocket, you can
prepare a hiring plan before the game starts, and you can keep your eye on the
money card.
Mastering the VC Game: A Venture Capital Insider Reveals How
to Get from Start-up to IPO on Your Terms
By Jeffrey Bussgang
Determining the pre-money valuation is an art, not a science, and many entrepreneurs get
frustrated with what seems like an opaque process. Unlike what you learn in a finance class in
business school, where you calculate discounted cash flows and apply a weighted average cost of
capital, there is no magic formula. The valuation for entrepreneurial ventures is set in a back-andforth negotiation based on three factors: (1) the amount of capital that the entrepreneur is trying to
raise in order to prove out the first set of milestones; (2) the VC’s target ownership (often 20-30
percent); (3) how competitive the deal is (that is, if the entrepreneur has numerous VCs chasing
them, they can drive up the price). I’ve seen pre-money valuations range from a typical $3-$6
million all the way up to $80 million, which is what our pre-money valuation was in our first
round of financing at Upromise. That was an unusual time in history, the late 1990s and early
2000, where companies with only a few million dollars in revenue were going public for billiondollar valuations. In most situations today, the initial pre-money valuation is under $ 10 million.
In the end, the VC has to be convinced that he can make five to ten times his money in three to
five years and so backs into the valuation with that heuristic in mind.
But the pre-money isn’t the only term that defines price: the post-money plays a part as
well. The post-money is the pre-money plus the money raised. That is, if a company raises $4
million at a pre-money valuation of $ 6 million, then the post-money is $ 10 million. Thus, the
investors who provided the $4 million own 40 percent of the company and the management team
(founders, employees, executives) owns 60 percent.
Another term that impacts the price is the size of the option pool. Most VCs invest in
companies that need to hire additional management team members, sales and marketing
personnel, and technical talent to build the business. Some start-ups begin life with a founding
team that aspires to hire a strong outside executives as CEO. There new hires typically receive
stock options, and the issuance of those stock options dilutes the other shareholders.
In anticipation of those hiring needs, many VCs will require that an option pool with
unallocated stock options be created, thereby forming a stock option budget for new hires that
Term Sheet Tutorial 18
will be set aside to avoid further dilution. The stock option pool typically comes out of the
management team allocation (i.e., the option pool is included in the pre-money valuation),
independent of the VC investment ownership. In the example above of $ 4 million invested in a $
6 million pre-money valuation (known in VC-speak shorthand as “4 on 6”), if the VCs insist on
an unallocated stock option pool of 20 percent, then the VC investors still own 40 percent and the
remaining 60 percent is split between a 20 percent unallocated stock option pool at the discretion
of the board and a 40 percent stake owned by the management team. In other words, the existing
management team/founders have given up 20 percentage points of their 60 percent ownership in
order to reserve it for future management hires.
This relationship between option pool size and price isn’t always understood by
entrepreneurs, but is well understood by VCs. I learned it the hard way in the first term sheet that
I put forward to an entrepreneur. I was competing with another firm, we put forward a “6 on 7”
deal with a 20 percent option pool. In other words, we would invest (alongside another VC) $ 6
million at a $ 7 million pre-money valuation to own 46 percent of the company (6 divided by
6+7). The founders would own 34 percent and would set aside a stock option pool of 20 percent
for future hires. One of my competitors put forward a “6 on 9” deal, in other words, $ 6 million
invested at $ 9 million pre-money valuation to own 40 percent of the company (6 divided by
6+9). But my competitor inserted a larger option pool than I did – 30 percent – so the founders
would only receive 30 percent of the company as compared to my offer that gave them 34
percent. The entrepreneur chose the competing deal. When I asked why, he looked me in the eye
and said, “Jeff-their price was better. My company is worth more than seven million.”
At the time, I wasn’t facile enough with the nuances to argue against his faulty logic. But
later, we instituted a policy at Flybridge to talk about the “promote” for the founding team rather
than just the “pre”. The “promote,” as we have called it, is the founding team’s ownership
percentage multiplied by the post-money valuation.
Back to my example of the “6 on 7” deal with the 20 percent option pool. The founding
team owns 34 percent of a company with a $ 23 million post-money valuation. In other words,
they have a $ 4.4 million “promote” (13 * 0.34) in exchange for their founding contributions.
Note that in the “6 on 9” deal, the founding team had a nearly identical promote: 30 percent of $
15 million post-money valuation, or $ 4.5 million. In other words, my offer was basically
identical to the competing offer; it just had a lower pre-money valuation and a smaller option
pool.
Not that this pricing framework assumes that the financing is the first money that has
been invested in the company (i.e., it is the Series A round of financing). If there is already
Term Sheet Tutorial 19
invested capital in the company (i.e., someone has already invested in a Series A and the
entrepreneur is now raising a Series B round of financing), then the Series A investors have two
competing motivations. Assuming they want to put more money into the company, they will
either seek to raise capital at the highest price possible from outside investors in order to limit
dilution on their earlier money (and limit the amount of new capital they put in at the higher
price) or invest their own capital at a price lower than (down round) or equal to (flat round) the
previous round. It all depends on how bullish they are about the company’s future and how much
money they have invested in the company already as compared to their target figure as a function
of their overall fund size.
Term Sheet Tutorial 20
TERM SHEET: RIGHT OF FIRST REFUSAL
Right of First Refusal
Investor Favorable:
The Investors shall have the right in the event the Company proposes to offer
equity securities to any person (other than securities issued pursuant to employee benefit plans or
acquisitions, in each case as approved by the Board of Directors, including the director elected by holders
of the Series [A] Preferred) to purchase on a pro rata basis all or any portion of such shares. Any securities
not subscribed for by an Investor may be reallocated among the other Investors. If the Investors do not
purchase all of such securities, that portion that is not purchased may be offered to other parties on terms no
less favorable to the Company for a period of sixty (60) days. Such right of first refusal will terminate upon
a Qualified IPO.
Middle of the Road:
Investors holding at least [one eighth of the shares originally issued] shares of
Registrable Securities shall have the right in the event the Company proposes to offer equity securities to
any person (other than securities issued pursuant to employee benefit plans or pursuant to acquisitions) to
purchase their pro rata portion of such shares. Any securities not subscribed for by an eligible Investor may
be reallocated among the other eligible Investors. Such right of first refusal will terminate upon a Qualified
IPO.
Company Favorable:
Each Investor holding at least [one quarter of the shares originally issued] shares
of Series [A] Preferred shall have the right in the event the Company proposes to offer equity securities to
any person (other than securities issued to employees, directors, or consultants or pursuant to acquisitions,
etc.) to purchase its pro rata share of such securities (based on the total fully diluted number of common
stock equivalents outstanding). Such right of first refusal will terminate upon an underwritten public
offering of shares of the Company.
Term Sheet: Right of First Refusal by Feld Thoughts
Today's "term that doesn't matter much" from our term sheet series is the Right of First Refusal.
When we say "it doesn't matter much", we really mean "don't bother trying to negotiate it away the VCs will insist on it.” Following is the standard language:
"Right of First Refusal: Investors who purchase at least (____) shares of Series A Preferred (a
"Major Investor") shall have the right in the event the Company proposes to offer equity securities
to any person (other than the shares (i) reserved as employee shares described under "Employee
Pool" below, (ii) shares issued for consideration other than cash pursuant to a merger,
consolidation, acquisition, or similar business combination approved by the Board; (iii) shares
issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement
or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares
with respect to which the holders of a majority of the outstanding Series A Preferred waive their
right of first refusal) to purchase [X times] their pro rata portion of such shares. Any securities not
subscribed for by an eligible Investor may be reallocated among the other eligible Investors. Such
right of first refusal will terminate upon a Qualified IPO. For purposes of this right of first refusal, an
Investor’s pro rata right shall be equal to the ratio of (a) the number of shares of common stock
(including all shares of common stock issuable or issued upon the conversion of convertible
Term Sheet Tutorial 21
securities and assuming the exercise of all outstanding warrants and options) held by such Investor
immediately prior to the issuance of such equity securities to (b) the total number of share of
common stock outstanding (including all shares of common stock issuable or issued upon the
conversion of convertible securities and assuming the exercise of all outstanding warrants and
options) immediately prior to the issuance of such equity securities."
There are two things to pay attention to in this term that can be negotiated. First, the share
threshold that defines a "Major Investor" can be defined. It's often convenient - especially if you
have a large number of small investors - not to have to give this right to them. However, since in
future rounds, you are typically interested in getting as much participation as you can, it's not worth
struggling with this too much.
A more important thing to look for is to see if there is a multiple on the purchase rights (e.g. the "X
times" listed above). This is an excessive ask - especially early in the financing life cycle of a
company - and can almost always be negotiated to 1x.
As with "other terms that don't matter much", you shouldn't let your lawyer over engineer these. If
you feel the need to negotiate, focus on the share threshold and the multiple on the purchase
rights.
Right of First Offer Versus Right of First Refusal:
Clearly the ROFO favors the company, while all investors would prefer a ROFR because:
1) If an investor wants to sell shares to someone else and one of the original
investors is interested in buying them then the original investor must “do the work” to
make an offer. If he/she is too busy to do so then the ROFO has been passed by.
2) However under a ROFR the company first goes to an interested buyer and after
that party “does the work” to formulate a bid price/offer then the other investors can
decide if they want to match it and buy the shares.
3) No VC’s will settle for a ROFO. They’ll demand a ROFR.
Term Sheet Tutorial 22
TERM SHEET: INFORMATION AND REGISTRATION RIGHTS
Information Rights
Investor Favorable:
So long as an Investor continues to hold shares of Series [A] Preferred
or Common Stock issued upon conversion of the Series [A] Preferred, the Company shall deliver to the
Investor audited annual financial statements, audited by a Big Five accounting firm, and unaudited
quarterly financial statements. In addition, the Company will furnish the Investor with monthly and
quarterly financial statements and will provide a copy of the Company's annual operating plan within 30
days prior to the beginning of the fiscal year. Each Investor shall also be entitled to standard inspection and
visitation rights.
Middle of the Road:
So long as an Investor continues to hold shares of Series [A] Preferred
or Common Stock issued upon conversion of the Series [A] Preferred, the Company shall deliver to the
Investor audited annual financial statements audited by a Big Five accounting firm and unaudited quarterly
financial statements. So long as an Investor holds not less than [one quarter of the Shares originally issued]
shares of Series [A] Preferred (or [one quarter of the Shares originally issued] shares of the Common Stock
issued upon conversion of the Series [A] Preferred, or a combination of both), the Company will furnish
the Investor with monthly financial statements compared against plan and will provide a copy of the
Company's annual operating plan within 30 days prior to the beginning of the fiscal year. Each Investor
shall also be entitled to standard inspection and visitation rights. These provisions shall terminate upon a
public offering of the Company's Common Stock.
Company Favorable:
So long as an Investor continues to hold shares of Series [A] Preferred
or Common Stock issued upon conversion of the Series [A] Preferred, the Company shall deliver to the
Investor audited annual financial statements audited by a Big Five accounting firm and unaudited quarterly
financial statements. Each Investor shall also be entitled to standard inspection and visitation rights. These
provisions shall terminate upon a registered public offering of the Company's Common Stock.
Term Sheet : Information and Registration Rights by Feld
Thoughts
When Jason and I last wrote about term sheets, Jack was still trying to save the world (surprise - he
did) and we dealt with a meaty and important issue – vesting. For completeness (and because all
good “series” deserve to be finished off), we’re tackling the terms that rarely matter in the next
couple of posts. Today we’re starting with Information Rights and Registration Rights.
You might ask, "If these terms rarely matter, why bother?" Well - you'll end up having to deal with
them in a VC term sheet, so you might as well (a) be exposed to them and (b) hear that they don't
matter much. Of course, from a VC perspective, "doesn't matter much" means "Mr. Entrepreneur,
please don't pay much attention to these terms - just accept them as is." Specifically, if one of
these terms is being hotly negotiated by an investor or company, that time (and lawyer money) is
most likely being wasted.
First up is Information Rights – the typical clause follows:
Term Sheet Tutorial 23
"Information Rights: So long as an Investor continues to hold shares of Series A Preferred or
Common Stock issued upon conversion of the Series A Preferred, the Company shall deliver to the
Investor the Company’s annual budget, as well as audited annual and unaudited quarterly financial
statements. Furthermore, as soon as reasonably possible, the Company shall furnish a report to
each Investor comparing each annual budget to such financial statements. Each Investor shall also
be entitled to standard inspection and visitation rights. These provisions shall terminate upon a
Qualified IPO."
Information rights are generally something companies are stuck with in order to get investment
capital. The only variation one sees is putting a threshold on the number of shares held (some finite
number vs. "any") for investors to continue to enjoy these rights.
Registration Rights are more tedious and tend to take up a page or more of the term sheet. The
typical clause(s) follows:
"Registration Rights: Demand Rights: If Investors holding more than 50% of the outstanding
shares of Series A Preferred, including Common Stock issued on conversion of Series A Preferred
("Registrable Securities"), or a lesser percentage if the anticipated aggregate offering price to the
public is not less than $5,000,000, request that the Company file a Registration Statement, the
Company will use its best efforts to cause such shares to be registered; provided, however, that the
Company shall not be obligated to effect any such registration prior to the [third] anniversary of
the Closing. The Company shall have the right to delay such registration under certain
circumstances for one period not in excess of ninety (90) days in any twelve (12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand
right provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty
(180) day period commencing with the date of the Company’s initial public offering, or (ii) if it
delivers notice to the holders of the Registrable Securities within thirty (30) days of any registration
request of its intent to file a registration statement for such initial public offering within ninety (90)
days.
Company Registration: The Investors shall be entitled to "piggy-back" registration rights on all
registrations of the Company or on any demand registrations of any other investor subject to the
right, however, of the Company and its underwriters to reduce the number of shares proposed to be
registered pro rata in view of market conditions. If the Investors are so limited, however, no party
shall sell shares in such registration other than the Company or the Investor, if any, invoking the
demand registration. Unless the registration is with respect to the Company’s initial public offering,
in no event shall the shares to be sold by the Investors be reduced below 30% of the total amount
of securities included in the registration. No shareholder of the Company shall be granted piggyback
registration rights which would reduce the number of shares includable by the holders of the
Registrable Securities in such registration without the consent of the holders of at least a majority of
the Registrable Securities.
S-3 Rights: Investors shall be entitled to unlimited demand registrations on Form S-3 (if available to
the Company) so long as such registered offerings are not less than $1,000,000.
Term Sheet Tutorial 24
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and
commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one
special counsel of the selling shareholders not to exceed $25,000).
Transfer of Rights: The registration rights may be transferred to (i) any partner, member or retired
partner or member or affiliated fund of any holder which is a partnership, (ii) any member or former
member of any holder which is a limited liability company, (iii) any family member or trust for the
benefit of any individual holder, or (iv) any transferee satisfies the criteria to be a Major Investor
(as defined below); provided the Company is given written notice thereof.
Lock-Up Provision: Each Investor agrees that it will not sell its shares for a period to be specified by
the managing underwriter (but not to exceed 180 days) following the effective date of the
Company’s initial public offering; provided that all officers, directors, and other 1% shareholders are
similarly bound. Such lock-up agreement shall provide that any discretionary waiver or termination
of the restrictions of such agreements by the Company or representatives of underwriters shall
apply to Major Investors, pro rata, based on the number of shares held.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect
to registration rights as are reasonable, including cross-indemnification, the period of time in which
the Registration Statement shall be kept effective, and underwriting arrangements. The Company
shall not require the opinion of Investor’s counsel before authorizing the transfer of stock or the
removal of Rule 144 legends for routine sales under Rule 144 or for distribution to partners or
members of Investors."
Registration rights are also something the company will have to offer to investors. What is most
interesting about this section is that lawyers seem genetically incapable of leaving this section
untouched and always end up "negotiating something." Perhaps because this provision is so long in
length, they feel the need to keep their pens warm while reading. We find it humorous (so long as
we aren’t the ones paying the legal fees), because in the end, the modifications are generally
innocuous and besides, if you ever get to the point where registration rights come into play (e.g. an
IPO), the investment bankers of the company are going to have a major hand in deciding how the
deal is going to be structured, regardless of the contract the company entered into years before
when it did an early private financing.
Registration Rights
Investor Favorable:
Demand Rights: If Investors holding at least 30 percent of the
outstanding shares of Series [A] Preferred, including Common Stock issued on conversion of Series [A]
Preferred ("Registrable Securities"), request that the Company file a Registration Statement having an
aggregate offering price to the public of not less than $5,000,000, the Company will use its best efforts to
cause such shares to be registered; provided, however, that the Company shall not be obligated to effect any
such registration prior to the second anniversary of the Closing. The Company shall have the right to delay
such registration under certain circumstances for two periods not in excess of ninety (90) days each in any
twelve (12) month period.
Term Sheet Tutorial 25
The Company shall not be obligated to effect more than two (2) registrations under these demand right
provisions, and shall not be obligated to effect a registration (i) during the ninety (90) day period
commencing with the date of the Company's initial public offering, or (ii) if it delivers notice to the holders
of the Registrable Securities within thirty (30) days of any registration request of its intent to file a
registration statement for a Qualified IPO within ninety (90) days.
Company Registration: The Investors shall be entitled to "piggy-back" registration rights on all
registrations of the Company or on any demand registrations of any other investor subject to the right,
however, of the Company and its underwriters to reduce the number of shares proposed to be registered pro
rata in view of market conditions. If the Investors are so limited, however, no party shall sell shares in such
registration other than the Company or the Investor, if any, invoking the demand registration. No
shareholder of the Company shall be granted piggy-back registration rights that would reduce the number
of shares includable by the holders of the Registrable Securities in such registration without the consent of
the holders of at least two thirds of the Registrable Securities.
S-3 Rights: Investors shall be entitled to an unlimited number of demand registrations on Form S-3 (if
available to the Company) so long as such registered offerings are not less than $500,000. The Company
shall not be obligated to file more than one S-3 registration in any six month period.
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and
commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one special
counsel of the selling shareholders).
Transfer of Rights: The registration rights may be transferred to (i) any partner or retired partner of any
holder which is a partnership, (ii) any family member or trust for the benefit of any individual holder, or
(iii) any transferee who acquires at least [one quarter of the shares originally issued] shares of Registrable
Securities; provided the Company is given written notice thereof.
Standoff Provision: No Investor holding more than 1 percent of the Company will sell shares within 120
days of the effective date of the Company's initial public offering if all officers, directors, and other 1
percent shareholders are similarly bound.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to
registration rights as are reasonable, including cross-indemnification, the period of time in which the
Registration Statement shall be kept effective, and underwriting arrangements.
Middle of the Road:
Demand Rights: If Investors holding more than 50 percent of the
outstanding shares of Series [A] Preferred, including Common Stock issued on conversion of Series [A]
Preferred ("Registrable Securities"), request that the Company file a Registration Statement having an
aggregate offering price to the public of not less than $5,000,000, the Company will use its best efforts to
cause such shares to be registered; provided, however, that the Company shall not be obligated to effect any
such registration prior to the third anniversary of the Closing. The Company shall have the right to delay
such registration under certain circumstances for one period not in excess of ninety (90) days in any twelve
(12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand right
provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty (180) day
period commencing with the date of the Company's initial public offering, or (ii) if it delivers notice to the
holders of the Registrable Securities within thirty (30) days of any registration request of its intent to file a
registration statement for such initial public offering within ninety (90) days.
Company Registration: The Investors shall be entitled to "piggy-back" registration rights on all
registrations of the Company or on any demand registrations of any other investor subject to the right,
however, of the Company and its underwriters to reduce the number of shares proposed to be registered pro
rata in view of market conditions. If the Investors are so limited, however, no party shall sell shares in such
Term Sheet Tutorial 26
registration other than the Company or the Investor, if any, invoking the demand registration. No
shareholder of the Company shall be granted piggy-back registration rights that would reduce the number
of shares includable by the holders of the Registrable Securities in such registration without the consent of
the holders of at least two thirds of the Registrable Securities.
S-3 Rights: Investors shall be entitled to two (2) demand registrations on Form S-3 (if available to the
Company) so long as such registered offerings are not less than $500,000.
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and
commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one special
counsel of the selling shareholders not to exceed $15,000).
Transfer of Rights: The registration rights may be transferred to (i) any partner or retired partner of any
holder which is a partnership, (ii) any family member or trust for the benefit of any individual holder, or
(iii) any transferee who acquires at least [one eighth of the shares originally issued] shares of Registrable
Securities; provided the Company is given written notice thereof.
Lock-Up Provision: If requested by the Company and its underwriters, no Investor will sell its shares for a
specified period (but not to exceed 180 days) following the effective date of the Company's initial public
offering; provided that all officers, directors, and other 1 percent shareholders are similarly bound.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to
registration rights as are reasonable, including cross-indemnification, the period of time in which the
Registration Statement shall be kept effective, and underwriting arrangements.
Company Favorable:
Company Registration: The Investors shall be entitled to "piggy-back"
registration rights on all registrations of the Company subject to the right, however, of the Company and its
underwriters to reduce the number of shares proposed to be registered pro rata among all Investors in view
of market conditions.
S-3 Rights: Investors shall be entitled to two (2) demand registrations on Form S-3 (if available to the
Company) so long as such registered offerings are not less than $500,000.
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and
commissions) of all such piggy-backs, and S-3 registrations (including the expense of a single counsel to
the selling shareholders not to exceed $5,000).
Standoff Provision: If requested by the underwriters no Investor will sell shares of the Company's stock for
up to 180 days following a public offering by the Company of its stock.
Termination of Rights: The registration rights shall terminate on the date three (3) years after the
Company's initial public offering, or with respect to each Investor, at such time as (i) the Company's shares
are publicly traded, and (ii) the Investor is entitled to sell all of its shares in any ninety (90) day period
pursuant to SEC Rule 144.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to
registration rights as are reasonable and standard, including cross-indemnification, the period of time in
which the Registration Statement shall be kept effective, and underwriting arrangements.
Term Sheet Tutorial 27
TERM SHEET: VESTING
Term Sheet: Vesting by Feld Thoughts
When Jason and I last wrote on the mythical term sheet, we were working our way through the
terms that "can matter." The last one on our list is vesting, and we approach it with one eyebrow
raised understanding the impact of this term is crucial for all founders of an early stage company.
While vesting is a simple concept, it can have profound and unexpected implications. Typically,
stock and options will vest over four years - which means that you have to be around for four years
to own all of your stock or options (for the rest of this post, I'll simply refer to the equity as "stock"
although exactly the same logic applies to options.) If you leave the company earlier than the four
year period, the vesting formula applies and you only get a percentage of your stock. As a result,
many entrepreneurs view vesting as a way for VCs to "control them, their involvement, and their
ownership in a company" which, while it can be true, is only a part of the story.
A typical stock vesting clause looks as follows:
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors,
consultants and other service providers will be subject to vesting provisions below unless different
vesting is approved by the majority (including at least one director designated by the Investors)
consent of the Board of Directors (the "Required Approval"): 25% to vest at the end of the first year
following such issuance, with the remaining 75% to vest monthly over the next three years. The
repurchase option shall provide that upon termination of the employment of the shareholder, with
or without cause, the Company or its assignee (to the extent permissible under applicable securities
law qualification) retains the option to repurchase at the lower of cost or the current fair market
value any unvested shares held by such shareholder. Any issuance of shares in excess of the
Employee Pool not approved by the Required Approval will be a dilutive event requiring adjustment
of the conversion price as provided above and will be subject to the Investors' first offer rights.
The outstanding Common Stock currently held by _________ and ___________ (the "Founders")
will be subject to similar vesting terms provided that the Founders shall be credited with [one
year] of vesting as of the Closing, with their remaining unvested shares to vest monthly over three
years.
Industry standard vesting for early stage companies is a one year cliff and monthly thereafter for a
total of 4 years. This means that if you leave before the first year is up, you don't vest any of your
stock. After a year, you have vested 25% (that's the "cliff"). Then - you begin vesting monthly (or
quarterly, or annually) over the remaining period. So - if you have a monthly vest with a one year
cliff and you leave the company after 18 months, you'll have vested 37.25% of your stock.
Often, founders will get somewhat different vesting provisions than the balance of the employee
base. A common term is the second paragraph above, where the founders receive one year of
vesting credit at the closing and then vest the balance of their stock over the remaining 36 months.
Term Sheet Tutorial 28
This type of vesting arrangement is typical in cases where the founders have started the company a
year or more earlier then the VC investment and want to get some credit for existing time served.
Unvested stock typically "disappears into the ether" when someone leaves the company. The equity
doesn't get reallocated - rather it gets "reabsorbed" - and everyone (VCs, stock, and option holders)
all benefit ratably from the increase in ownership (or - more literally - the reverse dilution.") In the
case of founders stock, the unvested stuff just vanishes. In the case of unvested employee options,
it usually goes back into the option pool to be reissued to future employees.
A key component of vesting is defining what happens (if anything) to vesting schedules upon a
merger. "Single trigger" acceleration refers to automatic accelerated vesting upon a merger.
"Double trigger" refers to two events needing to take place before accelerated vesting (e.g., a
merger plus the act of being fired by the acquiring company.) Double trigger is much more common
than single trigger. Acceleration on change of control is often a contentious point of negotiation
between founders and VCs, as the founders will want to "get all their stock in a transaction - hey,
we earned it!" and VCs will want to minimize the impact of the outstanding equity on their share of
the purchase price. Most acquires will want there to be some forward looking incentive for founders,
management, and employees, so they usually either prefer some unvested equity (to help incent
folks to stick around for a period of time post acquisition) or they'll include a separate management
retention incentive as part of the deal value, which comes off the top, reducing the consideration
that gets allocated to the equity ownership in the company. This often frustrates VCs (yeah - I hear
you chuckling "haha - so what?") since it puts them at cross-purposes with management in the M&A
negotiation (everyone should be negotiating to maximize the value for all shareholders, not just
specifically for themselves.) Although the actual legal language is not very interesting, it is included
below.
In the event of a merger, consolidation, sale of assets or other change of control of the Company
and should an Employee be terminated without cause within one year after such event, such person
shall be entitled to [one year] of additional vesting. Other than the foregoing, there shall be no
accelerated vesting in any event."
Structuring acceleration on change of control terms used to be a huge deal in the 1990's when
"pooling of interests" was an accepted form of accounting treatment as there were significant
constraints on any modifications to vesting agreements. Pooling was abolished in early 2000 and under purchase accounting - there is no meaningful accounting impact in a merger of changing the
vesting arrangements (including accelerating vesting). As a result, we usually recommend a
balanced approach to acceleration (double trigger, one year acceleration) and recognize that in an
M&A transaction, this will often be negotiated by all parties. Recognize that many VCs have a
distinct point of view on this (e.g. some folks will NEVER do a deal with single trigger acceleration;
some folks don't care one way or the other) - make sure you are not negotiating against and "point
of principle" on this one as VCs will often say "that's how it is an we won't do anything different."
Recognize that vesting works for the founders as well as the VCs. I've been involved in a number of
situations where one or more founders didn't work out and the other founders wanted them to leave
the company. If there had been no vesting provisions, the person who didn't make it would have
Term Sheet Tutorial 29
walked away with all their stock and the remaining founders would have had no differential
ownership going forward. By vesting each founder, there is a clear incentive to work your hardest
and participate constructively in the team, beyond the elusive founders "moral imperative."
Obviously, the same rule applies to employees - since equity is compensation and should be earned
over time, vesting is the mechanism to insure the equity is earned over time.
Of course, time has a huge impact on the relevancy of vesting. In the late 1990's, when companies
often reached an exit event within two years of being founded, the vesting provisions - especially
acceleration clauses - mattered a huge amount to the founders. Today - as we are back in a normal
market where the typical gestation period of an early stage company is five to seven years, most
people (especially founders and early employees) that stay with a company will be fully (or mostly)
vested at the time of an exit event.
While it's easy to set vesting up as a contentious issue between founders and VCs, we recommend
the founding entrepreneurs view vesting as an overall "alignment tool" - for themselves, their cofounders, early employees, and future employees. Anyone who has experienced an unfair vesting
situation will have strong feelings about it - we believe fairness, a balanced approach, and
consistency is the key to making vesting provisions work long term in a company.
Vesting of Founders Shares by John Huston
For a thorough review of the issues associated with the highly contentious topic
of vesting of founders shares please see Appendix A
Term Sheet Tutorial 30
TERM SHEET: CONDITIONS PRECEDENT TO FINANCING
Conditions Precedent
Investor Favorable:
This proposal is non-binding, and is specifically subject to:
(1) Completed due-diligence reviews satisfactory to [Investor] and Investors' counsel, specifically including
review of [Investor Counsel].
(2) Customary stock purchase and related agreements satisfactory to [Investor] and Investors' counsel,
including stock option plan.
(3) Intellectual property, confidentiality, and non-compete agreements with all key employees of the
Company satisfactory to Investors' counsel.
(4) Satisfactory review of the Company's compensation programs and stock allocation and vesting
arrangements for officers, key employees, and others, as well as any existing employment or similar
agreements.
(5) Both the Company and Investors will negotiate exclusively and in good faith toward an investment as
outlined in this proposal and agree to "no-shop" provisions for reasonable and customary periods of time.
(6) Conversion of all outstanding convertible securities (e.g., convertible notes or preferred stock issued
prior to the date of this Series A financing).
Middle of the Road and Company Favorable:
This proposal is non-binding, and is specifically
subject to:
(1) Completed due-diligence reviews satisfactory to [Investor] and Investors' counsel, specifically including
review of [Investor Counsel].
(2) Customary stock purchase and related agreements satisfactory to [Investor] and Investors' counsel,
including stock option plan.
(3) Both the Company and Investors will negotiate exclusively and in good faith toward an investment as
outlined in this proposal and agree to "no-shop" provisions for reasonable and customary periods of time.
Term Sheet: Conditions Precedent to Financing by Feld Thought
As I watched 24 last night, I kept thinking to myself "Why the **** does Jack have his cell phone
ringer on - hasn't he ever heard of vibrate?" immediately after his cell phone rang but right before
he got shot at because the bad guys now knew where he was. I had a parallel thought this morning
- "Why do we make all this term sheet stuff so long, verbose, and tedious." The answer - word
processers. If we had to type all this crap on a typewriter (or write it out by hand) it'd be a lot
shorter. In both cases, technology is working against us. But - then again, we wouldn't have blogs
(and I can hear a few of you (and I know who you are) saying "and that would be a bad thing
because?")
While there is a lot to negotiate in a term sheet (as you can see from the series of posts on term
sheets that Jason and I have written), a term sheet is simply a step on the way to an actual deal.
Term sheets are often either non-binding (or mostly non-binding), and most investors will load
them up with conditions precedent to financing. Entrepreneurs glance over these – usually because
they are in the back sections of the term sheet and are typically pretty innocuous, but they
occasionally have additional "back door outs" for the investor that the entrepreneur should watch
out for, if only to better understand the current mindset of the investor proposing the investment.
A typical conditions precedent to financing clause looks as follows:
Term Sheet Tutorial 31
"Conditions Precedent to Financing: Except for the provisions contained herein entitled "Legal
Fees and Expenses", "No Shop Agreement", and "Governing Law" which are explicitly agreed by the
Investors and the Company to be binding upon execution of this term sheet, this summary of terms
is not intended as a legally binding commitment by the Investors, and any obligation on the part of
the Investors is subject to the following conditions precedent: 1. Completion of legal documentation
satisfactory to the prospective Investors; 2. Satisfactory completion of due diligence by the
prospective Investors; 3. Delivery of a customary management rights letter to Investors; and 4.
Submission of detailed budget for the following twelve months, acceptable to Investors."
Notice that the investor will try to make a few things binding – specifically (a) that his legal fees get
paid whether or not a deal happens, (b) that the company can’t shop the deal once the term sheet
is signed, and (c) that the governing law be set to a specific domicile – while explicitly stating "there
are a bunch things that still have to happen before this deal is done and I can back out for any
reason."
There are a few conditions to watch out for since they usually signal something non-obvious on the
part of the investor. They are:
1. "Approval by Investors’ partnerships" – this is super secret VC code for "this deal has not
been approved by the investors who issued this term sheet. Therefore, even if you love the
terms of the deal, you still may not have a deal.
2. "Rights offering to be completed by Company" – this indicates that the investors want
the company to offer all previous investors in the company the ability to participate in the
currently contemplated financing. This is not necessarily a bad thing – in fact in most cases
this serves to protect all parties from liability - but does add time and expense to the deal.
3. "Employment Agreements signed by founders as acceptable to investors" – beware what
the full terms are before signing the agreement. As an entrepreneur, when faced with this,
it’s probably wise to understand (and negotiate) the form of employment agreement early
in the process. While you’ll want to try to do this before you sign a term sheet and accept a
no-shop, most VCs will wave you off and say “don’t worry about it – we’ll come up with
something that works for everyone.” Our suggestion – at the minimum, make sure you
understand the key terms (such as compensation and what happens on termination).
There are plenty of other wacky conditionals – if you can dream it, it has probably been done. Just
make sure to look carefully at this paragraph and remember that just because you’ve signed a term
sheet, you don’t have a deal.
Term Sheet Tutorial 32
TERM SHEET: CONVERSION
Automatic Conversion
Investor Favorable:
The Series [A] Preferred shall be automatically converted into
Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least two
thirds of the outstanding Series [A] Preferred consent to such conversion or (ii) upon the closing of a firmly
underwritten public offering of shares of Common Stock of the Company at a per share price not less than
[3 times the Original Purchase Price] per share and for a total offering with net proceeds to the Company of
not less than $40 million (a "Qualified IPO").
Middle of the Road:
The Series [A] Preferred shall be automatically converted into
Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least two
thirds of the outstanding Series [A] Preferred consent to such conversion or (ii) upon the closing of a firmly
underwritten public offering of shares of Common Stock of the Company at a per share price not less than
[2 times the Original Purchase Price] per share and for a total offering with gross proceeds to the Company
of not less than $25 million (a "Qualified IPO").
Company Favorable:
The Series [A] Preferred shall be automatically converted into
Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least a
majority of the outstanding Series [A] Preferred consent to such conversion or (ii) upon the closing of a
firmly underwritten public offering of shares of Common Stock of the Company at a per share price not
less than two times the Original Purchase Price (as adjusted for stock splits and the like) and for a total
offering of not less than $5 million, before deduction of underwriters commissions and expenses (a
"Qualified IPO").
(15) Purchase Agreement:
Investor Favorable:
The investment shall be made pursuant to a Stock Purchase Agreement
reasonably acceptable to the Company and the Investors, which agreement shall contain, among other
things, appropriate representations and warranties of the Company, representations of the Founders with
respect to patents, litigation, previous employment and outside activities, covenants of the Company
reflecting the provisions set forth herein, and appropriate conditions of closing , including an opinion of
counsel for the Company. The Stock Purchase Agreement shall provide that it may only be amended and
any waivers thereunder shall only be made with the approval of the holders of two thirds of the Series [A]
Preferred. Registration rights provisions may be amended or waived solely with the consent of the holders
of two thirds of the Registrable Securities.
Middle of the Road:
The investment shall be made pursuant to a Stock Purchase Agreement
reasonably acceptable to the Company and the Investors, which agreement shall contain, among other
things, appropriate representations and warranties of the Company, covenants of the Company reflecting
the provisions set forth herein, and appropriate conditions of closing, including an opinion of counsel for
the Company. The Stock Purchase Agreement shall provide that it may only be amended and any waivers
thereunder shall only be made with the approval of the holders of two thirds of the Series [A] Preferred.
Registration rights provisions may be amended or waived solely with the consent of the holders of two
thirds of the Registrable Securities.
Company Favorable:
The investment shall be made pursuant to a Stock Purchase Agreement
reasonably acceptable to the Company and the Investors, which agreement shall contain, among other
things, appropriate representations and warranties of the Company, covenants of the Company reflecting
the provisions set forth herein, and appropriate conditions of closing, including an opinion of counsel for
the Company. The Stock Purchase Agreement shall provide that it may only be amended and any waivers
Term Sheet Tutorial 33
thereunder shall only be made with the approval of the holders of 50 percent of the Series [A] Preferred.
Registration rights provisions may be amended or waived solely with the consent of the holders of 50
percent of the Registrable Securities.
(16) Employee Matters:
Investor Favorable:
Employee Pool: Upon the Closing of this financing there will be [______] shares of issued and
outstanding Common Stock held by the Founders and an additional [_______] shares of Common Stock
reserved for future issuance to key employees.
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors and
consultants will be subject to vesting as follows: 20 percent to vest at the end of the first year following
such issuance, with the remaining 80 percent to vest monthly over the subsequent four years. The
repurchase option shall provide that upon termination of the employment of the shareholder, with or
without cause, the Company or its assignee (to the extent permissible under applicable securities law
qualification) retains the option to repurchase at cost any unvested shares held by such shareholder.
The outstanding Common Stock currently held by the Founders will be subject to similar vesting terms,
with such vesting period beginning as of the Closing Date.
Restrictions on Sales:
Stock.
The Company shall have a right of first refusal on all transfers of Common
Proprietary Information and Inventions
Agreement:
Each officer, employee and consultant of the Company shall enter into an
acceptable proprietary information and inventions agreement.
Co-Sale Agreement:
The shares of the Company's securities held by the Founders of the Company
shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the holders of the
Series [A] Preferred such that the Founders may not sell, transfer or exchange their stock unless each
holder of Series [A] Preferred has an opportunity to participate in the sale on a pro rata basis. This right of
co-sale shall not apply to and shall terminate upon a Qualified IPO.
Key-Man Insurance:
As soon as reasonably possible after the Closing, the Company shall procure a
key-man life insurance policy for [_________] in the amount of $1,000,000, naming the Company as
beneficiary; provided, however, that at the election of holders of a majority of the outstanding Series [A]
Preferred, such proceeds shall be used to redeem shares of Series [A] Preferred.
Management:
The Company will, on a best efforts basis, hire a chief [_________] officer
within the six (6) month period following the closing of the financing.
Middle of the Road:
Employee Pool: Upon the Closing of this financing there will be [______] shares of issued and
outstanding Common Stock held by the Founders and an additional [_______] shares of Common Stock
reserved for future issuance to key employees. Promptly after the Closing, Messrs. [____________] and
[____________] will be granted incentive stock options from the [_____________] share pool in the
amount of [_____________] shares each exercisable at $0.10 per share, which options will vest in
accordance with the following paragraph.
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors,
consultants and other service providers will be subject to vesting as follows: [20 percent to vest at the end
of the first year following such issuance, with the remaining 80 percent to vest monthly over the next four
years.] The repurchase option shall provide that upon termination of the employment of the shareholder,
with or without cause, the Company or its assignee (to the extent permissible under applicable securities
law qualification) retains the option to repurchase at cost any unvested shares held by such shareholder.
Term Sheet Tutorial 34
The outstanding Common Stock currently held by the Founders will be subject to similar vesting terms,
provided that the Founders shall be credited with two years of vesting as of the Closing, with their
remaining unvested shares to vest monthly over three years.
Restrictions on Sales:
The Company shall have a right of first refusal on all transfers of Common
Stock, subject to normal exceptions.
Proprietary Information and Inventions
Agreement:
Each officer and employee of the Company shall enter into an acceptable
proprietary information and inventions agreement.
Co-Sale Agreement:
The shares of the Company's securities held by [________________],
[_______________], [______________] and [______________] (the "Founders") shall be made subject to
a co-sale agreement (with certain reasonable exceptions) with the holders of the Series [A] Preferred such
that the Founders may not sell, transfer or exchange their stock unless each holder of Series [A] Preferred
has an opportunity to participate in the sale on a pro rata basis. This right of co-sale shall not apply to and
shall terminate upon the Company's initial public offering.
Key-Man Insurance:
The Company shall procure a key-man life insurance
[_____________] in the amount of $1,000,000, naming the Company as beneficiary.
Company Favorable:
Closing Date:
policy
for
None.
[_____________], 200[_] (the "Closing Date").
Legal Counsel:
The Company shall select legal counsel acceptable to [Investor]
([_____________]). Unless counsels agree otherwise, Investors' counsel [_____________] shall draft the
financing documents for review by Company counsel.
Expenses:
Investor Favorable:
counsel and Company counsel.
The Company shall pay the reasonable fees and expenses of Investors'
Middle of the Road:
The Company shall pay the reasonable fees for one special counsel to
the Investors, expected not to exceed $[25,000 – $35,000], and for Company counsel.
Company Favorable:
The Company and the Investors shall each bear their own legal fees and
expenses in connection with the transaction.
Finders:
The Company and the Investors shall each indemnify the other
for any finder's fees for which either is responsible.
Term Sheet: Conversion by Feld Thought
While lots of VCs posture during term sheet negotiations by saying "that is non-negotiable", terms
rarely are (as you’ve likely inferred from previous posts on term sheets be me and Jason.)
Occasionally, a term will actually be non-negotiable. In all the VC deals we’ve ever seen, the
preferred has the right - at any time - to convert its stake into common. Following is the standard
language:
Term Sheet Tutorial 35
"Conversion: The holders of the Series A Preferred shall have the right to convert the Series A
Preferred, at any time, into shares of Common Stock. The initial conversion rate shall be 1:1,
subject to adjustment as provided below."
This allows the buyer of preferred to convert to common should he determine on a liquidation that
he is better off getting paid on a pro rata common basis rather than accepting the liquidation
preference and participating amount. It can also be used in certain extreme circumstances whereby
the preferred wants to control a vote of the common on a certain issue. Do note, however, that
once converted, there is no provision for "re-converting" back to preferred.
A more interesting term is the automatic conversion, especially since it has several components that
are negotiable.
"Automatic Conversion: All of the Series A Preferred shall be automatically converted into
Common Stock, at the then applicable conversion price, upon the closing of a firmly underwritten
public offering of shares of Common Stock of the Company at a per share price not less than [three]
times the Original Purchase Price (as adjusted for stock splits, dividends and the like) per share and
for a total offering of not less than [$15] million (before deduction of underwriters commissions and
expenses) (a "Qualified IPO"). All, or a portion of, each share of the Series A Preferred shall be
automatically converted into Common Stock, at the then applicable conversion price in the event
that the holders of at least a majority of the outstanding Series A Preferred consent to such
conversion."
In an IPO of a venture-backed company, the investment bankers will want to see everyone convert
into common stock at the time of the IPO (it is extremely rare for a venture backed company to go
public with multiple classes of stock – it happens – but it’s rare). The thresholds of the automatic
conversion are critical to negotiate – as the entrepreneur; you want them lower to insure more
flexibility while your investors will want them higher to give them more control over the timing and
terms of an IPO.
Regardless of the actual thresholds, one thing of crucial importance is to never allow investors to
negotiate different automatic conversion terms for different series of preferred stock. There are
many horror stories of companies on the brink of going public and having one class of preferred
stockholders that have a threshold above what the proposed offering would consummate and
therefore these stockholders have an effective veto right on the offering. We strongly recommend
that – at each financing – you equalize the automatic conversion threshold among all series of
stock.
Term Sheet Tutorial 36
TERM SHEET: REDEMPTION RIGHTS
Redemption
Investor Favorable:
Redemption at Option of Investors:
At the election of the holders of at least [a majority] of the Series [A] Preferred, the Company shall redeem
1/3 of the outstanding Series [A] Preferred on the [third] anniversary of the Closing, 1/2 of the outstanding
Series [A] Preferred on the fifth anniversary of the Closing and all of the remaining outstanding Series [A]
Preferred on the sixth anniversary of the Closing. Such redemptions shall be at a purchase price equal to
[three] times the Original Purchase Price plus accrued and unpaid dividends.
Middle of the Road:
Redemption at Option of Investors:
At the election of the holders of at least [two thirds] of the Series [A] Preferred, the Company shall redeem
the outstanding Series [A] Preferred in three equal annual installments beginning on the [fifth] anniversary
of the Closing. Such redemptions shall be at a purchase price equal to the Original Purchase Price plus
declared and unpaid dividends.
Company Favorable:
None.
Term Sheet: Redemption Rights by Feld Thoughts
If you are avid followers of the TV series 24 (as Jason and I are), you’ll recognize that the next item
in our term sheet series – Redemption at Option of Investors – has similar characteristics to the
regular exchange Jack has with CTU:
CTU Director (any of them – Driscoll, Tony, Ryan, George, Michelle): "Jack – stand down – don’t go
in there without backup."
Jack: (Gruffly, in a hoarse voice) "I gotta go in – there’s no time to wait – if I don’t go, the world
will end and my (current babe, hostage, daughter, partner) will die."
CTU Director: (Mildly panicked) "Jack – wait – it’s too dangerous – I command you – wait."
Jack: (Insolently) "I gotta go." (Jack hangs up the phone).
Cut to clock ticking and commercial or teaser for scenes from next week.
Think of the discussion around redemption rights as this scene – utterly predictable and ultimately
benign. Jack always goes in. Jack always stops the bad stuff – for the time being. Jack (or the bad
guys) always creates a new problem. The CTU director always forgets that Jack disobeyed a direct
order shortly after Jack is successful with his latest task.
You are Jack. Your investor is the CTU director. If you ask your CTU director "have you ever actually
ever triggered redemption rights?" you will normally get some nervous fidgeting ("wait – it’s too
dangerous"), a sheepish "no" followed by a confident "but we have to have them or we won’t do the
deal!" ("I command you – wait.")
Term Sheet Tutorial 37
Redemption rights usually look something like:
"Redemption at Option of Investors: At the election of the holders of at least majority of the
Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual
installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a
purchase price equal to the Original Purchase Price plus declared and unpaid dividends."
There is some rationale for redemption rights. First, there is the "fear" (on the VCs part) that a
company will become successful enough to be an on-going business, but not quite successful
enough to go public or be acquired. In this case, redemption rights were invented to allow the
investor a guaranteed exit path. However, any company that is around for a while as a going
concern that is not an attractive IPO or acquisition candidate will not generally have the cash to pay
out redemption rights.
The second reason for redemption rights pertains to the life span of venture funds. The average
venture fund has a 10 years life span to conduct its business. If a VC makes an investment in year 5
of the fund, it might be important for that fund manager to secure redemption rights in order to
have a liquidity path before his fund must wind down. As with the previous case, whether or not the
company has the ability to pay is another matter.
Often, companies will claim that redemption rights create a liability on their balance sheet and can
make certain business optics more difficult. In the past few years, accountants have begun to argue
more strongly that redeemable preferred stock is a liability on the balance sheet, not an equity
feature. Unless the redeemable preferred stock is mandatorily redeemable, this is not the case and
most experienced accountants will be able to recognize the difference.
There is one form of redemption that we have seen in the past few years and we view as
overreaching – the adverse change redemption. We recommend you never agree to the following
which has recently crept into terms sheets.
"Adverse Change Redemption: Should the Company experience a material adverse change to its
prospects, business or financial position, the holders of at least majority of the Series A Preferred
shall have the option to commit the Company to immediately redeem the outstanding Series A
Preferred. Such redemption shall be at a purchase price equal to the Original Purchase Price plus
declared and unpaid dividends."
This is just too vague, too punitive, and shifts an inappropriate amount of control to the investors
based on an arbitrary judgment. If this term is being proposed and you are getting pushback on
eliminating it, make sure you are speaking to a professional investor and not a loan shark.
In our experience – just like Jack’s behavior - redemption rights are well understood by the market
and should not create a problem, except in a theoretical argument between lawyers or accountants.
Term Sheet Tutorial 38
TERM SHEET: COMPELLED SALE RIGHT
Compelled Sale Right
So long as VC (together with its permitted transferees) continues to hold at least
10% of the outstanding common shares (on an as-converted basis), and so long
as an IPO has not been completed, then, at any time from and after the seventh
anniversary of the transaction, if VC or the Company shall receive a bona fide
offer from an unaffiliated third party to purchase 100% of the equity of the
Company, VC shall have the right to cause each other stockholder to sell such
stockholder’s equity securities on the same terms and conditions applicable to
VC.
My first reaction was “what the @X#%?” My second reaction was “eh – this is
just a different twist on redemption rights.” But - then I thought about it some
more and thought “you’ve got to be kidding me!”
So – after seven years, if there hasn’t been a liquidity event, a VC that owns at
least 10% of the company can force all the other shareholders to sell their shares
to an unaffiliated third party. Read it slowly and think about it. Basically, this
term gives a minority shareholder the right to sell the company after 7 years, with
no input from any other shareholders.
Be forewarned - this is not a nice term.
Term Sheet Tutorial 39
TERM SHEET: DIVIDENDS
Dividend Provisions
Investor Favorable:
The holders of the Series [A] Preferred shall be entitled to receive
cumulative dividends in preference to any dividend on the Common Stock at the rate of 15 percent of the
Original Purchase Price per annum, when and as declared by the Board of Directors.
Middle of the Road:
The holders of the Series [A] Preferred shall be entitled to receive noncumulative dividends in preference to any dividend on the Common Stock at the rate of 8 percent of the
Original Purchase Price per annum, when and as declared by the Board of Directors. The Series [A]
Preferred also will participate pro rata in any dividends paid on the Common Stock on an as-converted
basis.
Company Favorable:
The holders of the Series [A] Preferred shall be entitled to receive noncumulative dividends in preference to any dividend on the Common Stock at the rate of 8 percent of the
Original Purchase Price per annum, when, as and if declared by the Board of Directors.
Term Sheet: Dividends by Feld Thoughts
As our term sheet series unfolds (almost as exciting as 24, eh? – if you’ve been reading the last few
days I bet you figured out that I recently had a 7 hour plane ride with a laptop battery that was in
pretty good shape) we now shift gears from nuclear meltdown situations (also known as "things
that matter a lot") to economic terms that can matter, but aren’t as important (e.g. "why doesn’t
Kim have a job at CTU anymore?")
Dividends are up first. While private equity guys love dividends (e.g. I guarantee you that when
Bain Capital buys the NHL and renames it the "BHL", the deal will have dividends in it), many
venture capitalists – especially early stage ones - don’t really care about dividends (although some
do – especially those that come from a pure financial focus and have never had a 50x+ return on
anything). Typical dividend language in a term sheet follows:
"Dividends: The holders of the Series A Preferred shall be entitled to receive [non-]cumulative
dividends in preference to any dividend on the Common Stock at the rate of [8%] of the Original
Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of Series
A Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock
on an as-if-converted basis."
For early stage investments, dividends generally do not provide "venture returns" – they are simply
modest juice in a deal. Let’s do some simple math. Assume a typical dividend of 10% (dividends will
range from 5% to 15% depending on how aggressive your investor is – we picked 10% to make the
math easy). Now – assume that you are an early stage VC (painful and yucky – we understand –
just try for a few minutes). Success is not a 10% return – success is a 10x return. Now, assume
that you (as the VC) have negotiated hard and gotten a 10% cumulative (you get the dividend
every year, not only when they are declared), automatic (they don’t have to be declared, they
happen automatically), annual dividend. Again – to keep the math simple – let’s assume the
Term Sheet Tutorial 40
dividend does not compound – so every year you simply get 10% of your investment as a dividend.
In this case, it will take you 100 years to get your 10x return. Since a typical venture deal lasts 5 to
7 years (and you’ll be dead in 100 years anyway), you’ll never see the 10x return from the
dividend.
Now – assume a home run deal – assume a 50x return on a $10m investment in five years. Even
with a 10% cumulative annual dividend, this only increases the investor return from $500m to
$505m (the annual dividend is $1m (10% of $10m) times 5 years).
So – while the juice from the dividend is nice, it doesn’t really move the meter in the success case –
especially since venture funds are typically 10 years long – meaning as a VC you’ll only get 1x your
money in a dividend if you invest on day 1 of a fund and hold the investment for 10 years. (NB to
budding early stage VCs – don’t raise your fund on the basis of your future dividend stream from
your investments).
This also assumes the company can actually pay out the dividend – often the dividends can be paid
in either stock or cash – usually at the option of the company. Obviously, the dividend could drive
additional dilution if it is paid out in stock, so this is the one case where it is important not to get
head faked by the investor (e.g. the dividend simply becomes another form of anti-dilution
protection – although in this case one that is automatic and simply linked to the passage of time).
Of course – we’re being optimistic about the return scenarios. In downside cases, the juice can
matter, especially as the invested capital increases. For example, take a $40m investment with a
10% annual cumulative dividend in a company that was sold at the end of the fifth year to another
company for $80m. In this case, assume that there was a straight liquidation preference (e.g. no
participating preferred) and the investor got 40% of the company for her investment (or a $100m
post money valuation). Since the sale price was below the investment post money valuation (e.g. a
loser, but not a disaster), the investor will exercise the liquidation preference and take the $40m
plus the dividend ($4m per year for 5 years – or $20m). In this case, the difference between the
return in a no dividend scenario ($40m) and a dividend scenario ($60m) is material.
Mathematically, the larger the investment amount and the lower the expected exit multiple, the
more the dividend matters. This is why you see dividends in private equity and buyout deals, where
big money is involved (typically greater than $50m) and the expectation for return multiples on
invested capital are lower.
Automatic dividends have some nasty side effects, especially if the company runs into trouble, as
they typically should be included in the solvency analysis and – if you aren’t paying attention – an
automatic cumulative dividend can put you unknowingly into the zone of insolvency (a bad place –
definitely one of Dante’s levels – but that’s for another post).
Cumulative dividends can also annoying and often an accounting nightmare, especially when they
are optionally in stock, cash, or a conversion adjustment, but that’s why the accountants get paid
the big bucks at the end of the year to put together the audited balance sheet.
Term Sheet Tutorial 41
That said, the non-cumulative when declared by the board dividend is benign, rarely declared, and
an artifact of the past, so we typically leave it in term sheets just to give the lawyers something to
do.
Another Look At Dividends
Somehow when you see that little clause on the term sheet about an 8% dividend for the
preferred shares, it doesn't seem that big of a deal at the time. But to put it in perspective,
let's take a typical "success" story and see how that dividend affects the deal.
Imagine a scenario where a startup raises $14.5MM in 4 rounds (seed plus A, B and C)
and that each round has the 8% compounding dividend paid on exit. Further, let's
imagine the company sells for $75MM. Here's the cash flow:
Date
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Cashflow
-500
-2000
-5000
-7000
0
0
75000
In this scenario, the dividend results in an extra $4.9MM paid to the preferred shares
which is about 6% of the sale economics. So the way to think about this little term is
whether you want to give a 6% vig to your investor.
Term Sheet Tutorial 42
TERM SHEET: PAY-TO-PLAY
Term Sheet: Pay-to-Play by Feld Thought
There’s nothing like a solid week of vacation with no phone, email, or blogs to get the writing juices
rolling again. Of course, now that I’m through my email, I only have 8200 blog posts to read to
catch up – thank god for jet lag – wait, what am I saying?
In our term sheet series, Jason Mendelson and I have been focusing first on "the terms that really
matter." We are down to the last one – the pay-to-play provision. At the turn of the century, a payto-play provision was rarely seen. After the bubble burst in 2001, it became ubiquitous. Interesting,
this is a term that most companies and their investors can agree on if they approach it from the
right perspective.
In a pay-to-play provision, an investor must keep "paying" (participating pro ratably in future
financings) in order to keep "playing"(not have his preferred stock converted to common stock) in
the company. Sample language follows:
"Pay-to-Play: In the event of a Qualified Financing (as defined below), shares of Series A Preferred
held by any Investor which is offered the right to participate but does not participate fully in such
financing by purchasing at least its pro rata portion as calculated above under "Right of First
Refusal" below will be converted into Common Stock.
[(Version 2, which is not quite as aggressive): If any holder of Series A Preferred Stock fails to
participate in the next Qualified Financing, (as defined below), on a pro rata basis (according to its
total equity ownership immediately before such financing) of their Series A Preferred investment,
then such holder will have the Series A Preferred Stock it owns converted into Common Stock of the
Company. If such holder participates in the next Qualified Financing but not to the full extent of its
pro rata share, then only a percentage of its Series A Preferred Stock will be converted into
Common Stock (under the same terms as in the preceding sentence), with such percentage being
equal to the percent of its pro rata contribution that it failed to contribute.]
A Qualified Financing is the next round of financing after the Series A financing by the Company that
is approved by the Board of Directors who determine in good faith that such portion must be
purchased pro rata among the stockholders of the Company subject to this provision. Such
determination will be made regardless of whether the price is higher or lower than any series of
Preferred Stock.
When determining the number of shares held by an Investor or whether this "Pay-to-Play" provision
has been satisfied, all shares held by or purchased in the Qualified Financing by affiliated
investment funds shall be aggregated. An Investor shall be entitled to assign its rights to participate
Term Sheet Tutorial 43
in this financing and future financings to its affiliated funds and to investors in the Investor and/or
its affiliated funds, including funds which are not current stockholders of the Company."
We believe this is good for the company and its investors as it causes the investors "stand up" and
agree to support the company during its lifecycle at the time of the investment. If they do not, the
stock they have is converted from preferred to common and they lose the rights associated with the
preferred stock. When our co-investors push back on this term, we ask: "Why? Are you not going to
fund the company in the future if other investors agree to?" Remember, this is not a lifetime
guarantee of investment, rather if other prior investors decide to invest in future rounds in the
company, there will be a strong incentive for all of the prior investors to invest or subject
themselves to total or partial conversion of their holdings to common stock. A pay-to-play term
insures that all the investors agree in advance to the "rules of engagement" concerning participating
in future financings.
The pay-to-play provision impacts the economics of the deal by reducing liquidation preferences for
the non-participating investors. It also impacts the control of the deal, as it reshuffles the future
preferred shareholder base by insuring only the committed investors continue to have preferred
stock (and the corresponding rights).
When companies are doing well, the pay-to-play provision is often waived, as a new investor wants
to take a large part of the new round. This is a good problem for a company to have, as it typically
means there is an up-round financing, existing investors can help drive company-friendly terms in
the new round, and the investor syndicate increases in strength by virtue of new capital (and –
presumably – another helpful co-investor) in the deal.
Pay To Play
Always think about the penalty for not paying (i.e. participating in a round). It can range
from merely losing your pre-emptive Rights to being forcibly converted to common and
silenced. Also: always see what impact it has on the Anti-dilution rights. Often if you
don’t Pay you lose your Anti-dilution protection.
Term Sheet Tutorial 44
TERM SHEET: ANTI-DILUTION
Anti-dilution Provisions
Investor Favorable:
The conversion price of the Series [A] Preferred will be subject to a full
ratchet adjustment in the event that the Company issues additional equity securities (other than the reserved
employee shares described under "Employee Pool") at a purchase price less than the applicable conversion
price. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends,
recapitalizations, and the like.
Middle of the Road:
The conversion price of the Series [A] Preferred will be then subject to
a weighted average adjustment (based on all outstanding shares of Preferred and Common Stock) to reduce
dilution in the event that the Company issues additional equity securities (other than the reserved employee
shares described under "Employee Pool") at a purchase price less than the applicable conversion price. The
conversion price will also be subject to proportional adjustment for stock splits, stock dividends,
recapitalizations, and the like. This anti-dilution protection is subject to a play-or-lose provision that
provides that adjustments will be made to the Series [A] Conversion Price only if the Series [A] holder
participates in such dilutive offering to the extent of its pro rata equity interest in the Preferred. Any
investor who does not participate in a future financing forfeits the benefits of dilution protection [for all
future rounds of financing/only for that financing round].
Company Favorable:
The conversion price of the Series [A] Preferred will be subject to
proportional adjustment for stock splits, stock dividends, recapitalizations, and the like.
Dilution? By Frank Demmler
It may not be what you think
Anti-dilution protection. Everyone has heard that phrase. Most people think they know
what it means. Many first-time entrepreneurs don’t. That can lead to huge mistakes.
One of the problems is that “dilution” has several meanings when it comes to doing a
deal.
Percentage-Based Dilution
If you own 60% of the equity of your company before an investment and 30% afterward,
that’s dilution.
If an investor owns 40% of your company before a round of investment and 20%
afterward, that’s dilution.
BUT that’s NOT the kind of dilution that anti-dilution protection applies to.
Share Price Dilution
Confused?
Well, let’s talk about the kind of dilution that investors do seek protection against.
Term Sheet Tutorial 45
If an investor buys shares of stock in your business at $1.00 per share and the next round
of investment is at $0.50 per share, now that’s dilution.
Getting Back to Basics
Let’s go back to some of the first things we talked about in this series of articles.

 Deals are negotiated with percentages, but are structured with shares.

 The value of a company is only known at the instant of a transaction when
cash is being exchanged for equity.

 The value of a company is determined by multiplying the total number of
common shares by the most recent share price.

 Pre-Financing Value + Investment = Post-Financing Value.

 Pre-Financing Value = Post-Financing Value – Investment.

 Price per share = Amount of investment divided by the number of shares
purchased.
That’s all pretty dry and boring gobblygook, unless it’s your company and you’re doing
the deal.
The First Round
Let’s translate some of this into an example.

 I offer to invest $400,000 in your company in exchange for 40% of it.

 Since you own all 600,000 shares of your company, I am offering to buy
400,000 new shares in order to acquire 40%.

 My investment of $400,000 divided by 400,000 shares that I’m buying yields a
per share price of $1.00.

 Since you own 600,000 shares, that means the value of the stake in your
company is $600,000, which is the pre-financing value.

 Adding my $400,000 to that yields a post-financing value of $1,000,000.

 That is confirmed by taking the total number of outstanding shares, 1,000,000
(your 600,000 and my 400,000) and multiplying that by the share price of $1.00.

 That also says that the post-financing value of your company is $1,000,000.
Term Sheet Tutorial 46
Everything is in balance. The world is good.
The Good Second Round: Share Price Increase
As time progresses, you and your company forge ahead. It’s time to raise some more
money. Fortunately for you, you are in a business that venture capital investors are
interested in. Several of them are looking at you, and after a while you negotiate a deal
with one of them.

 The new investor offers to invest $2,000,000 for 50% of your company.

 If 50% of the company is worth $2,000,000, then the total company must be
worth $4,000,000.

 Since there are 1,000,000 shares outstanding today and they will represent
50% of the company after the financing, then the new investor is buying
1,000,000 shares.

 The $2,000,000 investment divided by 1,000,000 shares yields a share price of
$2.00.

 Since I paid $1.00 per share, I’m happy. In fact, the 400,000 shares that I paid
$400,000 for are now worth $800,000 (400,000 shares X $2.00 per share).

 The value of my investment has appreciated (grown in value).

 Even though the percent of the company I own has decreased (been diluted)
from 40% to 20%, I’m happy.

 By the same reasoning, your equity stake is now worth $1.2 million, and
you’ve got $2,000,000 of investor’s money to pursue your dream!
Term Sheet Tutorial 47
Everything is in balance. The world is good.
The Not-So-Good Second Round: Share Price Decrease
Alternatively, as time progresses, you and your company move forward. It’s time to raise
some more money. Unfortunately for you, you are in a business that venture capital
investors shun. Only one expresses lukewarm interest. Finally, you extract a deal.

 The new investor offers to invest $500,000 for 50% of your company.

 If 50% of the company is worth $500,000, then the total company must be
worth $1,000,000.

 Since there are 1,000,000 shares outstanding today and they will represent
50% of the company after the financing, then the new investor is buying
1,000,000 shares.

 The $500,000 investment divided by 1,000,000 shares yields a share price of
$0.50.

 Since I paid $1.00 per share, I’m not happy. In fact, the 400,000 shares that I
paid $400,000 for are now worth $200,000 (400,000 shares X $0.50 per share).

 The value of my investment has been diluted.

 In addition, the percent of the company I own has decreased (been diluted)
from 40% to 20%.

 By the same reasoning, your equity stake is now only worth $300,000, and
you’ve only got $500,000 of investor’s money to keep your business alive.
Term Sheet Tutorial 48
Everything is in balance. The world is not so good. I want some protection against this
form of dilution.
Recap
Dilution has several meanings in deal making. It is critical to understand the context. An
investor is most concerned about the value of his investment. If a proposed transaction
will reduce the value of the investor’s investment (a lower price per share than he paid),
he will seek anti-dilution protection.
Term Sheet : Anti-Dilution by Feld Thoughts
It has been a while since I put up a term sheet post so I thought I’d tackle a hard one today. While
it’s fun to tease lawyers about math (and – actually – about anything), my co-author on this series
Jason Mendelson (a lawyer) often reminds me that lawyers can do basic arithmetic (and
occasionally have to resort to algebra). The anti-dilution provision demonstrates this point.
Traditionally, the anti-dilution provision is used to protect investors in the event a company issues
equity at a lower valuation then in previous financing rounds. There are two varieties: weighted
average anti-dilution and ratchet based anti-dilution. Standard language is as follows:
Anti-dilution Provisions: The conversion price of the Series A Preferred will be subject to a [full
ratchet / broad-based / narrow-based weighted average] adjustment to reduce dilution in the event
that the Company issues additional equity securities (other than shares (i) reserved as employee
shares described under the Company’s option pool,, (ii) shares issued for consideration other than
cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by
the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property
leasing arrangement or debt financing from a bank or similar financial institution approved by the
Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A
Preferred waive their anti-dilution rights) at a purchase price less than the applicable conversion
price. In the event of an issuance of stock involving tranches or other multiple closings, the
Term Sheet Tutorial 49
antidilution adjustment shall be calculated as if all stock was issued at the first closing. The
conversion price will also be subject to proportional adjustment for stock splits, stock dividends,
combinations, recapitalizations and the like.
Full ratchet means that if the company issues shares at a price lower than the Series A, then the
Series A price is effectively reduced to the price of the new issuance. One can get creative and do
"partial ratchets" (such as "half ratchets" or "two-thirds ratchets") which are a less harsh, but rarely
seen.
While full ratchets came into vogue in the 2001 – 2003 time frame when down-rounds were all the
rage, the most common anti-dilution provision is based on the weighted average concept, which
takes into account the magnitude of the lower-priced issuance, not just the actual valuation. In a
"full ratchet world" if the company sold one share of its stock to someone for a price lower than the
Series A, all of the Series A stock would be repriced to the issuance price. In a "weighted average
world," the number of shares issued at the reduced price are considered in the repricing of the
Series A. Mathematically (and this is where the lawyers get to show off their math skills – although
you’ll notice there are no exponents or summation signs anywhere) it works like this (note that
despite the fact one is buying preferred stock, the calculations are always done in as-if-converted to
common stock basis):
NCP = OCP * ((CSO + CSP) / (CSO + CSAP))
Where:

NCP = new conversion price

OCP = old conversion price

CSO = common stock outstanding

CSP = common stock purchasable with consideration received by company (i.e. "what the
buyer should have bought if it hadn’t been a ‘down round’ issuance")

CSAP = common stock actually purchased in subsequent issuance (i.e., "what the buyer
actually bought")
Recognize that we are determining a "new conversion price" for the Series A Preferred . We are not
actually issuing more shares (you can do it this way, but it’s a silly and unnecessarily complicated
approach that merely increases the amount the lawyers can bill the company for the financing).
Consequently, "anti-dilution provisions" generate a "conversion price adjustment" and the phrases
are often used interchangeably.
Got it? I find it’s best to leave the math to the lawyers.
You might note the term "broad-based" in describing weighted average anti-dilution. What makes
the provision a broad-based versus narrow-based is the definition of "common stock outstanding"
(CSO). A broad-based weighted average provision includes both the company’s common stock
outstanding (including all common stock issuable upon conversion of its preferred stock) as well as
Term Sheet Tutorial 50
the number of shares of common stock which could be obtained by converting all other options,
rights, and securities (including employee options). A narrow-based provision will not include these
other convertible securities and limit the calculation to only currently outstanding securities. The
number of shares and how you count them matter – make sure you are agreeing on the same
definition (you’ll often find different lawyers arguing over what to include or not include in the
definitions – again – this is another common legal fee inflation technique).
In our example language, we’ve included a section which is generally referred to as "anti-dilution
carve outs" (the section (other than shares (i) … (iv)). These are the standard exceptions for share
granted at lower prices for which anti-dilution does not kick in. Obviously - from a company (and
entrepreneur) perspective - more exceptions are better – and most investors will accept these
carve-outs without much argument.
One particular item to note is the last carve out: (iv) shares with respect to which the holders of a
majority of the outstanding Series A Preferred waive their anti-dilution rights. This is a carve out
that started appearing recently which we have found to be very helpful in deals where a majority of
the Series A investors agree to further fund a company in a follow-on financing, but the price will be
lower than the original Series A. In this example, several minority investors signaled they were not
planning to invest in the new round, as they would have preferred to "sit back" and increase their
ownership stake via the anti-dilution provision. Having the larger investors (the majority of the
class) "step up" and vote to carve the financing out of the anti-dilution terms was a huge bonus for
the company common holders and employees who would have suffered the dilution of additional
anti-dilution from investors who were not continuing to participate in financing the company. This
approach encourages the minority investors to participate in the round in order to protect
themselves from dilution.
Occasionally, anti-dilution will be absent in a Series A term sheet. Investors love precedent (e.g. the
new investor says "I want what the last guy got, plus more"). In many cases anti-dilution provisions
hurt Series A investors more than prior investors if you assume the Series A price is the low
watermark for the company. For instance, if the Series A price is $1.00, the Series B price is $5.00,
and the Series C price is $3.00, then the Series B is benefited by an anti-dilution provision at the
expense of the Series A. However, our experience is that anti-dilution is usually requested despite
this as Series B investors will most likely always ask for it and – since they do – the Series A
proactively asks for it anyway.
In addition to economic impacts, anti-dilution provisions can have control impacts. First, the
existence of an anti-dilution provision incents the company to issue new rounds of stock at higher
valuations because of the ramifications of anti-dilution protection to the common stock holders. In
some cases, a company may pass on taking an additional investment at a lower valuation (although
practically speaking, this only happens when a company has other alternatives to the financing).
Second, a recent phenomenon is to tie anti-dilution calculations to milestones the investors have set
for the company resulting in a conversion price adjustment in the case that the company does not
meet certain revenue, product development or other business milestones. In this situation, the antidilution adjustments occur automatically if the company does not meet in its objectives, unless this
is waived by the investor after the fact. This creates a powerful incentive for the company to
Term Sheet Tutorial 51
accomplish its investor-determined goals. We tend to avoid this approach, as blindly hitting predetermined (at the time of financing) product and sales milestones is not always best for the longterm development of a company, especially if these goals end up creating a diverging set of goals
between management and the investors as the business evolves.
Anti-dilution provisions are almost always part of a financing, so understanding the nuances and
knowing which aspects to negotiate is an important part of the entrepreneur’s toolkit. We advise
you not to get hung up in trying to eliminate anti-dilution provisions – rather focus on (a)
minimizing their impact and (b) building value in your company after the financing so they don’t
ever come into play.
(Source?)
Consider this: Isn’t a Full Ratchet essentially, therefore, just a “Price
Guarantee” while the Weighted Average Anti-Dilution protection is
essentially just “Price Protection?”
Anti-Dilution Protection Key Aspect of Raising Money
Article from Techyvent/Pittsburgh ()
April 19, 2004
Anti-Dilution Protection Key Aspect of Raising
Money
Tips for Protecting Your Investment
by Jeremiah G. Garvey and David A. Grubman
It's (Almost) All About Anti-Dilution
When entrepreneurs and venture capitalists sit down to talk deal, it’s almost always first and
foremost about pre-money enterprise valuation. And that’s not a small matter. But other terms
can break a deal too, and one of them is anti-dilution protection.
It's always about enterprise valuation. If you ask any participant in a venture deal the first deal
term anyone wants to talk about is: What's the "pre-money valuation." Don't get us wrong, the
"pre-money valuation" is crucial and often times a deal breaker. Pre-money valuation is an
important term because it establishes what (puts a stake in the ground) the baseline exit will (or
might) look like (how much on a percentage basis everyone gets). But it is only part of the
story. The other terms of the deal really do matter as well. A pre-money valuation of $5 million
with onerous terms may be more harmful to a company and its shareholders than a pre-money
valuation of $3 million with less onerous terms.
Term Sheet Tutorial 52
The point is that other terms really do matter, and one term that deserves a lot of attention is
anti-dilution protection. If the pre-money valuation is the price, anti-dilution is the price
guarantee (in the case of full ratchet anti-dilution) or price protection in the case of weighted
average. Anti-dilution provisions can have a tremendous impact on a company (and in
particular its founders and option holders) especially in the event of a subsequent "down round"
of financing
Anti-dilution protection is perhaps the most important deal term beyond valuation, but it is often
misunderstood. To get a better picture of what anti-dilution means, we need to drill down on
what is meant by dilution. In the context of a typical venture deal, the term dilution refers to
economic dilution, not straight percentage dilution. For example, assume that a company is
capitalized with 100 shares of common stock outstanding where there are two shareholders
and each shareholder paid $1.00 per share. The value of the company is $100. Let's say that
each shareholder owns 50% of the company. So each shareholder has 1/2 of $100 of the
company or $50 in "value." Now the company undergoes a subsequent financing, where it
sells an additional 100 shares at $2 per share to a third investor. Now the original 2
shareholders have 25% of the company. As a matter of percentage dilution, each has been
diluted by half. However, as a matter of economic dilution, each is better off. There is no
economic dilution. Each of the original two stockholders owns 50 shares that pre-financing
were worth $50, which now on a post financing basis are worth $75 because the enterprise
valuation is now $300.
Anti-dilution provisions are intended to provide investors with an element of "downside
protection" in the event that a company "sells" additional securities at a lower price than the
securities previously purchased by such investors. Anti-dilution provisions enable the
conversion price of such investor's securities to be adjusted downward so that upon conversion
to common stock the investors are entitled to receive additional shares of the company's
common stock. How many more shares depends on the type of anti-dilution formula which
exists in the company's charter. Anti-dilution formulas generally fall into two categories: (1) full
ratchet anti-dilution, and (2) weighted average anti-dilution. The differences between these
types of anti-dilution provisions and their potential impact are described in more detail below.
Full Ratchet Anti-Dilution
A full ratchet anti-dilution formula provides that the conversion price of an investor's securities
will be automatically decreased, upon the issuance of additional securities, to the same price
that such additional securities are "sold" by the company. The conversion price is the price by
which one share of preferred stock (using preferred as the convertible security) converts into
common stock, by dividing the original issue price (the price an investor paid for a share of
preferred stock) by the conversion price. The lower the conversion price, the more shares of
common stock one share of preferred stock will convert into. A typical full ratchet anti-dilution
provision would read as follows: "In the event this Corporation shall issue Additional Shares of
Common Stock (including Additional Shares of Common Stock deemed to be issued) without
consideration or for consideration per share less than the applicable Conversion Price in effect
on the date of and immediately prior to such issue, then and in such event the Conversion
Price of the Series A Preferred shall be reduced, concurrently with such issue, to the lowest
price at which any of the Additional Shares of Common Stock are issued."
An example of the effect of a full ratchet anti-dilution formula is as follows: Investor A
purchased 1,000,000 shares of Series A Preferred Stock of Company X at $1.00 per share at a
pre-money valuation of $3,000,000 for a 25% stake, on a post-financing basis ($4,000,000), in
Company X (we assume as is usually the case, each share of Series A Preferred initially
converts into one share of common stock). One year later, Company X sells 1,000,000 shares
of Series B Preferred Stock at $0.50 per share (again, convertible one-to-one into common) at
Term Sheet Tutorial 53
a pre-money valuation of $2,000,000 for a 20% stake, on a post-financing basis ($3,000,000),
to Investor B. With no anti-dilution protection, Investor A would own 20% of Company X after
the sale of the Series B Preferred Stock (1,000,000 shares out of 5,000,000 shares). However,
the full ratchet anti-dilution provision in Company X's charter provides that the conversion price
for the Series A Preferred Stock that Investor A purchased for $1.00 per share will be reduced
to $0.50 per share, such that upon conversion, Investor A would be entitled to receive
2,000,000 shares of Company X common stock upon conversion rather than 1,000,000
shares. What will really happens is that Investor B will take into account this anti-dilutive effect
into its term sheet to allow it to maintain its percentage interest at 20% thus further crushing
Company X's founders and holders of common stock (including optionees). However, the real
issue here is that full rachet adjusts the Series A Preferred Conversion price regardless of the
number of shares of Series B Preferred actually sold at the dilutive price. Therefore, the issue
is one share of Series B Preferred issued at $0.50 per share will have the same impact on the
Company from an anti-dilution adjustment standpoint.
Weighted Average Anti-Dilution
There is also weighted average anti-dilution protection, which is divided into two categories: (1)
broad-based weighted average anti-dilution protection, and (2) narrow-based weighted average
anti-dilution protection. Weighted average anti-dilution protection is a more moderate type of
anti-dilution provision than full ratchet, where an investor's conversion price is decreased, and
thus the number of shares of common stock received on conversion is increased. A weighted
average anti-dilution formula takes into account both: (a) the reduced price and, (b) how many
shares are issued in the "down round" of financing.
Both of these types of weighted average anti-dilution provisions provide that the conversion
price of an investor's securities will be reduced upon the issuance of additional securities at a
price less than such securities. A typical broad-based anti-dilution provision would read as
follows: "In the event this Corporation shall issue Additional Shares of Common Stock
(including Additional Shares of Common Stock deemed to be issued) without consideration or
for consideration per share less than the applicable Conversion Price in effect on the date of
and immediately prior to such issue, then and in such event the Conversion Price of the Series
A Preferred shall be reduced, concurrently with such issue, to a price (calculated to the nearest
cent) determined by multiplying such Conversion Price by a fraction, the numerator of which
shall be the number of shares of Common Stock outstanding immediately prior to such issue
(including all shares of Common Stock issuable upon conversion of the outstanding Preferred
Stock) plus the number of shares of Common Stock which the aggregate consideration
received by the Corporation for the total number of Additional Shares of Common Stock so
issued would purchase at such Conversion Price; and the denominator of which shall be the
number of shares of Common Stock outstanding immediately prior to such issue (including all
shares of Common Stock issuable upon conversion of the outstanding Preferred Stock) plus
the number of such Additional Shares of Common Stock so issued (or deemed to be issued)."
An example of the effect of a broad-based weighted average anti-dilution formula is as follows:
Investor A purchased 1,000,000 shares of Series A Preferred Stock of Company X at $1.00 per
share at a pre-money valuation of $3,000,000 for a 25% stake, on a post-financing basis, in
Company X. One year later, Company X sells 1,000,000 shares of Series B Preferred Stock at
$0.50 per share at a pre-money valuation of $2,000,000 for a 20% stake, on a post-financing
basis, to Investor B. Again, with no anti-dilution protection, Investor A would own 20% of
Company X after the sale of the Series B Preferred Stock (1,000,000 shares out of 5,000,000
shares). However, the broad-based weighted average anti-dilution provision in Company X's
charter provides that the conversion price for the Series A Preferred Stock that Investor A
purchased for $1.00 per share will be reduced to $0.90 per share, such that upon conversion,
Investor A would be entitled to receive 1,111,111 shares of Company X common stock rather
Term Sheet Tutorial 54
than 1,000,000 shares. While Investor B will take into account this anti-dilutive effect into its
valuation so as to maintain its 20% stake in the company on a post-financing basis, you can
clearly see that this will have a much less punitive effect on the company's founders and
management than a full ratchet anti-dilution provision will have.
A typical narrow-based anti-dilution provision would read as follows: "If and whenever the
Corporation shall issue or sell, or is deemed to have issued or sold, any shares of Common
Stock for a consideration per share less than the then applicable Conversion Price for the
Convertible Preferred Stock in effect immediately prior to the time of such issue or sale, then,
forthwith upon such issue or sale, the Conversion Price for the Convertible Preferred Stock
shall be reduced to an amount equal to the following: the quotient obtained by dividing the total
computed under clause (A) below by the total computed under clause (B) below as follows: (A)
an amount equal to the sum of (1) the aggregate purchase price of the shares of the
Convertible Preferred Stock sold pursuant to the Stock Purchase Agreement, plus (2) the
aggregate consideration, if any, received by the corporation for all Additional Stock issued on
or after the date of the Stock Purchase Agreement at a per share price below the then
applicable Conversion Price; (B) an amount equal to the sum of (1) the aggregate purchase
price of the shares of Convertible Preferred Stock sold pursuant to the Stock Purchase
Agreement divided by the applicable Conversion Price for such shares in effect on the date of
the Stock Purchase Agreement, plus (2) the number of shares of Additional Stock issued since
the date of the Stock Purchase Agreement at a per share price below the then applicable
Conversion Price."
Using the same example above, a typical narrow based weighted average anti-dilution formula
would provide that the conversion price for the Series A Preferred Stock that Investor A
purchased for $1.00 per share will be reduced to $0.75 per share, such that upon conversion,
Investor A would be entitled to receive 1,333,333 shares of Company X common stock rather
than 1,000,000 shares.
Now don't get us wrong, while anti-dilution protection can clearly have potential punitive effects
on management and/or a founder's percentage interest in a company, it is a very standard and
common provision for a venture capital investor to ask for. Remember, anti-dilution provisions
only kick in when the pre-money valuation of a company in a future round of financing (or other
issuance of the company's securities which are not excluded from such formula) is less than
the post-money valuation in one of the company's previous rounds of financing, so the antidilution provision is "protecting" the investor's investment. There can be a number of reasons
why a company's valuation would be less today than it was 6 months or even 1 year ago, for
example, market conditions change, the company fails to execute on its business plan or
unforeseen events occur, so it's extremely commonplace for an investor to be somewhat
protected on the "downside." What level of "downside" protection is what really should be the
focal point of the discussion.
The above examples clearly demonstrate the differing effects that the varying anti-dilution
provisions can have on a company's founders and holders of common stock, in the event of a
"downround" of financing. So, when negotiating a venture capital term sheet, management
should be mindful of the effects of anti-dilution provisions and focus on the potential impact of
such provisions on the company, particularly in light of valuation discussions.
Copyright © 2004 Buchanan Ingersoll Professional Corporation
Jeremiah G. Garvey and David A. Grubman are with law firm of Buchanan Ingersoll.
Term Sheet Tutorial 55
Practical Implications of Anti-Dilution Protection
Getting real
In recent articles we’ve looked at anti-dilution protection. Recapping:

 An investor in any given round of financing is concerned that the next round
could be at a lower price per share than what he is paying this round.

 The investor will insist upon anti-dilution protection.

 There are two common types of anti-dilution protection: full ratchet and
weighted average.
We’ve covered the mechanics of anti-dilution protection. Now let’s look at what it really
means.
The Starting Position
First we will review the example transactions. I agreed to invest $400,000 for 40% of
your company’s equity. The results of this investment are shown in the following table.
The Down Round
It’s time to raise some more money. Unfortunately, the only investment offer you are able
to attract is at a lower valuation than the prior round.

 The new investor offers to invest $500,000 for 50% of your company.

 If 50% of the company is worth $500,000, then the pre-financing value of the
company is $500,000.

 The $500,000 of pre-financing value is divided among you, my anti-dilution
protection, and me.
Let’s look at how this would play out with the two different types of protection.
Term Sheet Tutorial 56
Full Ratchet Anti-Dilution Protection
As a practical matter, full ratchet anti-dilution protection gives the original investor rights
to that number of shares of common stock as if I paid the current round’s lower price.
The share price must meet the conditions that the new investor gets 50% of the equity and
I get my full ratchet anti-dilution protection. Instead of $0.50 per share as might be
inferred from the investment offer, the actual share price is $0.1667.
Weighted Average Anti-Dilution Protection
Weighted average anti-dilution protection gives consideration to the relationship between
the total shares outstanding as compared to the shares held by the original investor. The
formula is CP2 = CP1 * (A+B) / (A+C). These variables were defined in the prior article.
Term Sheet Tutorial 57
What Causes a Down Round?
Very simply, a down round happens when you accept an investment at a price per share
lower than that paid in a prior round. Notice that the emphasis is on “you accept…”
Anyone can offer anything. It only matters if you accept the offer.
Why would you accept such a deal? Most likely because you need the money and you
don’t have any alternatives. How could you find yourself in this position? Some possible
reasons include:

 You didn’t make your sales plan

 You didn’t complete your product

 Your current investors can’t invest any more money in your company

 Your current investors could invest more money in your company, but won’t

 Potential investors just don’t “get it”

 You’ve got too many people

 You’ve got too few people

 You have the right number of people, but they aren’t the “right” people

 Your business model is flawed

 You don’t have a business model

 Private equity markets suck and you’re lucky to get any offer
The fact of the matter is that it doesn’t really matter why the down round happens.
Participants in the Investment
Let’s look at the participants in the investment, and their relative positions:

 You – You still believe in your dream. You are still convinced that you’ve got
a great business opportunity. Sure, you haven’t hit plan, but what entrepreneur
does? You are willing to accept a down round if it gives you another time at bat,
and you’ve got enough equity in your company to make it worthwhile.

 Me (the current investor) – Even if you (and your company) have done
everything that you “should” have (exceeded plan, built out the management
team…), I’m aware that I am vulnerable if only one next-round investor is at the
table.
Knowing this, the primary way to avoid a down round is for the current
investor(s) to do an “inside round,” in which the investors (at least the major
investors, and quite possibly all investors) in previous rounds take their pro rata
shares of an alternative round of financing. As mentioned in previous articles,
such inside rounds are usually structured as an extension of the most recent round,
or as a convertible note.
Term Sheet Tutorial 58
If I don’t step up, I am pretty much at the mercy of the new investor. Yes, I’ve got
all sorts of legal protections built into my deal, including anti-dilution protection,
but how meaningful are they really?

 The New Investor – He wouldn’t be looking at the deal unless he thought the
fundamental business was promising and that he could achieve a superior rate of
return. Of course that rate of return will be greatly impacted by the valuation of
the company at the time of his initial investment. Obviously, the lower that value,
the better for the new investor. But no matter how low the valuation, if the
business doesn’t have that promise, there’s no deal to be done at any price.
OK, so how does the new investor view the other participants?
As far as the new investor is concerned, I don’t have much to offer. Unless I have
agreed to invest a significant amount in the new investor’s round, he doesn’t have
any incentive to care about me.
You, though, are the jockey he’s betting on. The new investor has been able to
understand how the company has gotten to this point, is willing to “give you the
benefit of the doubt,” and is willing to back you. You are important to him.
With these dynamics in place, the new investor will want to keep you relatively
happy (under the circumstances) and is likely to dictate terms to me, insisting that
I waive or significantly modify my rights and protective provisions.
If only one investor is interested in doing the next round, the Golden Rule
prevails – “He who has the gold rules!”
Anti-dilution protection will receive particular attention.
o o Note that in the case of full ratchet anti-dilution protection, your share
of your company will drop from 60% to 10%! This will not be acceptable
to the new investor. He wants you to be satisfied by the terms of the deal,
and he doesn’t really care about me. The new investor will demand that
I waive my full ratchet anti-dilution protection.
This is likely to be presented as “take it, or leave it.” If I don’t agree, the
new investor is likely to threaten to walk away from the deal. This is a
game of Chicken that I’m not likely to win.
o o With weighted average anti-dilution protection, your share of the
company is reduced from 60% to 28%, almost all of which is caused by
the valuation decline and not my anti-dilution protection. This level of
protection is much more likely to be honored.
The bottom line is that under most circumstances full ratchet anti-dilution protection will
be completely waived, while weighted average is likely to be accepted.
Full Ratchet Anti-Dilution Protection
Fasten your seat belt
Term Sheet Tutorial 59
In last week’s article, we discussed how the word “dilution” has several meanings in deal
making. It is critical to understand the context.
An investor in any given round of financing is concerned that the next round could be at a
lower price per share than what he is paying this round. Therefore, the investor will insist
upon anti-dilution protection.
If pressed for justification, the investor may explain that if the value of a company
declines between rounds, management must be largely responsible. The investor
maintains that he shouldn’t be penalized for management’s deficiencies.
There are two common types of anti-dilution protection: full ratchet and weighted
average.
This week we will examine full ratchet anti-dilution protection.
Full Ratchet Anti-Dilution Protection
As a practical matter [as compared to the legal language below], full ratchet anti-dilution
protection gives the original investor rights to that number of shares of common stock as
if he paid the current round’s lower price.
I’ve tried to keep unnecessary complexity out of these articles, but it’s unavoidable at
juncture.
Investors purchase preferred stock that is convertible into common stock. Initially the
conversion is on a one-to-one basis, or at the same share price as that paid for the
preferred stock. Anti-dilution protection is implemented by adjusting the conversion
price.
The language that is used in a term sheet to say this is:
In the event that the Company issues additional securities
in the future at a purchase price less than the current Series
A Preferred conversion price, such conversion price shall
be adjusted in accordance with the following formula:
Full-ratchet – the conversion price will be reduced to the
price at which the new shares are issued.
National Venture Capital Association
Let’s look at how this works.
The First Round
Let’s review last week’s example.

 I offer to invest $400,000 in your company in exchange for 40% of it.

 Since you own all 600,000 shares of your company, I am offering to buy
400,000 new shares in order to acquire 40%.

 My investment of $400,000 divided by 400,000 shares that I’m buying yields a
per share price of $1.00.
Term Sheet Tutorial 60

 Since you own 600,000 shares, that means the value of the stake in your
company is $600,000, which is the pre-financing value.

 Adding my $400,000 to that yields a post-financing value of $1,000,000.

 That is confirmed by taking the total number of outstanding shares, 1,000,000
(your 600,000 and my 400,000) and multiplying that by the share price of $1.00.

 That also says that the post-financing value of your company is $1,000,000.
There’s one big difference this week. The terms of this deal include full ratchet antidilution protection.
The Second Round
It’s time to raise some more money. Unfortunately, the only investment offer you are able
to attract is at a lower price per share than the prior round.
Without anti-dilution protection, the deal would proceed:

 The new investor offers to invest $500,000 for 50% of your company.

 If 50% of the company is worth $500,000, then the total company must be
worth $1,000,000.

 Since there are 1,000,000 shares outstanding today and they will represent
50% of the company after the financing, then the new investor is buying
1,000,000 shares.

 The $500,000 investment divided by 1,000,000 shares yields a share price of
$0.50.

 Since I paid $1.00 per share, I’m not happy. In fact, the 400,000 shares that I
paid $400,000 for are now worth $200,000 (400,000 shares X $0.50 per share).
Term Sheet Tutorial 61

 The value of my investment has been diluted.

 In addition, the percent of the company I own has decreased (been diluted)
from 40% to 20%.

 By the same reasoning, your equity stake is now only worth $300,000, and
you’ve only got $500,000 of investor’s money to keep your business alive.
BUT I do have anti-dilution protection, so the deal will have needs to be adjusted.
The Adjustment – Step #1
With anti-dilution protection, the deal would proceed:

 The new investor offers to invest $500,000 for 50% of your company.

 If 50% of the company is worth $500,000, then the total company must be
worth $1,000,000.

 Since there are 1,000,000 shares outstanding today and they will represent
50% of the company after the financing, then the new investor is buying
1,000,000 shares.

 The $500,000 investment divided by 1,000,000 shares yields a share price
of $0.50.

 While I paid $1.00 per share, the new round will reduce that price to $0.50.
So, in addition to the original 400,000 shares for which I paid $400,000, I will
receive an additional 400,000 shares, bringing my total shares to 800,000
($400,000 divided by $0.50 per share).
Term Sheet Tutorial 62
Done? Nope.
By issuing an additional 400,000 shares, the total number of shares has increased as well.
The new investor would only own 42% if we were to stop here, but we won’t.
The Adjustment – Step #2
Remember the first element of the deal:

 The new investor offers to invest $500,000 for 50% of your company.

 If 50% of the company is worth $500,000, then the total company must be
worth $1,000,000.

 Since there are 1,400,000 shares outstanding, including those created by my
anti-dilution protection, the new investor must buy 1,400,000 shares to purchase
50%.

 The $500,000 investment divided by 1,400,000 shares yields a share price
of $0.36.
Term Sheet Tutorial 63
Done? Nope.
The Adjustment – Step #3
With the share price having dropped to $0.36, my anti-dilution protection needs to be
recalculated

 Since the price per share this round is $0.36, in addition to the original
400,000 shares for which I paid $400,000, I will receive an additional 720,000
shares, bringing my total shares to 1,120,000 ($400,000 divided by $0.36 per
share).
Term Sheet Tutorial 64
Done? Nope. Beginning to see a pattern?
The Adjustment – Steps #4-?
When I get additional shares from anti-dilution protection, the investor’s ownership drops
to less than 50%.
The share price is reduced so that the investor is buying enough shares to own 50%.
The lower price means I get more shares. That lowers the investor’s share price. And on
and on…
This why I learned to use the “Iterate” function in my spreadsheet.
The Investor Outcome
The share price drops all the way to less than $0.17.
The new investor buys 3,000,012 shares.
I get 2,000,010 shares as a result of full ratchet anti-dilution protection.
Your Outcome
As you may have noticed, all of these adjustments have occurred to the investors’
positions. What happens to you?
It isn’t pretty. As the number of shares for the investors ratchet higher and higher, your
number of shares remains constant at 600,000.
Your share of your company has fallen to 10%!
The value of your shares has dropped to $100,000!
Reviewing the Basics
Term Sheet Tutorial 65
Let’s look at some of the relevant basics.

 Deals are negotiated with percentages, but are structured with shares.

 The value of a company is determined by multiplying the total number of
common shares by the most recent share price.

 Price per share = Amount of investment divided by the number of shares
purchased.
As I’ve said before, these may appear to be pretty dry and boring gobblygook, but as
we’ve seen, they can have very significant consequences.
Recap
An investor in any given round of financing is concerned that the next round could be at a
lower price per share than what he is paying this round. Therefore, the investor will insist
upon anti-dilution protection.
Full ratchet anti-dilution protection is very friendly to the investor and is very harsh to the
founder.
Next week we’ll look at weighted-average anti-dilution protection.
Weighted Average Anti-Dilution Protection
Get out your calculator
An investor in any given round of financing is concerned that the next round could be at a
lower price per share than what he is paying this round. Therefore, the investor will insist
upon anti-dilution protection.
If pressed for justification, the investor may explain that if the value of a company
declines between rounds, management must be largely responsible. The investor
maintains that he shouldn’t be penalized for management’s deficiencies.
There are two common types of anti-dilution protection: full ratchet and weighted
average.
Last week’s article examined full ratchet anti-dilution protection. This week we will look
at weighted average anti-dilution protection.
Weighted Average Anti-Dilution Protection
Unlike full ratchet anti-dilution protection that is effectively a “do-over,” weighted
average anti-dilution protection gives consideration to the relationship between the total
shares outstanding as compared to the shares held by the original investor.
A reminder, investors purchase preferred stock that is convertible into common stock.
Initially the conversion is on a one-to-one basis, or at the same share price as that paid for
the preferred stock. Anti-dilution protection is implemented by adjusting the conversion
price.
The legal language that is used in a term sheet to say this is:
Term Sheet Tutorial 66
In the event that the Company issues additional securities at
a purchase price less than the current Series A Preferred
conversion price, such conversion price shall be adjusted in
accordance with the following formula:
CP2 = CP1 * (A+B) / (A+C), where:
CP2 = New Series A Conversion Price
CP1 = Series A Conversion Price in effect immediately
prior to new issue
A
= Number of shares of Common Stock deemed to
be outstanding immediately prior to new issue
(includes all shares of outstanding common stock,
all shares of outstanding preferred stock on an asconverted basis, and all outstanding options on an
as-exercised basis; and does not include any
convertible securities converting into this round of
financing)
B
= Aggregate consideration received by the
Corporation with respect to the new issue divided
by CP1
C
= Number of shares of stock issued in the subject
transaction
National Venture Capital Association
Let’s look at how this works.
The First Round
Let’s go back to our example transaction.

 I offer to invest $400,000 in your company in exchange for 40% of it.

 Since you own all 600,000 shares of your company, I am offering to buy
400,000 new shares in order to acquire 40%.

 My investment of $400,000 divided by 400,000 shares that I’m buying yields a
per share price of $1.00.

 Since you own 600,000 shares, that means the value of the stake in your
company is $600,000, which is the pre-financing value.

 Adding my $400,000 to that yields a post-financing value of $1,000,000.

 That is confirmed by taking the total number of outstanding shares, 1,000,000
(your 600,000 and my 400,000) and multiplying that by the share price of $1.00.

 That also says that the post-financing value of your company is $1,000,000.
Term Sheet Tutorial 67
There’s one difference this week. The terms of this deal include weighted average antidilution protection.
The Second Round
It’s time to raise some more money. Unfortunately, the only investment offer you are able
to attract is at a lower price per share than the prior round.
Without anti-dilution protection, the deal would proceed:

 The new investor offers to invest $500,000 for 50% of your company.

 If 50% of the company is worth $500,000, then the total company must be
worth $1,000,000.

 Since there are 1,000,000 shares outstanding today and they will represent
50% of the company after the financing, then the new investor is buying
1,000,000 shares.

 The $500,000 investment divided by 1,000,000 shares yields a share price of
$0.50.

 Since I paid $1.00 per share, I’m not happy. In fact, the 400,000 shares that I
paid $400,000 for are now worth $200,000 (400,000 shares X $0.50 per share).

 The value of my investment has been diluted.

 In addition, the percent of the company I own has decreased (been diluted)
from 40% to 20%.

 By the same reasoning, your equity stake is now only worth $300,000, and
you’ve only got $500,000 of investor’s money to keep your business alive.
Term Sheet Tutorial 68
BUT I do have anti-dilution protection, so the deal will have needs to be adjusted.
The Adjustment – Scenario #1
With anti-dilution protection, the deal would proceed:

 The new investor offers to invest $500,000 for 50% of your company.
Let’s enter the values for the variables in the weighted average anti-dilution formula:
CP2 = CP1 * (A+B) / (A+C), where:
CP2 = New Series A Conversion Price
CP1 =
$1.00
A
=
1,000,000
B
=
500,000
C
=
1,000,000
CP2 = $1.00 * (1,000,000 + 500,000) / (1,000,000 + 1,000,000)
CP2 = $1.00 * (1,500,000) / (2,000,000)
CP2 = $0.75
So, with my conversion price being reduced from $1.00 to $0.75, my 400,000 shares of
preferred stock will convert into 533,333 shares of common stock. Weighted average
anti-dilution protection has given me the rights to 133,333 shares of common stock.
Term Sheet Tutorial 69
Are we done? Maybe. Maybe not.

 Deals are negotiated with percentages, but are structured with shares.
The Adjustment – Scenario #2
Remember the first element of the deal:

 The new investor offers to invest $500,000 for 50% of your company.
Does that mean before, or after, consideration of the shares associated with the antidilution protection? If the former, then the solution found above is correct.
If the latter, then we have to put the “Iterate” function of our spreadsheet to work again
(as we did last week with full ratchet anti-dilution protection).
Term Sheet Tutorial 70
This yields a transaction price per share of $0.4231, instead of $0.50. My conversion
price has become $0.6875, instead of $0.75 and the number of common stock shares to
which I have rights has increased from 533,333 shares to 581,818 shares.
The Investor Outcome
The new investor buys 50% of the company (or almost 50%, depending upon the
scenario that’s been selected).
I get rights to less than 200,000 shares of common stock as a result of weighted average
anti-dilution protection. That’s something, but pretty modest when compared to the
2,001,000 shares that resulted from full ratchet anti-dilution protection.
Your Outcome
Just as in the case of full ratchet anti-dilution protection, all of these adjustments have
occurred to the investors’ positions. What happens to you?
It isn’t pretty. As the number of shares for the investors ratchet higher and higher, your
number of shares remains constant at 600,000.
Your share of your company is in the range of 25-30%, compared to 10% with full
ratchet!
The value of your shares has dropped to less than $300,000, which is better than
$100,000 in the full ratchet case! You have paid a price for the down round, but not
to the extreme of full ratchet anti-dilution protection.
Recap
An investor in any given round of financing is concerned that the next round could be at a
lower price per share than what he is paying this round. Therefore, the investor will insist
upon anti-dilution protection.
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Weighted average anti-dilution protection is more friendly to entrepreneur than full
ratchet anti-dilution protection.
Next week we’ll look at the practical implications of the forms of anti-dilution protection.
Anti-Dilution Protection Postscript
At the risk of beating a dead horse…
Let’s summarize where we’ve been in recent weeks.
An investor in any given round of financing is concerned that the next round could be at a
lower price per share than what he is paying this round. Therefore, the investor will insist
upon anti-dilution protection.
In recent weeks, we have discussed the two common types of anti-dilution protection: full
ratchet and weighted average. In the event that the current round of investment is at a
lower price per share, then:

 Full ratchet anti-dilution protection gives the original investor rights to that
number of shares of common stock as if he paid the current round’s lower price.

 Weighted average anti-dilution protection gives consideration to the
relationship between the total number of shares outstanding compared to the
number of shares held by the original investor.
You will prefer weighted average anti-dilution protection to full ratchet.
While I know that several readers will not believe this, but what I’ve done in prior weeks
is to try to simplify the calculations involved in the explanations of the various forms of
anti-dilution protection.
This week I will introduce one of the primary components of complexity – the treatment
of stock options.
Fully Diluted Basis
The strict definition of fully diluted basis is:
Number of shares of Common Stock deemed to be
outstanding immediately prior to new issue (includes all
shares of outstanding common stock, all shares of
outstanding preferred stock on an as-converted basis, and
all outstanding options on an as-exercised basis; and does
not include any convertible securities converting into this
round of financing).
In essence, an investor will phrase the terms of his investment as being calculated on a
“fully diluted basis,” by including shares of common stock that are not currently
outstanding, but the company is obligated to issue them based upon existing agreements
(convertible preferred stock, options, etc.). The inclusion of these numbers in the share
base can significantly impact the resulting outcomes.
Let’s take a look at how option pools can impact full ratchet anti-dilution protection.
Term Sheet Tutorial 72
The First Round
Let’s review the example that we’ve been using in this series of articles.

 I offer to invest $400,000 in your company in exchange for 40% of it.

 Since you own all 600,000 shares of your company, I am offering to buy
400,000 new shares in order to acquire 40%.

 My investment of $400,000 divided by 400,000 shares that I’m buying yields a
per share price of $1.00.

 Since you own 600,000 shares, that means the value of the stake in your
company is $600,000, which is the pre-financing value.

 Adding my $400,000 to that yields a post-financing value of $1,000,000.

 That is confirmed by taking the total number of outstanding shares, 1,000,000
(your 600,000 and my 400,000) and multiplying that by the share price of $1.00.

 That also says that the post-financing value of your company is $1,000,000.
The terms of this deal include full ratchet anti-dilution protection for me.
The Second Round
It’s time to raise some more money. Unfortunately, the only investment offer you are able
to attract is at a lower price per share than the prior round.

 The new investor offers to invest $500,000 for 50% of your company.
Since I have full ratchet anti-dilution protection; that has to be included in the
calculations.
Term Sheet Tutorial 73
As I noted in the original article, the full ratchet anti-dilution protection creates a pretty
ugly outcome for you.
The Investor Outcome
The share price drops all the way to less than $0.17.
The new investor buys 3,000,012 shares.
I get 2,000,010 shares as a result of full ratchet anti-dilution protection.
Your Outcome
All of these adjustments have occurred to the investors’ positions. What happens to you?
It isn’t pretty. As the number of shares for the investors ratchet higher and higher, your
number of shares remains constant at 600,000.
Your share of your company has fallen to 10%!
The value of your shares has dropped to $100,000!
But…
As a practical matter, the investor in Round 2 would not do the deal without a provision
for a management option pool. Let’s say that the investor call for a 9% pool. That gives
us several values for variables that will allow us to calculate the resulting capitalization
table.
 You own 600,000 shares of common stock.

I have invested $400,000 with full ratchet anti-dilution protection.
Term Sheet Tutorial 74

The new investor has agreed to invest $500,000 for 50% of the company on a
fully diluted basis after provision for a 9% option pool.
Let’s take a look at the outcome.
The Investor Outcome
The share price drops all the way to less than $0.02.
The new investor buys 30,000,000 shares.
I get 23,600,000 shares as a result of full ratchet anti-dilution protection.
Your Outcome
All of these adjustments have occurred to the investors’ positions. What happens to you?
It is pretty ugly. As the number of shares for the investors have ratcheted higher and
higher, your number of shares remains constant at 600,000.
Your share of your company has fallen to 1%!
The value of your shares has dropped to $10,000!
Reviewing the Basics
Let’s look at some of the relevant basics.

 Deals are negotiated with percentages, but are structured with shares.

 The value of a company is determined by multiplying the total number of
common shares by the most recent share price.

 Price per share = Amount of investment divided by the number of shares
purchased.
Term Sheet Tutorial 75
As I’ve said before, these may appear to be pretty dry and boring gobblygook, but as
we’ve seen, they can have very significant consequences.
Recap
An investor in any given round of financing is concerned that the next round could be at a
lower price per share than what he is paying this round. Therefore, the investor will insist
upon anti-dilution protection.
An investor will invest on a fully diluted basis.
Avoid any deal that has a non-diluted fixed percentage of the equity.
If that’s unavoidable, at least negotiate for conditions under which that restriction goes
away.
Well, that’s about it for anti-dilution protection. Next week we’ll move on to something
else. Whew!
Protective Covenants
Protective covenants become more important depending on board composition. They
matter more if angels don’t have a significant role on the board. I try to think of the
protective covenants in two groups.
The first category consists of actions which relate to the operations of the company, such
as changes to the stock option pool, incurrence of debt, and certain kinds of licensing.
These should require only a vote of the board including angel directors to authorize them.
Once the board has spoken, why appeal to the stockholders?
The second category includes actions which fundamentally affect the angels’ investment
and should go back to them for authorization—for example amendments to the charter or
bylaws or mergers and acquisitions.
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TERM SHEET: PROTECTIVE PROVISIONS
Protective Provisions
Investor Favorable:
The consent of the holders of at least two thirds of the Series [A]
Preferred shall be required for any action that (i) alters or changes the rights, preferences, or privileges of
the Series [A] Preferred; (ii) increases or decreases the authorized number of shares of Series [A] Preferred;
(iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences, or
privileges senior or pari passu to those of the Series [A] Preferred; (iv) results in the redemption of any
shares of Common Stock (other than pursuant to employee agreements); (v) results in any merger, other
corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of
the Company are sold or exclusively licensed; (vi) amends or waives any provision of the Company's
Certificate of Incorporation or Bylaws; (vii) increases or decreases the authorized size of the Company's
board; or (viii) results in the payment or declaration of any dividend on any shares of Common or Preferred
Stock.
Middle of the Road:
For so long as at least [one-half of the shares originally issued] shares
of Series [A] Preferred remain outstanding, consent of the holders of at least two thirds of the Series [A]
Preferred shall be required for any action that (i) alters or changes the rights, preferences, or privileges of
the Series [A] Preferred; (ii) increases or decreases the authorized number of shares of Common or
Preferred Stock; (iii) creates (by reclassification or otherwise) any new class or series of shares having
rights, preferences, or privileges senior to or pari passu with the Series [A] Preferred; (iv) results in the
redemption of any shares of Common Stock (other than pursuant to equity incentive agreements with
service providers giving the Company the right to repurchase shares upon the termination of services); (v)
results in any merger, other corporate reorganization, sale of control, or any transaction in which all or
substantially all of the assets of the Company are sold; or (vi) amends or waives any provision of the
Company's Certificate of Incorporation or Bylaws relative to the Series [A] Preferred.
Company Favorable:
The consent of the holders of at least 50 percent of the Series [A]
Preferred shall be required for any action that (i) adversely alters or changes the rights, preferences, or
privileges of the Series [A] Preferred, or (ii) decreases the authorized number of shares of Series [A]
Preferred.
Term Sheet: Protective Provisions by Feld Thoughts
As Jason and I continue to work our way through a typical venture capital term sheet, we encounter
another key control term - the "protective provisions." Protective provisions are effectively veto
rights that investors have on certain actions by the company. Not surprisingly, these provisions
protect the VC (unfortunately, not from himself.)
The protective provisions are often hotly negotiated. Entrepreneurs would like to see few or no
protective provisions in their documents. VCs – in contrast – would like to have some veto-level
control over a subset of actions the company could take, especially when it impacts the VC’s
economic position.
A typical protective provision clause looks as follows:
"Protective Provisions: For so long as any shares of Series A Preferred remain outstanding,
consent of the holders of at least a majority of the Series A Preferred shall be required for any
Term Sheet Tutorial 77
action, whether directly or though any merger, recapitalization or similar event, that (i) alters or
changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases
the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or
otherwise) any new class or series of shares having rights, preferences or privileges senior to or on
a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of
Common Stock (other than pursuant to equity incentive agreements with service providers giving
the Company the right to repurchase shares upon the termination of services), (v) results in any
merger, other corporate reorganization, sale of control, or any transaction in which all or
substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the
Company’s Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of
the Company’s Board of Directors, or (viii) results in the payment or declaration of any dividend on
any shares of Common or Preferred Stock, or (ix) issuance of debt in excess of $100,000."
Subsection (ix) is often the first thing that gets changed by raising the debt threshold to something
higher, as long as the company is a real operating business rather than an early stage startup.
Another easily accepted change is to add a minimum threshold of preferred shares outstanding for
the protective provisions to apply, keeping the protective provisions from “lingering on forever”
when the capital structure is changed – either through a positive or negative event.
Many company counsels will ask for “materiality qualifiers” (e.g. that the word "material" or
"materially" be inserted in front of subsections (i), (ii) and (vi), above.) We always decline this
request, not to be stubborn (ok – sometimes to be stubborn), but because we don’t really know
what "material" means (if you ask a judge, or read any case law, they will not help you either) and
we believe that specificity is more important that debating reasonableness. Remember – these are
protective provisions – they don’t “eliminate” the ability to do these things – they simply require
consent of the investors. As long as things are “not material” from the VC’s point of view, the
consent to do these things will be granted. We’d always rather be clear up front what the rules of
engagement are, rather than having a debate over “what material means” in the middle of a
situation where these protective provisions might come into play.
When future financing rounds occur (e.g. Series B – a new “class” of preferred stock), there is
always a discussion as to how the protective provisions will work with regard to the new financing.
There are two cases: (a) the Series B gets its own protective provisions or (b) the Series B investors
vote alongside the original investors as a single class. Entrepreneurs almost always will want a
single vote for all the investors (case b), as the separate investor class protective provision vote
means the company now has two classes of potential veto constituents to deal with. Normally new
investors will ask for a separate vote, as their interests may diverge from those of the original
investors due to different pricing, different risk profiles, and a false need for overall control.
However, many experienced investors will align with the entrepreneur’s point of view of not wanting
separate class votes as they do not want the potential headaches of another equity class vetoing an
important company action. If your Series B investors are the same as your Series A investors, this
is an irrelevant discussion, and it should be easy for everyone to default to case b. If you have new
investors in the Series B, be wary of inappropriate veto rights for small investors (e.g. consent
percentage required is 90% instead of a majority (50.1%), so a new investor who only owns 10.1%
of the financing can effectively assert control over the protective provisions through his vote.)
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Some investors that feel they have enough control with their board involvement to ensure the
company does not take any action contrary to their interests, and as a result will not focus on these
protective provisions. During a financing, this is the typical argument used by company counsel to
try to convince the VCs to back off of some or all of the protective provisions We think this is a
short-sighted approach for the investor, for as a board member, an investor designee has legal
duties to work in the best interests of the company. Sometimes the interests of the company and a
particular class of shareholders diverge. Therefore, there can be times whereby an individual would
legally have to approve something as a board member in the best interests of the company as a
whole and not have a protective provision to fall back on as a shareholder. While this dynamic does
not necessarily “benefit” the entrepreneur, it’s good governance, as it functionally separates the
duties of a board member from that of a shareholder, shining a clearer lens on a area of potential
conflict.
While one could make the argument that protective provisions are at the core of the “trust” between
a VC and entrepreneur, we think that’s a hollow and inappropriate statement. When an
entrepreneur asks “don’t you trust me - why do we need these things?”, the simple answer is that it
is not an issue of trust. Rather, we like to eliminate the discussion about who ultimately gets to
make which decisions before we do a deal. Eliminating the ambiguity in roles, control, and rules of
engagement is an important part of any financing – the protective provisions cut to the heart of
some of this.
Term Sheet Tutorial 79
TERM SHEET: BOARD OF DIRECTORS
Board Composition and Meetings
Investor Favorable:
The size of the Company's Board of Directors shall initially be set at
[three]. The holders of the Series [A] preferred, voting as a separate class, shall be entitled to elect two
members of the Company's Board of Directors, the holders of the Common Stock shall be entitled to elect
one member, and the third member shall be mutually agreed upon. The Board shall initially be comprised
of [____________], [_______________], and [_________________]. Board of Directors will be elected
annually. Board of Directors meetings will be held at least four times per year. Until the Company is
profitable or the Board otherwise agrees, Board meetings will be targeted for every two months, or six
times per year.
Middle of the Road:
The size of the Company's Board of Directors shall be set at [five]. The
Board shall initially be comprised of [____________], [_______________], [_________________],
[_________________], and [______________]. At each meeting for the election of directors, the holders
of the Series [A] Preferred, voting as a separate class, shall be entitled to elect one member of the
Company's Board of Directors, the holders of Common Stock, voting as a separate class, shall be entitled to
elect two members, and the remaining directors will be mutually agreed upon by the Common and
Preferred. It is anticipated that the Company's CEO will occupy one of the remaining seats. Board of
Directors meetings will be held at least four times per year. Until the Company is profitable or the Board
otherwise agrees, Board meetings will be targeted for every two months, or six times per year.
Company Favorable:
The size of the Company's Board of Directors shall initially be set at
[five]. All directors shall be elected by the shareholders voting on an as-converted basis.
Term Sheet: Board of Members by Feld Thoughts
In our series of posts on Term Sheets, Jason and I thought we’d take on a relatively easy one
today. In our previous posts on Price and Liquidation Preferences, we discussed the key economic
terms that VCs care about. In this post, we tackle one of the two primary “control terms” that
matter to VCs.
VCs care about control provisions in order to keep an eye on their investment as well as – in some
cases - comply with certain federal tax statutes that are a result of the types of investors that invest
in VC funds. One of the key control mechanisms is the election of the board of directors.
There is no secret science in the board of director election paragraph – it simply spells out how the
board of directors will be chosen. The entrepreneur should think carefully about what they believe
the proper balance should be between investor, company, founder and outsider representation
should be on the board. There are many existing VC (and entrepreneur) posts concerning the value
of a board, the desired composition of the board, and what a board is responsible for. This post
doesn’t delve into those issues - we are simply addressing how the board is selected.
A typical term sheet looks as follows:
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Board of Directors: The size of the Company’s Board of Directors shall be set at [n]. The Board
shall initially be comprised of ____________, as the Investor representative[s] _______________,
_________________, and ______________. At each meeting for the election of directors, the
holders of the Series A Preferred, voting as a separate class, shall be entitled to elect [x]
member[s] of the Company’s Board of Directors which director shall be designated by Investor, the
holders of Common Stock, voting as a separate class, shall be entitled to elect [x] member[s], and
the remaining directors will be [Option 1: mutually agreed upon by the Common and Preferred,
voting together as a single class.] [ or Option 2: chosen by the mutual consent of the Board of
Directors].
If a subset of the board is being chosen by more than one constituency (e.g., two directors chosen
by the investors, two by founders / common holders and one by “mutual consent”), you should
consider what is best: (a) chosen my mutual consent of the board (one person, one vote) or (b)
voted upon on the basis of proportional share ownership on a common-as-converted basis.
VCs will often want to include a board observer as part of the agreement either instead of or in
addition to an official member of the board. This is typical and usually helpful, as many VC partners
have an associate that works with them on their companies. While there’s rarely any contention
about who attends a board meeting, most VCs will want the right to have another person from the
firm at the board meeting, even if they are non-voting (an “observer”).
Many investors will mandate that one of the common-stockholder chosen board members be the
then-serving CEO of the company. This can be tricky if the CEO is the same as one of the key
founders – often you’ll see language giving the right to a board seat to one of the founders and a
separate board seat to the then CEO – consuming two of the common board seats. Then – if
the CEO changes, so does that board seat.
While it is appropriate for board member and observers to be reimbursed for their reasonable outof-pocket costs for attending board meetings, we rarely see board members receive cash
compensation for serving on the board of a private company. Outside board members are usually
compensated with stock options – just like key employees – and are often invited to invest money
in the company alongside the VCs.
Special Board Approval
(10) Special Board Approval Items:
Board approval will be required for:
1. Hiring of all officers of the Company.
2. Any employment agreements (approval by a majority of disinterested Directors, or a Compensation
Committee when established).
3. Compensation programs including base salaries and bonus programs for all officers and key employees
(approval by a majority of disinterested Directors or a Compensation Committee when established).
4. All stock option programs as well as issuance of all stock and stock options (approval by a majority of
disinterested Directors or a Compensation Committee when established).
5. Annual budgets, business plans, and financial plans.
6. All real estate leases or purchases.
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7. Execution of entrance obligations or commitments, including capital equipment leases or purchases, with
total value greater than $[________] and which are outside the most recent business plan or budget
approved by the Board of Directors.
TERM SHEET: PREFERRED STOCK
Preferred Stock
Preferred stock is called preferred for a reason. It provides the investor with certain
preferences, some of which directly affect the value of his investment under different
circumstances.
Features of Preferred Stock
Preferred stock is materially different than common stock in many important respects.
Some of the terms and characteristics of preferred stock can have significant
consequences.
To a large degree, control and percentage of ownership become separate issues in deals
including preferred stock….which is one of the real attractions of this paper!
How preferred stock terms can affect valuation – a scenario
Let’s take a look at how all of this can play out.
The Original Investment
Let’s say an investor invests $1 million in your company at a pre-financing value of $1
million [50-50 ownership]. Let’s also say that the investment purchases Participating
Convertible Preferred Stock with a 10% dividend rate and a liquidation amount multiple
of two.
The Sale of The Company
Two years after he investment, the company has stalled for some reason, and it has never
really gotten significant commercial traction and probably never will. An opportunity
comes up for the company to be acquired for $5 million. While not a home run, everyone
should be relatively happy. Right? Maybe not.
The Distribution of the Proceeds
After two years, the preferred stock purchase price plus accrued dividends has grown to
$1.2 million. After applying the multiplier of two, the liquidation amount is $2.4 million,
which the investor gets “off the top.” The remaining $2.6 million is divided pro rata with
the as-converted shareholdings, or 50-50, meaning $1.3 million each. The investor has
received $3.7 million and you get $1.3 million. Under these circumstances, what
appeared to be a 50-50 deal at the outset became a 75-25 deal!
Advice to Entrepreneurs
 Valuation is only meaningful in the context of the complete deal.

Preferred stock provides the investor with extra benefits and rights as compared to
the common stock shareholders.
Term Sheet Tutorial 82

Understanding the arithmetic of deals is very important.

Surround yourself with professionals, mentors, and advisors who can help you
level the playing field.
Next week we’ll begin to look at the role of angel investors and how you can attract
them.
What’s so preferable about preferred stock?
Once upon a time an aspiring small businessperson needed some money to start his
business. Through a circuitous route he found himself in front of the owner of some
capital.
After explaining his plight, the small businessperson asked the capitalist for a loan. The
capitalist replied, “While I find your concept intriguing, there is too much risk associated
with it and I couldn’t possibly lend you the money. If I were to assume this much risk, I
would need an equity stake that I could sell in the future.”
“Well, I would consider selling you some common stock,” responded the aspirant.
“That’s fine for you, but I need some additional consideration, some kind of preference,
in the event you hit less than a home run,” observed the moneyman. “After all, I am
trying to achieve an appropriate return on my investment, while you are an enterprising
young man, an entrepreneur, if I might coin a phrase, trying to change the world.”
“You, sir, are a predatory vulture,” yelped the youngster.
“I prefer to think of it as being venturesome,” countered the investor. “If you want my
money, I need to get preferred stock.”
And thus the lexicon of early stage business added “entrepreneur,” “venture capital,” and
“preferred stock” to its dictionary.
Overview of preferred stock
The preceding fiction notwithstanding, preferred stock is the coin of the realm of virtually
all institutional, and many private, investors. It is materially different than common stock
in many important respects. Some of the terms and characteristics of preferred stock
have important characteristics.
Liquidation
The conventional definition of liquidation evokes images of “going out of business” signs
and sales at heavy discounts. In the industrial world, one thinks of Chapter 7 bankruptcy.
In the world of private equity, the definition is expanded to take in virtually any
transaction that is agreed to that is less than the proverbial home run. It is tantamount to
the investor throwing in the towel on achieving the originally conceived exit, and seeking
to “liquidate” his investment.
One of the key features of preferred stock is that higher in the pecking order of who gets
paid what and when in the event of a liquidation. Payroll and secured creditors, among
others, have first rights to the proceeds of liquidation. Preferred stock holders come next,
followed by common stock holders.
Liquidation Preference (or Amount)
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This is the amount of money the investor in preferred stock has a right to before the
common stock shareholders receive any money in liquidation. It is usually phrased in the
term sheet something like, “The Preferred Stock Shareholders shall receive all proceeds
from the liquidation until they have received 100% of their liquidation preference.”
The dollar amount is defined in the term sheet. It often starts with the investment amount
plus accrued, but unpaid dividends (often in the range of 6-10%). Then, depending upon
financial market conditions and the types of deals that are being done at the time, some
sort of adjustment multiple is defined and applied. These multiples can be
 a single number (1.25 – 2.00 in today’s [circa March 2004] market)

a time-based increment (1.25, increasing by .25 on each anniversary)

tied to some threshold event (2.00 until the second anniversary, 3.00 thereafter)

tied to the dollar amount of the liquidation (some formula if the proceeds are less
than some amount, and a different formula above that amount)
Participation
When preferred stock was originally created (see opening paragraph), it was intended to
address the differences between the entrepreneur and the financial investor. In essence, if
the financial out come was less than had been anticipate, the investor postured that he
wanted the opportunity to some minimum return. What resulted was the creation of
simple Convertible Preferred Stock.
 Simple Convertible Preferred Stock
In its infancy, preferred stock was an either-or proposition for the investor. Calculate the
liquidation preference, calculate the value of the common stock if converted, and pick the
one that is to the investor’s greater benefit.
The logic is straightforward and the justification appears to be reasonable.
 Participating Convertible Preferred Stock
After a period of time, someone came up with the idea of Participating Convertible
Preferred Stock. Its key feature was that the investor got the liquidation preference first,
AND then participated in the distributions on an as-converted basis. The investors justify
this on the basis of locking in as a good a return as possible in a less-than-desirable
outcome. Entrepreneurs often take umbrage at this and consider it to be double dipping.
This is a prime example of the Golden Rule: He who has the gold rules. Without
negotiating leverage, if the investor seeks participating preferred, then that’s likely to be
part of their investment style, and it’s unlikely that they will be willing to negotiate this
feature.
Anti-dilution protection
If the company sells shares at some future date at a share price less than what the investor
paid, the investor wants anti-dilution protection.
Full-ratchet anti-dilution protection
The harshest form of protection from the entrepreneur’s perspective is full-ratchet. It
says that the investor gets rights to that number of shares as if he had paid the lower
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price. If he paid $2.00 per share, and subsequent shares were sold for $1.00, his number
of shares would double to compensate for this transaction.
Weighted-average anti-dilution protection
Weighted-average is less painful. It takes the share base of the company into
consideration, they reducing the overall impact. For those of you who are interested, I
“borrowed” the following language from the documents one of the deals with which I
was involved.
“Adjustment of Conversion Price Upon Issuance of
Additional Shares of Common Stock. In the event that at
any time or from time to time after the Original Issue Date
for any series of Preferred Stock the Corporation shall issue
Additional Shares of Common Stock (including, without
limitation, Additional Shares of Common Stock deemed to
be issued pursuant to Subsection 2(e)(iii)(1) but excluding
Additional Shares of Common Stock deemed to be issued
pursuant to Subsection 2(e)(iii)(2), which event is dealt
with in Subsection 2(e)(vi)(1)), without consideration or for
a consideration per share less than the Conversion Price of
such series of Preferred Stock in effect on the date of and
immediately prior to such issue, then and in such event,
such Conversion Price of such series of Preferred Stock
shall be reduced, concurrently with such issue, to a price
(calculated to the nearest one tenth of one cent) determined
in accordance with the following formula:
NCP =
(P1) (Q1) + (P2) (Q2)
--------------------------Q1 + Q2
where:
NCP = New Series A Conversion Price or Series B
Conversion Price, as applicable
P1 = Series A Conversion Price or Series B Conversion
Price, as applicable, in effect immediately prior to new
issue;
Q1 = Number of shares of Common Stock outstanding, or
deemed to be outstanding as set forth below, immediately
prior to such issue;
P2 =Weighted average price per share received by the
Corporation upon such issue;
Q2 = Number of shares of Common Stock issued, or
deemed to have been issued, in the subject transaction;
Term Sheet Tutorial 85
provided that for the purpose of this Subsection 2(e)(iv), all
shares of Common Stock issuable upon conversion of
shares of Preferred Stock outstanding immediately prior to
such issue shall be deemed to be outstanding, and
immediately after any Additional Shares of Common Stock
are deemed issued pursuant to Subsection 2(e)(iii), such
Additional Shares of Common Stock shall be deemed to be
outstanding.”
Got that?
Control
I often hear entrepreneurs say, “I won’t give up control,” or “I’m willing to consider any
deal as long as I retain 51%.” For a plain, vanilla company, that makes sense and is
meaningful. But a company that brings in sophisticated private equity is no longer
“simple,” at least in a legal sense. To a large degree, control and percentage of
ownership become separate issues. Let me cite two examples.
Protective provisions
One of the features of preferred stock will be a series of provisions that require that the
preferred stock needs to approve before the company can do certain things. Let me
rephrase that, regardless of how much equity the preferred stock shareholders own, they
have veto power over certain company actions, typically including, but not limited to,
liquidation, alteration of the preferred stock, issuance of any class of preferred stock
superior to the existing preferred stock and restrictions on debt that the company can take
on.
Board of Directors
Similarly, as part of the Preferred Stock transaction there will be agreement to the
structure of the board and a Shareholders Agreement will be crafted whereby all
shareholders have to vote for members of the board in the proscribed manner, regardless
of relative equity positions.
Once a company goes down this path, the issue of “control” becomes complicated and
not intuitively obvious, particularly to first-time entrepreneurs.
Advice to Entrepreneurs

If you’re going to play the game, you need to understand the rules.

Deals are complex. Ignorance is not a defense against unpleasant outcomes.

Do everything that you can to prevent the investor from invoking the Golden
Rule.

Surround yourself with professionals, mentors, and advisors who can help you
level the playing field.
Term Sheet Tutorial 86
TERM SHEET: LIQUIDATION PREFERENCE
Liquidation
In the world of private equity, the definition of liquidation encompasses most
transactions, other than an initial public offering (IPO), through which the investor seeks
to “liquidate” his investment.
Liquidation Preference
One of the key features of preferred stock is that higher in the pecking order of who gets
paid what and when in the event of a liquidation. Preferred stock shareholders receive
distributions from liquidation before common stock shareholders.
Term Sheet: Liquidation Preference
(2) Liquidation Preference:
Investor Favorable:
In the event of any liquidation or winding up of the Company, the
holders of the Series [A] Preferred shall be entitled to receive in preference to the holders of the Common
Stock an amount equal to the Original Purchase Price plus any accrued, or declared, but unpaid dividends
(the "Liquidation Preference"). After the payment of the Liquidation Preference to the holders of the Series
[A] Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the
Series [A] Preferred on a common equivalent basis. A merger, acquisition, or sale of substantially all of the
assets of the Company in which the shareholders of the Company do not own a majority of the outstanding
shares of the surviving corporation shall be deemed to be a liquidation.
Middle of the Road:
In the event of any liquidation or winding up of the Company, the
holders of the Series [A] Preferred shall be entitled to receive in preference to the holders of the Common
Stock a per share amount equal to the Original Purchase Price plus any declared but unpaid dividends (the
"Liquidation Preference"). After the payment of the Liquidation Preference to the holders of the Series [A]
Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the
Series [A] Preferred on a Common Stock equivalent basis; provided that the holders of Series [A] Preferred
will stop participating once they have received a total liquidation amount equal to [three] times the Original
Purchase Price. A merger, acquisition, sale of voting control, or sale of substantially all of the assets of the
Company in which the shareholders of the Company do not own a majority of the outstanding shares of the
surviving corporation shall be deemed to be a liquidation.
Company Favorable:
In the event of any liquidation or winding up of the Company, the
holders of the Series [A] Preferred shall be entitled to receive in preference to the holders of the Common
Stock an amount equal to the Original Purchase Price (the "Liquidation Preference"). After the payment of
the Liquidation Preference to the holders of the Series [A] Preferred, the remaining assets shall be
distributed ratably to the holders of the Common Stock. A merger, acquisition, or sale of substantially all of
the assets of the Company in which the shareholders of the Company do not own a majority of the
outstanding shares of the surviving corporation shall be deemed to be a liquidation.
(From the Spring 2008 edition of Entrepreneurs Report published by the Wilson Sonsini Goodrich & Rosati
law firm:
Term Sheet Tutorial 87
Participating Preferences by Feld Thoughts
This article was originally published in Brad Feld's blog located at
http://www.feld.com.
August 24, 2004
When I wrote my first post on the structure and financial components of a typical
venture capital investment - where I described Liquidation Preferences - I alluded to
the concept of participating preferred as a maligned and typically hotly negotiated
issue in many venture capital investments. In this post, I'm going to try to explain
the notion of participating preferred (referred to hereafter as PP), how it works, and
its financial and emotional impact on a deal. I'm not going to take sides, but rather
try to give a broad perspective on it.
First - some history. I first encountered PP when several of the angel investments
that I did in 1994 and 1995 matured to the point where they raised a round of
institutional venture capital. Since I was living in Boston at the time, most of the VCs
looking at my angel deals were east coast firms. In every single case, the initial term
sheets each of these companies received included a PP feature - a "double dip" as
my east coast lawyer called it. When we pushed back on the PP, we were told that all
east coast term sheets had them (our lawyer told us it was negotiable, but that it
was definitely an east coast standard request). The PP survived several of term sheet
negotiations, but not all of them.
My east coast-centric world changed significantly after I moved to Colorado in 1996
and started doing venture capital. Because of geography and investment focus, I
ended up working on more stuff on the west coast. There, I rarely saw a PP feature
and was told flatly that PP was "an east coast term." As the 1990's marched on and
the bubble started to build, I rarely saw a PP - even the east coast guys had dropped
it from their standard term sheets.
After the bubble burst in 2001, PP was back - and this time on both coasts. Suddenly
every term sheet I saw had a PP feature in it, regardless of the stage of the
investment, type of business, or location of investor. It had once again become "a
standard feature", although it was now bi-coastal (or - more accurately - a redblooded American term.)
So, with this as background, and before we dig into the actual mechanics of a PP,
lets first recognize it for what it is - an economic feature in a venture investment. It's
not a standard term, nor is it something that is evil and should never be part of a
deal. Unlike a liquidation preference which is rarely negotiable with a VC, a PP is
almost always negotiable. There are even cases where it economically disadvantages
an early stage investor who insists on it in the deal from the beginning. Importantly,
there is not a consensus among investors on when a PP feature is appropriate in a
deal and each firm approaches it from their own, unique perspective.
A PP is the right of an investor, as long as they hold preferred stock, to get their
money back before anyone else (the "preference" part of PP), and then participate as
though they owned common stock in the business (or, more technically, on an "as
converted basis" - the "participation" part of PP). It takes a preferred investment,
which acts as either debt or equity (where the investor has to make a choice of
Term Sheet Tutorial 88
either getting their money back or converting their preferred shares to common),
and turns it into something that acts both as debt and equity (where the investor
both gets their money back and participates as if they had converted to common
shares).
To illustrate, let's take a simple case - a $5m Series A investment at $5m pre-money
where the company is sold for $20m without any additional investments being made.
In this case, the Series A investor owns 50% of the company. If they did not have a
PP, they would get 50% of the return, or $10m. With the PP they get their $5m back
and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series
A investor and $7.5m to everyone else. In this case, the Series A investor gets the
equivalent of 62.5% of the return (rather than the 50% which is equivalent to their
ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the
Series A investor.
Obviously, this can get much more complicated as you start to have multiple rounds
of investments with a PP feature. A simple way to think about how the economics of
a PP works is that the total dollar amount of the preference will come off the top of
the exit value (and go to the investors); everyone will then convert into common
stock and share the balance based on their ownership percentages. For example,
assume a company raises $40m over 3 rounds where each round has a PP feature
and the investors own 70% of the company. If this company is sold for $200m, the
first $40m would go to the investors and the remaining $160m would be split 70% to
investors / 30% to everyone else. In this case, the investors would get a total of
$152m, ($40m + $112m, or 76% of the proceeds - 6% more then they would have
gotten if there was no PP.)
If you sit and ponder the math, you'll realize that a PP usually has material impact on
the economics in low to medium return deals, but quickly becomes immaterial as the
return increases (or - more specifically - as the ratio of the exit value to invested
capital increases). For example, if a company is sold for $500m, a $10m PP reallocates a small portion of the deal ($10m of the $500m) to the investors vs. the
$40m of $200m or $5m of $20m in the other preceding examples. As a result, a PP
usually only matters in a low to medium return situation. If a company is sold for
less than paid in capital, the liquidation preference will apply and the participation
feature will not come into play. If a company is sold for a huge amount of money,
the PP won't have much economic impact, as the preference feature of the PP
becomes a small percentage of the deal total. In addition, in essentially every case,
PP's don't apply in an IPO where preferred stock (of any flavor) is typically converted
into common stock at the time of the offering.
As PP started showing up in more deals, some creative lawyer came out with a
perversion on the preferred feature called a "cap on the participate" (also known as a
"kick-out feature.") In this case, the participation feature of the PP goes away once
the investor holding the PP reaches a certain multiple return of capital. For example,
assume a 3x cap on a PP in a $5m Series A investment. In this case, the investor
would benefit from their PP until their proceeds from the deal reached $15m. Once
they reached this level, their shares are no longer counted in the cap structure and
the other shareholders share the remaining proceeds. Of course, the investor always
has the option to convert their shares to common stock and give up their preferred
return (but participate fully in the proceeds). Put another way, at a high enough
Term Sheet Tutorial 89
valuation the investor is better off simply converting to common (in the current
example at an exit value above $30m).
Participation caps, however, have a fundamental problem - they create a flat spot in
most deal economics where the investor gets the same amount across a range of
exit values. If we stay with the example above and assume a 50% ownership for the
Series A, the PP would apply until the exit value reached $25m, at which point the
investor receives $15m in proceeds. Between $25m and $30m, the investor would
continue to receive this same $15m (this is the flat spot - it doesn't matter whether
the exit value is $26m or $29m, the investor would get $15m). At exit values above
$30m, the investor would convert to common stock and take 50% of the proceeds
(i.e., their as-converted share of the proceeds would exceed the $15m cap so they
would be better off converting to common and taking this share of the exit value).
This is an odd dynamic, since the common shareholders are clearly not indifferent to
exit values in this flat spot, but the investor is (and consider a case where this flat
spot was much larger than the one in the example above). Any way you cut it there
is misalignment, at least for a range of outcomes, between the investor and the rest
of the shareholders.
Another perversion is the "multiple participate". In this case, the investor gets some
multiple of his participate off the top of the transaction. For example, a 3x multiple
participate on a $40m investment would mean the first $120m would go to the
investor (and then the remaining proceeds would be distributed to the investor and
the rest of the shareholders). This type of PP only appeared for a short while when
investors were doing recapitalizations without actually going through the mechanics
of recapitalizing the company (more about this in a future blog post).
Interestingly, there is a case to be made that PP in early financing rounds can
actually end up disadvantaging early investors. The math on this gets complicated
very quickly, but if you assume that every subsequent investment round has at least
as favorable terms as the initial round (i.e., include a PP if the first round does) and
that subsequent rounds include new investors there are many cases where the initial
investor is actually disadvantaged by the existence of the PP (they would have been
better off to have not put it in the initial round and because of that pushed for its
exclusion from subsequent rounds). It's counterintuitive, but it actually works out
this way in a number of very common financing scenarios.
So - if PP simply relates to economics, why is it a term that brings out such emotion
in entrepreneurs and investors alike? A close friend of mine who is an extremely
successful entrepreneur recently told me "I've walked on every investment deal for
any company that I've run that even smelled of multiple dips of participation - and
spit back in the direction the term sheet came from!" We debated back and forth a
while. For example, I asked him "would you take $5m for 33% of a company with no
participate or 25% of a company with full participate?" He responded "I would go
find a deal where I gave up 26.5% without a participate" which, while an emotional
reaction, ironically reinforced my point that it was just economics. After pondering
this term over the years, I've concluded that participating preferred is one of those
terms that creates real tension between the entrepreneur and the investor - it forces
the acknowledgement by the entrepreneur that a moderate return is not a success
case for the investor and at the same time forces the investor to acknowledge that in
those moderate cases they believe it is fair to receive a greater percentage of the
proceeds at the expense of the entrepreneur.
Term Sheet Tutorial 90
Term Sheet: Liquidation Preference by Feld Thoughts
I've written about liquidation preferences (and participating preferred) before, as have most of the
other VC bloggers (and several entrepreneur bloggers.) However, for completeness, and since
liquidation preferences are the second most important "economic term" (after price), Jason and I
decided to write a post on it. Plus - if you read carefully - you might find some new and exciting
super-secret VC tricks.
The liquidation preference determines how the pie is shared on a liquidity event. There are two
components that make up what most people call the liquidation preference: the actual preference
and participation. To be accurate, the term liquidation preference should only pertain to money
returned to a particular series of the company's stock ahead of other series of stock. Consider for
instance the following language:
Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of
the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock
a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends
(the Liquidation Preference).
This is the actual preference. In the language above, a certain multiple of the original investment
per share is returned to the investor before the common stock receives any consideration. For many
years, a "1x" liquidation preference was the standard. Starting in 2001, investors often increased
this multiple, sometimes as high as 10x! (Note, that it is mostly back to 1x today.)
The next thing to consider is whether or not the investor shares are participating. Again, note that
many people consider the term "liquidation preference" to refer to both the preference and the
participation, if any. There are three varieties of participation: full participation, capped participation
and non-participating.
Fully participating stock will share in the liquidation proceeds on a pro rata basis with common after
payment of the liquidation preference. The provision normally looks like this:
Participation: After the payment of the Liquidation Preference to the holders of the Series A
Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and
the Series A Preferred on a common equivalent basis.
Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata
basis until a certain multiple return is reached. Sample language is below.
Participation: After the payment of the Liquidation Preference to the holders of the Series A
Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and
the Series A Preferred on a common equivalent basis; provided that the holders of Series A
Preferred will stop participating once they have received a total liquidation amount per share equal
to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the
remaining assets shall be distributed ratably to the holders of the Common Stock.
Term Sheet Tutorial 91
One interesting thing to note in the section is the actually meaning of the multiple of the Original
Purchase Price (the [X]). If the participation multiple is 3 (three times the Original Purchase Price),
it would mean that the preferred would stop participation (on a per share basis) once 300% of its
original purchase price was returned including any amounts paid out on the liquidation preference.
This is not an additional 3x return, rather an addition 2x, assuming the liquidation preference were
a 1 times money back return. Perhaps because of this correlation with the actual preference, the
term liquidation preference has come to include both the preference and participation terms. If the
series is not participating, it will not have a paragraph that looks like the ones above.
Liquidation preferences are usually easy to understand and assess when dealing with a series A
term sheet. It gets much more complicated to understand what is going on as a company matures
and sells additional series of equity as understanding how liquidation preferences work between the
series is often mathematically (and structurally) challenging. As with many VC-related issues, the
approach to liquidation preferences among multiple series of stock varies (and is often overly
complex for no apparent reason.) There are two primary approaches: (1) The follow-on investors
will stack their preferences on top of each other: series B gets its preference first, then series A or
(2) The series are equivalent in status (called pari passu - one of the few latin terms lawyers
understand) so that series A and B share pro-ratably until the preferences are returned.
Determining which approach to use is a black art which is influenced by the relative negotiating
power of the investors involved, ability of the company to go elsewhere for additional financing,
economic dynamics of the existing capital structure, and the phase of the moon.
Most professional, reasonable investors will not want to gouge a company with excessive liquidation
preferences. The greater the liquidation preference ahead of management and employees, the lower
the potential value of the management / employee equity. There's a fine balance here and each
case is situation specific, but a rational investor will want a combination of "the best price" while
insuring "maximum motivation" of management and employees. Obviously what happens in the end
is a negotiation and depends on the stage of the company, bargaining strength, and existing capital
structure, but in general most companies and their investors will reach a reasonable compromise
regarding these provisions. Note that investors get either the liquidation preference and
participation amounts (if any) or what they would get on a fully converted common holding, at their
election; they do not get both (although in the fully participating case, the participation amount is
equal to the fully converted common holding amount.)
Since we've been talking about liquidation preferences, it's important to define what a "liquidation"
event is. Often, entrepreneurs think of a liquidation as simply a "bad" event - such as a bankruptcy
or a wind down. In VC-speak, a liquidation is actually tied to a "liquidity event" where the
shareholders receive proceeds for their equity in a company, including mergers, acquisitions, or a
change of control of the company. As a result, the liquidation preference section determines
allocation of proceeds in both good times and bad. Standard language looks like this:
A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company
in which the shareholders of the Company do not own a majority of the outstanding shares of the
surviving corporation shall be deemed to be a liquidation.
Term Sheet Tutorial 92
Ironically, lawyers don't necessary agree on a standard definition of the phrase "liquidity event."
Jason once had an entertaining (and unenjoyable) debate during a guest lecture he gave at his alma
mater law school with a partner from a major Chicago law firm (who was teaching a venture class
that semester) that claimed an initial public offering should be considered a liquidation event. His
theory was that an IPO was the same as a merger, that the company was going away, and thus the
investors should get their proceeds. Even if such a theory would be accepted by an investment
banker who would be willing to take the company public (no chance in our opinion), it makes no
sense as an IPO is simply another funding event for the company, not a liquidation of the company.
However, in most IPO scenarios, the VCs "preferred stock" is converted to common stock as part of
the IPO, eliminating the issue around a liquidity event in the first place.
That's enough for now - I'm going to go get a drink and have my own personal liquidity event (sorry
- the punmaster got control of my keyboard for a moment.)
Liquidation Preferences: What They Really Do
By Craig Sherman, Partner, Seattle Office. Email: csherman@wsgr.com
One of the fundamental terms of any preferred stock venture capital financing is the
liquidation preference—the right of the investors to receive distributions in a sale of
the company prior to the holders of common stock (typically founders and
employees). The liquidation preference is one of the most important and often one of
the most heavily negotiated terms contained in the term sheet proposed by the
investors. The basic concept is intuitive and seems fundamentally fair: that investors
receive back their invested capital before the founders, who normally paid a much
lower price for their common stock. There are, however, a number of variations on
liquidation preferences that should be negotiated carefully, as they can have a
significant impact on the allocation of the proceeds resulting from a sale of the
company.
The first issue is the amount distributed to the investors “off the top,” before any
distributions are made to the holders of common stock. In a typical West Coast
financing, the investors receive as their initial liquidation preference the amount of
their original investment. Sometimes in financings led by East Coast investors or in
later-stage financings for troubled companies, there will be a “super” liquidation
preference, where the investors receive more than their initial investment,
sometimes 1.5 or 2 times their initial investment, before the common stockholders
receive a distribution. Many East Coast transactions also have a “cumulative
dividend,” where an annual dividend (often 8% or higher) accrues and becomes
payable on a sale of the company. This cumulative dividend also increases the
amount payable to the investors as part of the initial liquidation preference prior to
any distributions to the holders of common stock.
There are three fundamental types of liquidation preferences that are typically
negotiated in connection with a financing involving the issuance of preferred stock to
investors. These consist of non-participating preferences, participating preferences
and participating preferences that are “capped.” The general differences between
these three categories of preferences are discussed in the data set of this report.
Term Sheet Tutorial 93
To demonstrate the impact of the various types of liquidation preferences, let’s take
a simple example of a company that sells 5 million shares of Series A Preferred
Stock, equal to 1/3rd of its outstanding stock following the financing, to a venture
capital firm for $5 million ($1.00 per share). For the sake of simplicity, we’ll assume
that the remaining 2/3rd of the company’s equity (10 million shares) is in the form of
common stock, and that there are no outstanding options or warrants. If that
company is subsequently sold for $20 million, the distributions will vary significantly
depending on the structure of the liquidation preference:

Participating Preferred: The first $5 million would be distributed to the holders of preferred stock,
and the remaining $15 million would be distributed based on the pro rata ownership, with 1/3rd
($5 million) to the holders of preferred stock and 2/3rd ($10 million) to the holders of common
stock. Therefore, the holders of preferred stock would receive $10 million total ($2.00 per share),
and the holders of common stock would receive $10 million total ($1.00
per share).

Non-Participating Preferred: The first $5 million would be distributed to the holders of preferred
stock, and the remaining $15 million would be distributed to the holders of common stock.
Therefore, if the preferred stock chose not to convert, the holders of preferred stock would
receive $5 million total ($1.00 per share), and the holders of common stock would receive $15
million total ($1.50 per share). However, the preferred stock would be better off converting into
common stock, because by doing so, the holders of preferred stock would receive $6.67 million
total ($1.33 per share), and the holders of common stock would receive $13.33 million total
($1.33 per share).

Participating Preferred with a 2x Cap: The first $5 million would be distributed to the holders of
preferred stock, and the remaining $15 million would be distributed based on the pro rata
ownership, with 1/3rd ($5 million) to the holders of preferred stock and 2/3rd ($10 million) to the
holders of common stock. Therefore, the holders of preferred stock would receive $10 million total
($2.00 per share), and the holders of common stock would receive $10 million total ($1.00 per
share). However, if the purchase price of the company increased above $20 million, no further
proceeds would be distributed to the holders of preferred stock. If the company were sold for $25
million, the holders of preferred stock still would be capped at the $10 million total ($2.00 per
share), and the holders of common stock would receive the remaining $15 million total ($1.50 per
share). If the company were sold for $30 million, the holders of preferred stock still would be
capped at the $10 million total ($2.00 per share), and the holders of common stock would receive
the remaining $20 million total (also $2.00 per share). At a purchase price above $30 million, the
holders of preferred stock will be better off converting to common stock, in order to receive the
same value per share.
Our data set shows that roughly two-thirds of preferred stock financings have a
participating liquidation preference, with roughly half of those capped and half
uncapped. The deals without a participation feature and with generally lighter terms
on liquidation preference tend to be earlier-stage deals led by West Coast venture
capitalists. West Coast term sheets may be more favorable to the common
stockholders, with a “1x” initial liquidation preference, no cumulative dividends and
no participation. In particular, entrepreneurs may find that some of the better-known
so-called “first tier” venture capitalists on the West Coast will offer the “softest” term
sheets (though frequently coupled with a lower valuation), because these investors
are the most focused on making their returns from “home run” investments.
Term Sheet Tutorial 94
It is critical to carefully negotiate the liquidation preference in the first preferred
stock investment in the life of the company. In an early-stage financing, the
investors often will be willing to agree to terms, including terms of liquidation
preference, that are relatively favorable to the company’s founders. Because the
terms of a subsequent venture financing typically will follow closely the terms of
previous financings (and, of course, the terms of later financings rarely are more
favorable to the founders than the terms of the earlier financings), the early
investors believe that they will benefit in the future by not subjecting their own
preferred stock to burdensome liquidation preferences and other onerous terms of
the later financings.
As the company raises additional rounds of preferred stock financing, or if the
already outstanding preferred stock has a multiple liquidation preference or
cumulative dividend, the liquidation preferences quickly add up, creating what is
commonly referred to as a preference “overhang.” As a result, the holders of
common stock (typically founders and management) may become disincentivized if
the common stock would have little to no value in a sale of the company. Holders of
common stock may demand a “recapitalization” of the company, where some or all
of the outstanding preferred stock is converted to common stock in order to reduce
or eliminate the liquidation preference overhang. Frequently, the liquidation
preference is left in place but a “management retention plan” is layered on top of the
liquidation preference to provide the key members of management with bonus
payments that are paid prior to the liquidation preference if the company is sold.
Disputes between management and investors over preference overhangs that are
not resolved through a recapitalization or management-retention plan have led in
some cases to business deadlocks and actual shutdowns of venture-backed
companies.
Term sheet overview: Liquidation Preference
Want to Know How VC’s Calculate Valuation Differently from Founders?
The second most important economic term in the term sheet other than price is “liquidation
preference.” This states how the proceeds from a sale or dissolution of the company will be
distributed. Investors will always want to get their money out of the company before founders,
which in the case where the company is sold for a low price is fair. You almost certainly will have
liquidation preferences if you raise VC so don’t worry about having them.
But not all liquidation preferences are equal – we discuss all this in the video – some can have a
“multiple” on top of them such as a 2x liquidation preference, which means that investors get 2x
their money before founders get anything. In an early round of investment where there is not an
extremely high price relative to normal valuations this is anything but benign.
More likely what you’ll see if you have an aggressive term sheet is “participating preferred” stock.
This means that investors get their money back AND they get to share in the proceeds. If you’ve
raised $6 million in total and still own 40% of the company and sell for $10 million (not a great
outcome but it happens) then with participating preferred investors would take $6 million off the
top and then 60% of the remaining $4 million so the founder’s take would be $1.6 million (.4 * $4
Term Sheet Tutorial 95
million) and not $4 million. Note that it might be even less than $1.6m because liquidation
preferences often have interest calculated on top of them.
VC’s in early rounds will argue that “participation” is simply downside protection and if you sell
for a lower price they should get more of the proceeds. While true, the problem I have is that any
terms you have in your early stages will certainly be asked for by future investors in your later
funding rounds so all of these terms pile up when you’ve been through 3-4 rounds of funding over
a 5 year time frame. And by the time most companies get to an exit (which despite what you read
on TechCrunch about all the high-profile early exits the most realistic case is still 8-10 years)
often the founders own very little of the economic upside. This is a shame.
Privately some early-stage VC’s talk about participation helping them to “juice their returns” on
smaller exits. This is silly talk. I don’t imagine any VC seriously makes money by having tons of
small to mid-sized outcomes and therefore “juicing” to me is delusional. I think VCs make money
by investing in 20-25 deals and finding 2-3 outliers that drive extra-ordinary returns. And those
are often done by the best and smartest founders who have enough knowledge to know which VCs
are juicers and which aren’t. You reap what you sow.
I also won’t say there is never a time for “participating preferred” but it tends to be in later-stage
rounds and particularly in the case where the founders are getting an exceedingly high valuation
relative to the norm. In those cases there are all sorts of mathematical reasons why participation
might make sense. These are edge cases.
But for founders stuck in this negotiation about participation or not with VCs the most standard
compromise is “participation with a cap” which is usually set at 2-3x their investment. This
means that participation truly only applies in downside scenarios and once your exit outcome is
above a certain price investors would still be better off converting to common stock and not taking
their preference. I prefer to see no participation but this is a good compromise if you can’t get a
straight 1x liquidation preference.
Liquidation Amount
This is the amount of money the investor in preferred stock has a right to receive before
the common stock shareholders receive anything. The dollar amount is defined in the
term sheet. It often starts with the investment amount plus accrued, but unpaid dividends.
Then some sort of multiplier is usually applied to that amount.
Participation
Originally, preferred stock was an ‘either-or’ proposition for the investor in the event of
liquidation. The investor would calculate the liquidation amount, calculate the value of
the common stock if converted, and pick the one that yielded the higher amount. This is
called non-participating preferred stock.
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The key feature of participating preferred is that the investor gets the liquidation amount
first, AND then participates in the distributions on an as-converted basis.
Limits On Participations (Three Alternative Examples)
Liquidation preferences are a key term in the definition of preferred stock (it's
generally acknowledged to be the second most important economic term). Earlier, I
wrote about this and other terms in a post on negotiating a term sheet, but here I
want to give some specific examples to illustrate why this is such an important term.
You probably already know this, but it's worth repeating that liquidation preference
refers to the procedure for paying investors off in a sale or winding up of the
company. It typically includes two components: a preference (which is an amount
that gets paid before others) and participation (the ability to "double dip"). Many
folks have written on preferences in terms of definitions, so instead I'm going to give
some simple examples.
For simplicity sake, imagine a VC has $10MM invested in one class of preferred stock
in a company, owns 40% and the company is sold for $50MM. Here’s how the three
different scenarios in my previous post work (in a specific example):
(1) 1x preference w/ no participation. In this case, the VC has the choice to take
$10MM (their 1x preference) or to convert to common and take $20MM (40% of the
$50MM). Obviously, they’d want to do the latter. You might ask, what’s the value of
the preference? Well, imagine if the company were sold for $15MM—in that case the
VC would take the $10MM preference which would mean they really own 75% of the
economics (not the 40% shown on the cap table).
(2) 1x preference capped at 2x with participation. In that case, the VC would
get $10MM off the top (1x preference) and then get 40% of the rest (or $16MM) but
here the cap kicks in so instead of getting the extra $16MM, the VC would get only
an additional $10MM for a total of $20MM (or 2x). It's helpful to look at a table of
outcomes here:
Sale
As Preferred
10
20
30
35
40
50
60
70
80
90
100
As Common
10
14
18
20
20
20
20
20
20
20
20
4
8
12
14
16
20
24
28
32
36
40
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The first column is the sale price, the second is the the value to the VC "as
preferred" and the right column is the value to the VC if they convert to common
(which they always have an option to do). You'll see how the cap creates a "donut
hole" where the VC receives the same amount whether the company is sold for
$35MM or $50MM (because the VC would convert to common in any sale over
$50MM).
(3) 1x preference with participation and no cap. In this case, the VC gets
$10MM off the top, then they convert to common and get 40% of the rest (or
$16MM) for a total of $26MM. In this case, the VC gets 52% as opposed to the 40%
shown on the cap table. You can see with this simple example how the liquidation
preference can add substantial returns for investors (which all comes out of the
pocket of common).
So my view is that, no participation is the best option for common, followed by a cap
and the worst deal is the no cap participation scenario.
Lastly, I would like to give a caveat on the cap scenario which is that the donut hole
sometimes creates an unwelcome incentive. Imagine in the above example if there
were two deals on the table: one for $35MM in cash and another for $35MM in cash
plus a $15MM earn out. Further, imagine that the $35MM all cash deal is slightly
more likely to close. In that scenario, the VC would be inclined to take the lower
priced deal (remember they get paid the same in both scenario) but common would
probably go for the higher deal.
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TERM SHEET: PRICE
Term Sheet: Price by Feld Thoughts
At the end of the year, I completed a financing that was much more difficult than it needed to be.
As Jason Mendelson (our general counsel) and I were whining to each other we decided to do
something about it. At the risk of giving away more super-top-secret VC magic tricks, we've decided
to co-author a series of posts on Term Sheets.
We have chosen to address the most frequently discussed terms in a venture financing term sheet.
The early posts in the series will be about terms that matter - as we go on, we'll get into the more
arcane and/or irrelevant stuff (which - ironically - some VCs dig in and hold on to as though the
health of their children depended on them getting the terms "just right.") The specific contract
language that we refer to (usually in italics) will be from actual term sheets that are common in the
industry. Ultimately, we might put this into a Wiki, but for now we'll just write individual posts.
Obviously, feel free to comment freely (and critically.)
In general, there are only two things that venture funds really care about when doing investments:
economics and control. The term "economics" refers to the end of the day return the investor will
get and the terms that have direct impact on such return. The term "control" refers to mechanisms
which allow the investors to either affirmatively exercise control over the business or allow the
investor to veto certain decisions the company can make. If you are negotiating a deal and an
investor is digging his or her feet in on a provision that doesn't affect the economics or control, they
are probably blowing smoke, rather than elucidating substance.
Obviously the first term any entrepreneur is going to look at is the price. The pre-money and postmoney terms are pretty easy to understand. The pre-money valuation is what the investor is
valuing the company today, before investment, while the post-money valuation is simply the premoney valuation plus the contemplated aggregate investment amount. There are two items to note
within the valuation context: stock option pools and warrants.
Both the company and the investor will want to make sure the company has sufficiently reserved
shares of equity to compensate and motivate its workforce. The bigger the pool the better, right?
Not so fast. While a large option pool will make it less likely that the company runs out of available
options, note that the size of the pool is taken into account in the valuation of the company, thereby
effectively lowering the true pre-money valuation. If the investor believes that the option pool of the
company should be increased, they will insist that such increase happen prior to the financing. Don't
bother to try to fight this, as nearly all VCs will operate this way. It is better to just negotiate a
higher pre-money valuation if the actual value gives you heartburn. Standard language looks like
this:
Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a
fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the
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Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock
following the issuance of its Series A Preferred is available for future issuances to directors, officers,
employees and consultants.
Alternatively:
Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a
fully-diluted pre-money valuation of $ __ million and a fully-diluted post money valuation of $__
million. For purposes of the above calculation and any other reference to fully-diluted in this term
sheet, fully-diluted assumes the conversion of all outstanding preferred stockof the Company, the
exercise of all authorized and currently existing stock options and warrants of the Company, and the
increase of the Companys existing option pool by [ ] shares prior to this financing.
Recently, another term that has gained popularity among investors is warrants associated with
financings. As with the stock option allocation, this is another way to back door a lower valuation for
the company. Warrants as part of a venture financing - especially in an early stage investment tend to create a lot of unnecessary complexity and accounting headaches down the road. If the
issue is simply one of price, we recommend the entrepreneur negotiate for a lower pre-money
valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with
existing investors who - for some reason - want to artificially inflate the valuation since the warrant
value is rarely calculated as part of the valuation (but definitely impacts the future allocation of
proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as
the bridge investor wants to get a lower price on the conversion of their bridge into the next round it's not worth fighting these warrants.
The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing
in his company - (economics 101: If you have more demand (VCs interested) than supply (equity in
your company to sell) then price will increase.) In early rounds, your new investors will likely be
looking for the lowest possible price that still leaves enough equity in the founders and employees
hands. In later rounds, your existing investors will often argue for the highest price for new
investors in order to limit the existing investors dilution. If there are no new investors interested in
investing in your company, your existing investors will often argue for an equal to (flat round) or
lower than (down round) price then the previous round. Finally, new investors will always argue for
the lowest price they think will enable them to get a financing done, given the appetite (or lack
thereof) of the existing investors in putting more money into the company. As an entrepreneur, you
are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is
incredibly important to pick your early investors wisely, as they can materially help or hurt this
process.
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TERMINOLOGY
The Off Road Investor
OffRoad Investment Primer
By Marc H. Morgenstern of Blue Mesa partners: this is a good compendium of legal terms for the
Off Road Investor…..i.e. private equity investor (read online)
http://www.bluemesapartners.com/images/DefinitiveDealDictionaryOffRoadCapital19
99.pdf
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EQUITY
VS. CONVERTIBLE NOTE
Convertible notes
The first decision is often whether to negotiate for Equity or a Convertible Note.
Convertible notes: One of the benefits of notes is that if the company were to face an
unpleasant ending, notes are higher in the pecking order for repayment in the case of
liquidation or some similar event. A convertible note addresses these concerns. It is a
note, with stated interest, but it may be converted into stock by the investor based upon
some predefined circumstances, such as a following round of equity investment, and on
terms that have been negotiated (usually a discount to the price per share of the equity
round, or warrant coverage).
Convertible notes are often used if you think there’s a compelling reason to avoid placing
a valuation on the company at the time of the transaction. For example, if the company
has received investment interest from a venture capital firm, but is only willing to
proceed when certain accomplishments have been achieved (such as customer acceptance
of a product or a patent issued). You will argue to the private investor that putting a
value on the company today will establish a lower baseline from which the venture
capital firm will establish its value for the next round. By doing a convertible note, you
will add, the investor gets into a deal with an almost guaranteed return (the discount or
warrants) with very little risk.
Moving along the continuum, this structure is a commitment to sell equity, with many of
the terms of the equity predetermined.
The Conundrum of Convertible Notes
(By Frank Demmler)
This week, for the first time since I began this series, I am going to express an opinion
with which I know many of you, both first-time entrepreneurs and investors, are going to
disagree.
Except in very special circumstances, I do not like convertible notes as an
investment vehicle.
Rationale for a convertible Note
You’ve started your company and have done a great job of bootstrapping it so far.
You’ve been able to convince some friends and business associates to join you, or to
work nights and weekends, so that your product is really beginning to take shape. You
know that it will just take a little bit more effort to do those things that will attract an
investment from a venture capitalist.
BUT, you need just a modest amount of money to make it from here to there [hence, the
term, “bridge loan”].
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You get linked up with some angel investors and they get excited about you, your
company, and its investment return potential. At that point the conversation usually goes
something like this.
You: “Your modest investment will help me get to the point where venture capitalists
will want to invest and then it’s all downhill from there.”
Angel: “You’ve convinced me. What did you have in mind?”
You: “We need to put together a convertible note with a premium for you for coming in
now. That’s what all the companies at this stage do.”
Angel: “I’m not sure I get it. Please explain.”
You: “Once we have done the things that your money will enable us to do [gotten a
customer, completed an alpha or beta test, attracted someone to the management team],
the VC is going to want to invest. Since we can’t really value the company today, we’ll
let the professional investor establish the value when he invests. In exchange for you
coming in now, though, I will offer you a sweetener so that you will buy your stock in
that round at a discount to the price the VC pays.
“By making it a note, if something were to go wrong, but nothing will, but if something
did, your note will be higher in the pecking order for repayment than stock.
“Besides, if we tried to value the company today, the VC would probably use that value
against us when we negotiate his round. I’m just looking out for you so that you’re
treated fairly.”
Angel: “Gee, thanks. Who do I make the check out to? What do I need to sign?”
As I’ve done before in this series, I’ve taken some poetic license, but it’s not too far from
the truth. The logic appears to make sense. In many cases, both sides think that they’ve
done the right thing and that it’s onward and upward.
Standard features of a convertible note
A convertible note is a loan to the company, with an interest rate, that the investor has the
right to convert the entire principal amount of the note (and often any accrued interest)
into equity when an institutional investor subsequently makes an investment. Usually
there is a premium for investing at this time. More specifically:
Principal Amount
This is the amount that the company is “borrowing” from the investors. In most
circumstances, each investor will an identical note with only the names of the note holder
and the amount of the note being different. For example, a round of $100,000 might be
shared by five investors investing $40,000, $25,000, $15,000, $10,000 and $10,000,
respectively. Sometimes, a limited partnership, or its equivalent is formed; the investors
invest in that; and then the LP becomes a single investor in the company.
Interest Rate
In my recent experience, annual interest rates on these loans are usually in the 6% - 10%
range.
Risk Premium
In exchange for investing now, the investor is given additional consideration that
effectively lowers his price per share as compared to the price paid by the subsequent
investor. Often a specified discount in the range of 15-40% is used depending upon lots
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of circumstances. This number may be fixed or may increase over time. An alternative
would be to issue warrants based upon an agreed to formula.
Repayment Terms
The convertible note is done with the presumption that it will, in fact, be converted. If it
isn’t, then the method of repayment must be defined.
Further, your private investor is doing this deal for the thrill of potentially making a lot of
money. As such there will be restrictions, or prohibitions, related to prepayment.
The interest may be treated in several ways. You may want to have the interest accrue so
that it doesn’t impact your cash flow. That may be agreeable to the investor if the
accrued interest will convert with the principal. Alternatively, you may want to pay the
interest quarterly to avoid the additional dilution that would occur with it accruing and
converting. Having current income from the investment may be desirable to your
investors as well.
Qualifying Transaction
You have solicited this investment with the explanation that it will enable you to attract a
significant investment on favorable terms. The investor will want to define what that
means. Not that you would, but the investor doesn’t want your Uncle Charley to invest
$1,000 at $10 per share, and have that cause his loan to be converted as well. Usually,
there needs to be at least a minimum amount raised before the conversion would occur.
Protective Provisions
As in any such security transaction [and a loan of this type is a security and must comply
with the relevant securities laws], the investors will have certain protective provisions.
Usually, certain transactions will require a majority approval of the note holders for such
things as taking out loans above a certain amount, selling some or all of the important
assets of the company, creating a new security that is senior to theirs, and the like.
Maturity Date
This is the date upon which your investor can seek repayment of the note. Depending
upon circumstances, this might be as short as 30 days or could stretch over several years.
Default & Remedies
If your investor requests to be repaid per the terms of the agreement, and the company is
unable, or unwilling, to make that payment, then your investor will have certain rights
that he can invoke through the judicial system.
Potential flaws of a convertible note
While this may all sound reasonable, the consequences may not be.
Operating objectives won’t be met on time
Nine times out of ten (actually more), a first-time entrepreneur will not achieve the
operating objectives on a timely basis.
The consequence of this is more money will be needed, and guess who is the only likely
source of that money? Look in the mirror.
Achieving operating objectives doesn’t attract investment
Even if the operating objectives are achieved, there’s no guarantee that an investor will
be ready and willing to invest.
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The consequence of this is more money will be needed, and guess who is the only likely
source of that money? Look in the mirror.
Institutional investors may not honor the terms of the note
Even if you hit your operating objectives and attract an investor to the bargaining table,
there’s no guarantee that he will abide by the terms of your notes. If you only have one
investor at the table, and you’re running out of cash [which are both highly likely if you
get this far], the Golden Rule will prevail: He who has the gold rules.
If a new investor agrees to invest only on the condition that the convertible note holders
waive some, or all, of their rights, your original investors are between a rock and a hard
place. They are faced with the decision of giving up all those financial benefits that you
had promised them, coming up with additional money themselves, or let the company
crater. Remember, a legal agreement is only the default if parties can’t negotiate an
alternative agreement. In this example, the potential investor can choose not to accept the
default, and just walk from the deal.
Institutional investors will probably ignore your valuation as a frame of reference
The premise that not valuing a round today will induce a higher value later is based upon
a flawed premise. An institutional investor will establish what he believes to be the
company’s value at the time of the investment consideration. Valuations of prior rounds,
if any, may serve as points of reference, but will not be major determinants of the
company’s current valuation.
This is particularly true in today’s funding environment and applies to all new rounds, not
just those funded by angels.
The downside protections aren’t really fair
If it gets to the point where the maturity date of the note comes and goes, it’s highly
unlikely that will be because the company is so prosperous. More than likely, you have
not been able to raise the follow on round of investment. As a result, it’s highly unlikely
that you will be able to repay the notes when requested to do so. Further, the default
provisions and remedies won’t yield much. You’ve heard the saying, “You can’t get
blood from a stone”? Well, you can’t get cash out of a close-to-bankrupt company.
Counterintuitive investment incentives
Quite often, a first-time entrepreneur pitches the convertible note structure so long and so
hard, that he begins to believe that the follow on investment by the institutional investor
is inevitable. After all, the convertible note is a “bridge” from here to there. That mind
set can be very dangerous. The discipline of controlling cash flow can get lax.
Another unintended consequence of this structure is that the institutional investors will
have a disincentive to come to the bargaining table. Even if you do everything that you
say you will do, you are still going to be an early stage company with lots of risks. The
seasoned investor knows that when a first-time entrepreneur raises angel money, it is
highly likely that the angels will pony up more money if there are no other alternatives.
The investor knows that if he sits on the sidelines, you will further reduce risk with
someone else’s money and that the Golden Rule is still likely to be in effect when he
comes to the table.
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Appropriate Use of Convertible Notes
I opened by saying that I didn’t like convertible notes except in specific circumstances.
Since I’ve slammed them so hard, I owe it to you to give you my opinion as to when they
are appropriate.
I believe that they are absolutely the right vehicle for economic development
organizations such as InnovationWorks, Idea Foundry, the Pittsburgh Digital
Greenhouse, and the Pittsburgh Life Sciences Greenhouse. If their early funding
launches a great success, then by all means, they deserve to participate on the upside.
I know for a fact that if current policies had been employed by InnovationWorks’
predecessor organization when Sean McDonald launched Automated Healthcare, the
return on its investment would have been staggering on a relative basis, and awfully darn
good on an absolute basis.
I also believe that convertible notes are appropriate investment vehicles for companies
that have already raised money at a fixed price and all of the current investors are willing
to take their pro rate share of the round.
Advice to entrepreneurs

Think long and hard as to whether a convertible note is really the best way to
structure a round of financing, even if it’s possible to do so.

A convertible note just delays the resolution of a fundamental difference of
opinion about valuation. The passage of time and intervening events are likely to
exacerbate those differences, not resolve them.

While likely to be painful for all involved parties, it is my sincere opinion that
pricing the round, putting that issue behind you, and building value from that
point forward will prove to be best for everyone.

Surround yourself with professionals, mentors, and advisors who have “been
there, done that” and can help you level the playing field.
Watch Out Angels When Buying Notes From An Llc:

If the worst happens….the venture goes out of business……then something even
worse might occur to those investors who did not buy the notes

The venture in essence, benefits from the forgiveness of debt….which

Might be a taxable event for the LP’s of the LLC, so

Not only do they lose their investment, they must pay taxes

Of course if they hold the notes, they can offset the loss…..but if they do not then
they cannot.
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FINANCING
Revenue Participation Certificates: Should I consider this
alternative?
Last week we looked at a range of investment structures that might be employed with
private investors. They fell upon a continuum based upon risk tolerance and desired rates
of return for investors, ranging from notes with interest to common stock.
This week we’ll look at some alternative deal structures that don’t really fit in that range,
and do reflect last week’s observation that deal structures are only limited by the
imaginations of the involved parties.
WEEKLY WARNING: I am not an attorney. Some of what I’m about to write could
violate securities laws if not done correctly. Make sure your attorney is aware of what
you are doing.
Avoid giving up equity
Many entrepreneurs don’t want to give up any equity in their company. Such
entrepreneurs often fall into one of two groups.
First-time entrepreneurs rarely look at equity as a bargaining chip that they’re willing to
bet. They view their equity as sacrosanct and won’t give it up for anything as crass as
money.
Secondly, sophisticated entrepreneurs who want to build their companies, but don’t want
to take them to an exit that rewards equity investment (acquisition or IPO) will need to
create a reward incentive that can be met through other means.
We’ll look at some examples that satisfy these conditions.
Revenue participation certificate
This is a simple and relatively elegant investment vehicle. It’s really a royalty with a
fancy name. Its essence says:
I will pay you X% of revenues until you get Y times
your money back.
This has several appeals.
Revenues are relatively straightforward to measure.
Both sides know how much money is owed; the only variable is timing.
X and Y will be negotiated in the context of your business plan. X will be large enough
to provide a reasonable cash flow to the investor and Y will be set based upon perceived
risk. Using your business plan as the basis, you will be able to tell the investor this deal
will provide him with a particular annual rate of return.
For the investor, this is structured so that the focus of the negotiation is on when he will
get his return on investment, not if he will.
If the company takes longer to grow sales than the plan anticipates, the rate of return will
be reduced, but it is still likely to be attractive. For example, if it takes five years to
provide the return rather than the three years that was anticipated when the deal was
struck, that may mean the annual rate of return might be reduced from 30% to 17%.
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The persistence of the payment will be an incentive for you to pay the security off as
quickly as possible. You will begin to look at those payments representing money that
you could use to grow your business, or put in your own pocket.
This base deal can be modified to accommodate specific circumstances. For example,
the parties can agree to delay the commencement of payments until 6 or 12 months after
closing so that the company has some runway to put the investment to work before
impacting the company’s cash flow.
Beyond the standard legal warning above, while the deal appears to be very simple, it
will be a challenge from an accounting and tax basis, so get good professional advice if
you go down this road.
Put and call
Another fairly simple structure is for you to sell a security to an investor that has a
straightforward put and call. A put is an investor’s right to force the company to buy his
security upon specified terms; to put the security to the company. A call is the
company’s right to buy back the investor’s security on specified terms; to call the
security. A deal using this structure might be phrased:
The company has a call on the investor’s security at X
times the investor’s investment amount until the third
anniversary of the investment. After the third
anniversary of the investment the investor may put his
security to the company at X+1 times the invested
amount.
Those multiples might be 2 and 3, for example, or 3 and 4, for that matter. The important
point here is that you have a finite period of time to pay off your investor before the cost
of that money increases significantly. Therefore you will manage your business with that
in mind so that you can avoid that. By setting up these rules at the beginning, everyone
knows the consequences of their actions.
Special situation: unwinding a partnership
While this is a little off topic, I offer it as another example of imaginative deal making.
It is not unusual for two people to start a business and after a period of time realize that
their goals are not the same. The worst thing that can happen is for the business to be
paralyzed because no decisions can be made. Under these circumstances, a “divorce” is
usually the best thing to do, and have one partner buy out the other. What if they can’t
agree on how to do this? Here’s an approach that I have seen used:
 Flip a coin.

The winner gets to choose whether he goes first or second.

The first person sets the price for the business.

The second person gets to decide whether he wants to buy or sell.
Right or wrong, the conundrum gets resolved and each partner can get on with his life,
and the business can prosper in the way that the buying partner envisioned.
Advice to Entrepreneurs
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
There are ways to raise money without giving up equity.

Only a subset of potential investors will find such deals of interest.

Deal structures are only limited by the imaginations and expectations of the
participating parties.

Surround yourself with professionals, mentors, and advisors who can help you
level the playing field.
Term Sheet Tutorial 109
VALUATION
How VCs Calculate Valuation (And How It's Different From The
Way Founders Do It)
Mark Suster, Both Sides of the Table
How VC’s Calculate Valuation: We walked through a standard deal where you raise $1
million at a $3 million pre-money valuation leading to a $4 million post money valuation.
The math works out that the investor owns 25% of the company post deal ($1 million invested /
$4 million valuation) and assuming 1 million shares, each share would be valued at $3 / share
($3,000,000 pre-money / 1 million shares = $3 / share). Investors own 25%, the founders own
75%. NOTE: In the video I talked about how VC’s and entrepreneurs decide the total number of
shares at the first major funding round and why it’s often a high number.
But this example above is all entrepreneur math, not the VC’s. The VC assumes you’ll have an
option pool. That’s normal. You’ll need to hire and retain talen to grow your company. Those
options need to come from somewhere. The more senior members you have (say you already
have a CEO, CTO, VP marketing, VP Biz Dev, VP Products) then the less options you’ll need and
vice versa. Industry standard post your first round of funding will be 15-20%. I say “post”
funding because you’ll need more than this amount pre-funding to get to this number after
funding. We walk through this in the video.
So taking the same fund raising round and assuming that the VC wants the options including
before he or she funds (and before is totally standard) then the math works like this: Assuming a
15% option pool post funding then you need a 20% option pool pre funding (because the pool gets
diluted by 25% also when the VC invests their money). So your 100% of the company is down to
80% even before VC funding. Normal.
The VC’s $1 million still buys them 25% of your company – it’s you who has diluted to 60%
ownership rather than 75%. The price / share is actually $2.40 (not $3.00), which is $3,000,000
pre-money / 1,250,000 shares (because you had to create the 250,000 share options). Thus the
“true” pre-money is only $2.4 million (and not $3 million) because $2.40 per share * 1 million
pre-money outstanding shards = $2.4 million.
Note that the term sheet you get will still say, “Pre-Money = $3 million” and there won’t be
anywhere in the term sheet that says “true Pre-Money” or “effective Pre-Money” – that’s for you
to calculate. So let’s start calling the term sheet listed pre-money valuation as the “nominal” premoney valuation. Luckily you all now have the spreadsheet to download that will calculate both
for you.
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APPENDIX A
Founders Shares Issues
(Last update: August 22, 2010)
Overview:
It is common practice for professional outside investors to require the
founders to agree to place a certain number (often all) of their fully vested and owned
shares under a repurchase restriction. This “repurchase right” lapses over time, restoring
the founders’ ownership to its original status before the financing round.
The concept of vesting founder shares originally arose from co-founders’ desire to ensure
that any founder who left the venture early it its life did not enjoy a “free ride” many
years later when the liquidity event occurred. The underlying concept was that those
founders who stayed with the venture, drove its growth, planned and executed a lucrative
exit deserved much more of the fruits of their labor than an ex-founder who essentially
got a “free ride.” Simply put, 100% of the venture’s value occurs at the exit, and those
who are not present at that time cannot have made the same contribution as those who
are.
Professional investors use the buyback right for these reasons:
A) The most critical component of the company’s success is the Founder who
should be incented to stay with the company, realizing that he/she will not get a totally
“free ride” if they leave prematurely (due to the forced sale of their unvested shares).
B) The acceleration of vesting upon a change of control aligns the Founders and
investors interests in seeking an exit prior to vesting expiry.
C) If the Founder leaves he/she will likely leave a hole which must be filled by
recruiting top talent from the outside. The relinquished (i.e. repurchased shares) enable
the company to attract better talent which benefits the ex-founder (due to their retained
vested shares).
Summary of Issues to Consider:
I. Vesting Issues:
A) Whose Shares get vested per the vesting schedule? Founder; Employees;
Directors; Consultants
B) Are they all treated the same, or does Founder get preferential treatment?
C) If the vesting schedule is based on the passage of time, what is the
commencement date for the vesting schedule to begin? Is any credit given for past
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service? How long is the vesting schedule (3 – 4 years) and how frequently are shares
released from potential repurchase (annually, quarterly, monthly)?
D) If milestone-based vesting is used, are the milestones not readily open to
misinterpretation? (For instance, closing a financing round is rather clear, but achieving
cash flow break even requires an unambiguous definition.)
E) How many shares are subject to the vesting schedule?
F) Be sure to file the 83 (b) form with the IRS within 30 days of a vesting
schedule being put in place. If not filed then the value of the vested shares (between
original cost and the then perceived value, such as derived from the financing round
which prompted the vesting) will be taxed as ordinary income! Just imagine having a
taxable event every month if monthly vesting were in place!
II. Termination Issues: When does vesting cease?
A) Can founder/employee/consultant continue vesting if they cease being on the
payroll but retained as a consultant or Director?
B) When fired for cause: Willful misconduct, gross negligence, fraudulent
conduct, and breaking agreements with the company (n.b.: clashing with the new CEO is
not “cause”).
C) Constructive Termination: Leave for a “good reason” such as vastly
diminished duties and compensation, required to move to distant location. Perhaps treat
like a severance package (i.e. credit with six months continued vesting)?
D) Quit: To join another venture (which might compete) or to retire and leave
the industry?
E) Health: Disability or death
III. Repurchase Issues:
A) What is repurchased? Only the unvested shares? (Never agree to have the
repurchase apply to vested shares.)
B) At what price? Original cost; Fair Market Value; lower or higher of the two?
C) Should the price vary based on the reason for termination? Quitting and being
fired for cause may warrant repurchase at cost; constructive termination may warrant
FMV.
D) What happens to the repurchased shares? Usually they are returned to
“Authorized but unissued common shares” which obviously enables all shareholders to
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enjoy “reverse dilution” and makes these shares available to attract replacement talent.
However, sometimes co-founders might try (usually unsuccessfully) to negotiate that
these shares are re-allocated only among the founders and not the investors.
IV. Acceleration of Vesting Schedule:
A) Change of Control (COC): This can be defined to mean an IPO, an M & A
event, or only an exit event which is substantially all cash.
B) Single Trigger: This event can trigger a full or partial vesting acceleration
(which in essence increases the cost of the acquisition)
C) Double Trigger: Both the COC and the termination of the Founder must
occur (how long, post COC, can be 6 – 12 months); and the second trigger can be tied to
the reason for the termination (e.g. no vesting if fired for cause). The double trigger
helps the acquirer believe the Founder will stay.
D) Combination of the Single and Double Triggers: A portion of shares become
vested upon COC, with the rest only if termination occurs thereafter within a specified
time.
V. Important Concepts:
A) The “Free Rider” refers to those who have left the company early so have
neither helped grow the company nor assisted in consummating the exit. They may have
made no contributions for many years since leaving, yet are cheering from the sidelines
for the exit (and voting their shares). Incidentally, be sure to consider “Drag Along
Rights.”
B) “Cash is fact; all else is opinion!” This refers to the reality that the company
only has value when it is converted to cash either via a liquidation (admitting failure) or
via a lucrative liquidity event. Up until the point that cash is paid for the company it
really has no value, despite the opinions of its valuation by the founder, employees, and
shareholders. Or, said differently, at all times the company’s only true value is how
much cash someone will pay for it. In essence, this highlights the view that starting and
growing a company is a wonderful adventure and should be highly respected. However,
100% of the value occurs at the time of the exit.
C) Among every venture’s scare resources are time and money. There is no
evidence to suggest that the more complex the term sheet, the more lucrative the exit. All
the time and money (legal fees) devoted to negotiating the fine points of any funding
round would be much better spent in executing the business plan and growing a great
company.
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D) This becomes painfully clear when either the next round or the exit occurs
because all items are again opened up to negotiation. At that instant all the time spent
haggling over all prior rounds was wasted.
VI. Opposing Perceptions of “Fairness:”
A) Founder: Usually thinks his/her baby is beautiful and would not even be
alive today, let alone so healthy, were it not for his/her total immersion (nights and
weekends) for which cash compensation has been woefully under market. The Founder
carries the largest “reputation risk” by far, works the hardest, and feels the unrelenting
pressure to succeed. The Founder has worked incredibly hard and also made huge
personal sacrifices (family and financial deprivations). These are obviously neither
grasped nor barely appreciated by these mere investors. Yet the Founder is serving up to
this latest round of investors a fabulous opportunity to make them lots of money for
comparatively little effort on their part. Moreover, the Founder currently has earned
his/her ownership stake via an enormous amount of hard work to date. It feels like going
backwards to subject this stake to a repurchase now that great momentum has been
established. “Market terms” are irrelevant because they are so incredibly and profoundly
inequitable and unjust they border on being immoral. This latest set of investors is
obviously taking unfair advantage because they know we so badly need their capital.
B) Latest Round of Investors: What this Founder has gone through is what every
Founder we see has also experienced, yet the others are not whining (as much). No one
forced the Founder (or anyone else on the team) to devote their past years to
commercializing this idea. We see lots of babies and this one is certainly not the most
beautiful we’ve seen. In fact, we’re looking at other babies right now just as attractive as
this one, and they may take much less care and feeding. It is true there would be no
company today without all the Founder’s/team’s previous hard work, but there may not
be a company going forward if we disengage now. We probably cannot adequately
appreciate their past sacrifices, but then that’s why we have not chosen to be
entrepreneurs ourselves. However, 100% of every venture’s value only occurs at the exit.
Therefore, the Founder should show some appreciation for the value we will bring. We
orchestrate exits for a living, but how many have they done? We see deals every day and
so know the market. How many deals did they see last week? We cannot attract a coinvestor unless the terms are “market.” All the successful entrepreneurs who have taken
VC money and had successful homeruns accepted vesting. Vesting should not be a
surprise because it’s been on the NVCA website for years and appears in all the standard
term sheet books. Remember that our goals are identical to the Founders: To grow a
highly valuable company which can be sold in a few years at a very substantial price.
When that happens the details of this round will be irrelevant.
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Examples of legal wording from the two most popular model
term sheet sources:
Per page nine of Alex Wilmerding’s term sheet book (Term Sheets & Valuations; Aspatore
Books; 2001):
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors and
consultants will be subject to vesting as follows: 20 percent to vest at the end of the first year following
such issuance, with the remaining 80 percent to vest monthly over the subsequent four years. The
repurchase option shall provide that upon termination of the employment of the shareholder, with or
without cause, the Company or its assignee (to the extent permissible under applicable securities law
qualification) retains the option to repurchase at cost any unvested shares held by such shareholder.
The outstanding Common Stock currently held by the Founders will be subject to similar vesting terms,
with such vesting period beginning as of the Closing Date.
Per page 14 of the NVCA Model Term Sheet (revised April 2009) available on the NVCA website:
Founders’ Stock: All Founders to own stock outright subject to Company right to buyback at cost.
Buyback right for ( )% for the firs (12 month) after Closing; thereafter, right lapses in equal (monthly)
increments over following ( ) months.
Brad Feld: Term Sheet - Vesting
May 10, 2005
When Jason and I last wrote on the mythical term sheet, we were working our
way through the terms that “can matter.” The last one on our list is vesting, and
we approach it with one eyebrow raised understanding the impact of this term is
crucial for all founders of an early stage company.
While vesting is a simple concept, it can have profound and unexpected
implications. Typically, stock and options will vest over four years - which means
that you have to be around for four years to own all of your stock or options (for
the rest of this post, I’ll simply refer to the equity as “stock” although exactly the
same logic applies to options.) If you leave the company earlier than the four
year period, the vesting formula applies and you only get a percentage of your
stock. As a result, many entrepreneurs view vesting as a way for VCs to “control
them, their involvement, and their ownership in a company” which, while it can be
true, is only a part of the story.
A typical stock vesting clause looks as follows:
Stock Vesting: All stock and stock equivalents issued after the Closing to
employees, directors, consultants and other service providers will be subject to
vesting provisions below unless different vesting is approved by the majority
(including at least one director designated by the Investors) consent of the Board
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of Directors (the “Required Approval”): 25% to vest at the end of the first year
following such issuance, with the remaining 75% to vest monthly over the next
three years. The repurchase option shall provide that upon termination of the
employment of the shareholder, with or without cause, the Company or its
assignee (to the extent permissible under applicable securities law qualification)
retains the option to repurchase at the lower of cost or the current fair market
value any unvested shares held by such shareholder. Any issuance of shares in
excess of the Employee Pool not approved by the Required Approval will be a
dilutive event requiring adjustment of the conversion price as provided above and
will be subject to the Investors’ first offer rights.
The outstanding Common Stock currently held by _________ and ___________
(the “Founders”) will be subject to similar vesting terms provided that the
Founders shall be credited with [one year] of vesting as of the Closing, with their
remaining unvested shares to vest monthly over three years.
Industry standard vesting for early stage companies is a one year cliff and
monthly thereafter for a total of 4 years. This means that if you leave before the
first year is up, you don’t vest any of your stock. After a year, you have vested
25% (that’s the “cliff”). Then - you begin vesting monthly (or quarterly, or
annually) over the remaining period. So - if you have a monthly vest with a one
year cliff and you leave the company after 18 months, you’ll have vested 37.25%
of your stock.
Often, founders will get somewhat different vesting provisions than the balance of
the employee base. A common term is the second paragraph above, where the
founders receive one year of vesting credit at the closing and then vest the
balance of their stock over the remaining 36 months. This type of vesting
arrangement is typical in cases where the founders have started the company a
year or more earlier then the VC investment and want to get some credit for
existing time served.
Unvested stock typically “disappears into the ether” when someone leaves the
company. The equity doesn’t get reallocated - rather it gets “reabsorbed” - and
everyone (VCs, stock, and option holders) all benefit ratably from the increase in
ownership (or - more literally - the reverse dilution.”) In the case of founders
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stock, the unvested stuff just vanishes. In the case of unvested employee
options, it usually goes back into the option pool to be reissued to future
employees.
A key component of vesting is defining what happens (if anything) to vesting
schedules upon a merger. “Single trigger” acceleration refers to automatic
accelerated vesting upon a merger. “Double trigger” refers to two events needing
to take place before accelerated vesting (e.g., a merger plus the act of being fired
by the acquiring company.) Double trigger is much more common than single
trigger. Acceleration on change of control is often a contentious point of
negotiation between founders and VCs, as the founders will want to “get all their
stock in a transaction - hey, we earned it!” and VCs will want to minimize the
impact of the outstanding equity on their share of the purchase price. Most
acquires will want there to be some forward looking incentive for founders,
management, and employees, so they usually either prefer some unvested
equity (to help incent folks to stick around for a period of time post acquisition) or
they’ll include a separate management retention incentive as part of the deal
value, which comes off the top, reducing the consideration that gets allocated to
the equity ownership in the company. This often frustrates VCs (yeah - I hear you
chuckling “haha - so what?”) since it puts them at cross-purposes with
management in the M&A negotiation (everyone should be negotiating to
maximize the value for all shareholders, not just specifically for themselves.)
Although the actual legal language is not very interesting, it is included below.
In the event of a merger, consolidation, sale of assets or other change of control
of the Company and should an Employee be terminated without cause within one
year after such event, such person shall be entitled to [one year] of additional
vesting. Other than the foregoing, there shall be no accelerated vesting in any
event.”
Structuring acceleration on change of control terms used to be a huge deal in the
1990’s when “pooling of interests” was an accepted form of accounting treatment
as there were significant constraints on any modifications to vesting agreements.
Pooling was abolished in early 2000 and - under purchase accounting - there is
no meaningful accounting impact in a merger of changing the vesting
arrangements (including accelerating vesting). As a result, we usually
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recommend a balanced approach to acceleration (double trigger, one year
acceleration) and recognize that in an M&A transaction, this will often be
negotiated by all parties. Recognize that many VCs have a distinct point of view
on this (e.g. some folks will NEVER do a deal with single trigger acceleration;
some folks don’t care one way or the other) - make sure you are not negotiating
against and “point of principle” on this one as VCs will often say “that’s how it is
an we won’t do anything different.”
Recognize that vesting works for the founders as well as the VCs. I’ve been
involved in a number of situations where one or more founders didn’t work out
and the other founders wanted them to leave the company. If there had been no
vesting provisions, the person who didn’t make it would have walked away with
all their stock and the remaining founders would have had no differential
ownership going forward. By vesting each founder, there is a clear incentive to
work your hardest and participate constructively in the team, beyond the elusive
founders “moral imperative.” Obviously, the same rule applies to employees since equity is compensation and should be earned over time, vesting is the
mechanism to insure the equity is earned over time.
Of course, time has a huge impact on the relevancy of vesting. In the late 1990’s,
when companies often reached an exit event within two years of being founded,
the vesting provisions - especially acceleration clauses - mattered a huge
amount to the founders. Today - as we are back in a normal market where the
typical gestation period of an early stage company is five to seven years, most
people (especially founders and early employees) that stay with a company will
be fully (or mostly) vested at the time of an exit event.
While it’s easy to set vesting up as a contentious issue between founders and
VCs, we recommend the founding entrepreneurs view vesting as an overall
“alignment tool” - for themselves, their co-founders, early employees, and future
employees. Anyone who has experienced an unfair vesting situation will have
strong feelings about it - we believe fairness, a balanced approach, and
consistency is the key to making vesting provisions work long term in a company.
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Optimum Share and Option Vesting by Basil Peters
Basil Peters (www.BasilPeters.com) See his book Early Exits (although none of
this appears in his book)
I believe vesting is the most important element of corporate structure. It is essential
to ensuring that both entrepreneurs and investors are treated fairly and equitably.
Vesting has incredibly powerful effects on the group psychology, culture and
corporate performance. I have seen many companies literally fail due to flaws in
their vesting.
Widespread employee ownership is still a relatively new concept. Even as recently as
the 1980s, there was still debate on the degree to which employee equity ownership
affected corporate performance.
Today, it is widely accepted in North America that companies with broad employee
ownership create larger increases in shareholder value.
After a couple of decades of experience and a few good analytical studies, there is
now a broad consensus on the range of equity that is reasonable for a new CEO, or
other senior employee, to expect when joining a company.
Agreement on Magnitudes But Not Vesting Formula
Even though there is now reasonable agreement on the ideal magnitudes of equity
ownership, there is still discussion on the optimum vesting formula.
In the mid-1980s, ten year linear vesting was common. As the technology industry
matured during the later 1980s, vesting periods shortened.
As tech gathered momentum through the 1990s, it became more difficult to hire and
retain. Vesting periods got shorter and shorter. In Silicon Valley, in the mid and later
1990s, vesting periods were often as short as 18 months.
Anyone who has built a company knows this doesn't make sense. It takes much
longer than 18 months to get a return on the cost of recruiting and training a new
employee. Many employees have not even reached their maximum level of
productivity in a new job for the better part of a year.
Interestingly, even though those short vesting periods did not make fundamental
sense, they were widespread because the market for human resources is so efficient.
Companies quickly realized if they did not offer short vesting periods, they would not
be successful in recruiting new employees.
Along with the equity markets, the pendulum swung back in the 2000s. As an
example, recent vesting at Microsoft was over 4.5 years. Common ranges for vesting
periods today are 4 to 6 years.
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Psychological Vesting
One of the challenges in discovering the optimum vesting formula is 'psychological
vesting'. Veteran serial entrepreneurs and investors usually agree that when
someone is two-thirds vested, they reach a psychological turning point where the
vesting of the balance of their equity is much less meaningful to them.
This means that six year vesting is really only effective as a retention mechanism for
about four years.
New Appreciation of the 'Contract' with Investors
Experienced early-stage investors have also come to believe that one term in the
fundamental 'contract' between the entrepreneurs and investors is that the
employees will both increase the value of the investors' shares and ensure that at
some point they also execute an exit.
Investors in companies with large founders positions have often found themselves in
situations where the founders have successfully increased the value of the shares but
have either no motivation to create an exit or have left the company to pursue some
new venture, leaving who ever comes next with the responsibility to create liquidity.
Investors familiar with this phenomenon often describe themselves as 'stuckholders'.
Up to Half the Value Can Be Created During The Exit
There is also increasing agreement that up to half the value that an investor or
entrepreneur realizes on an investment can be created during the last few months -during the exit transaction. If an employee leaves before the exit, it does not seem
fair that they participate in that final increase in value.
The Optimum Vesting Formula
The optimum vesting formula is the one that is most fair and equitable to both the
entrepreneurs and the investors. I believe the best formula has to incorporate the implicit
contract to execute an exit and realize on the 50% value increase that is often created at
the exit.
This means that the most fair and equitable structure, and the one that maximizes
the alignment between the founders and the investors, is to vest:



50% of the shares daily over a three year period; and
The other 50% when there is a sale of the Company.
All vesting for senior employees accelerates on a sale of the Company.
A sale of the company is an event where everyone in the company has an
opportunity to exchange their shares for cash or shares with effectively immediate
liquidity (for example, a stock with enough liquidity so everyone who wanted to could
sell their shares). In this context an IPO is not a sale of the company. Neither is a
conversion into restricted stock.
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In these situations, the board should develop a new formula to recognize the
incremental or delayed liquidity created by this type of transaction.
This vesting formula is built into the "one page term sheet". I've used this formula in
virtually all of my angel investments for over 20 years. During that period, I've had a
chance to watch how this vesting formula has affected the group psychology and
increased the probabilities of success in over thirty companies. I am convinced this is
as close as we can get to optimum.
Founders' Equity By Mary Beth Kerrigan and Shannon Zollo
(October 2007)
A highly negotiated, sensitive provision in a venture capital transaction centers on what
percentage of founders’ stock should be subject to additional vesting and the ramifications
that result. The following are key issues and suggested approaches to satisfy concerns of both
founders and investors regarding this topic.
Founders’ Perspective. Most founders receive their equity upon incorporation, which often is
at least a year prior to the initial venture capital round. Therefore, founders are usually
surprised by the vesting terms that venture capitalists will impose on their equity. From the
founders’ perspective, they already own the stock and it is difficult to concede such ownership
in order to satisfy the investors’ desire for the Company to retain the right to buy back
unvested shares upon the founders’ employment termination.
Investors’ Perspective. Venture capitalists will confirm that the two most important factors
regarding an investment decision pertain to the (i) quality and experience of the founding
team, and (ii) potential market size towards which the Company’s products or services are
directed. Consequently, they want to protect against the possibility of prematurely losing
founders, together with their full equity position, after their investment. Vesting of founders’
equity protects against this possibility because founders are motivated to stay the course to
receive the benefit of their equity position and, should they prematurely leave or be
terminated, the unvested shares can be (i) used to attract suitable replacements, or (ii)
reallocated to other founders, management, or employees.
Cliff Vesting. Standard vesting terms provide that 25% of founders equity will “cliff” vest
after one year with the remaining 75% vesting quarterly or monthly over a three or four year
period. This approach can be modified such that a negotiated percentage of equity
immediately vests at closing (i.e., 25%), which is usually a function of how long the founders
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have been part of the Company (i.e., the longer the period the more likely the founders will
attempt to negotiate a higher percentage of immediately vested equity). However, this effort
is balanced against the investors’ desire to require that a larger portion of equity be subject to
vesting in order to sufficiently incentivize the founders to continue to work for the Company.
Another compromise is for the founders to have their unvested shares subject to a shorter
time period (i.e., two years or less).
Repurchase Price. A second approach often employed by founders pertains to the
repurchase price paid by the Company for the founders’ equity if the founders leave the
Company. The standard approach is to allow the Company to repurchase unvested shares at
the nominal price paid by the founders for the stock if the founder leaves the Company for any
reason. Alternatively, founders can request that the purchase price be equal to the fair market
value (FMV) at the time of the repurchase (usually valued in good faith by the Board of
Directors or at a price mutually agreed upon by the parties). Investors often view the founders
as having not yet “earned” the stock upon premature departure or termination and, therefore,
are generally reluctant to allow the founders to benefit from an increase in equity value. This
view is bolstered by the fact that had the founders received an option in lieu of stock, the
founders would not be entitled to exercise the unvested portion of their option upon
departure. The usual compromise is to differentiate the purchase price based upon the reason
the founders have left the Company. If the founders leave the Company voluntarily or are
terminated for cause, the Company has the right to repurchase the shares at the price paid by
the founders. However, if the founders are terminated without cause or constructively
terminated (i.e., the founders leave for “good reason”), the shares are repurchased at the
current FMV. Lastly, a very unusual scenario requires the founders to sell back vested shares
at the FMV upon termination regardless of the reason.
Acceleration. Another common provision associated with founders’ equity relates to
accelerated vesting upon a change of control of the Company (COC). Founders often request
100% of the unvested shares accelerate and vest immediately upon a COC. Investors are
generally reluctant to accept a full acceleration clause as it could make the Company less
attractive to a potential acquirer because the acquirer will want key management (oftentimes
including the founders) to be motivated to remain with the Company after the acquisition for
at least a transition period. The more traditional approach if a COC provision is accepted is to
permit at least one year of accelerated vesting to occur. If not satisfied with this proposed
percentage, the founders could request a “double trigger” (i.e., additional acceleration after
the COC if certain events occur). The double trigger is generally tied to the termination of the
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founders (usually without cause) within a certain period of time after the COC. For example, if
25% of the founders’ stock accelerates upon a COC, the founders can also request that an
additional 25% automatically accelerates in the event they are terminated without cause
within six months thereafter. However, this practice can be difficult to implement if there is
cash only consideration at closing as it is difficult to determine what percentage of the
founders’ shares should be included in the sale and/or subject to the double trigger.
Conclusion. Founders and investors must strive to effectively understand the key needs and
requirements of the other as part of the negotiation of a successful venture capital
transaction. The treatment of founders’ equity is one such key need and requirement. In light
of the various alternatives that exist with respect to founders’ equity, consensus should be
attainable regarding vesting, repurchase rights, and acceleration, which is desirable in order
that all parties may focus their attention to growing the Company into a highly successful
venture from which all can benefit.
For more information on founders' equity, please contact the authors Mary Beth Kerrigan or
Shannon Zollo.
From
the Wilson Sonsini Goodrich & Rosati Entrepreneurs’ Newsletter (Spring 2008):
Vesting of Founders’ Stock: Beyond the Basics
By Doug Collom, Partner (Palo Alto Office)
One of the most fundamental elements in the issuance of founders’ stock in a startup company is vesting.
Vesting is virtually universal as a convention, and is highly effective as a retention tool in connection with
the grant of stock to founders and employees. Because common stock is a vital component of the
compensation package for managers and employees, vesting is also the means by which the company
conserves its equity for purposes of hiring new employees and retaining
continuing employees.
In a normal vesting arrangement, shares issued to an employee are subject to a repurchase right in favor
of the company that typically lapses in a linear manner over a period of time, subject to the continued
service of the employee. If the employee’s relationship with the company terminates for any reason,
shares that have not vested may be repurchased by the company at their original purchase price. Thus,
using a typical example, a founder may receive 1,000,000 shares of common stock in a startup company,
priced at $0.001 per share. Under the contractual stock purchase terms, these shares are subject to
monthly vesting in equal amounts over a period of 48 months. In this example, if the founder’s
employment relationship with the company is terminated at the end of three years (i.e., 36 months, or
3/4ths of the vesting period), the company as a matter of contract would have the right to repurchase
from the terminated founder a total of 250,000 shares, representing the unvested portion of the total
Term Sheet Tutorial 123
grant, by paying the sum of $250—even though the stock at that point in time may in fact be worth
considerably more.
So much for the basics. What are some of the more important elements of vesting that a founder might
need to understand in establishing the organizational structure of the company at its inception?
The Vesting Period. The predominant time period used by startup companies in establishing a vesting
program, for founder- and non-founder employees alike, is four years. Although some venture firms
require a five-year period for founders and employees of their portfolio companies, this is unusual and the
convention in Silicon Valley and other technology-intensive areas continues to be the four-year vesting
period. The vesting time period is highly relevant to the employee, since only vested shares end up in the
employee’s hands following a termination of employment. It is equally relevant to the company’s venture
investors—when shares have vested in the hands of founders or employees in accordance with the vesting
period, this usually signals the need to provide a round of replenishment stock grants with new vesting
schedules, which may dilute the ownership interest of the venture investors in the company.
Credit for Vesting. It is almost invariably the case that when a founder has successfully attracted the
attention of a venture investor, a discussion ensues about the vesting of the founder’s stock. Even in the
instance where there is no disagreement on vesting philosophy, the founder may focus on how much
“credit” the founder should receive in a time-based vesting arrangement for the time spent by the founder
prior to the investor’s investment, or for the founder’s contribution to the startup in the form of
technology, customer relationships, expertise, and the like. Some investors take the view that no credit
should be given—the time-based vesting clock begins only at the time of the investment, thus subjecting
the founder to a full four-year service requirement (in the case of a four-year vesting arrangement). Other
investors will acknowledge the time and/or value already contributed by the founder, and offer “credit” for
vesting, usually in a range of somewhere between 25 and 50% of the founder’s stock (i.e., the founder
may immediately take claim to the “credited” portion of the stock as fully vested, and the remainder of
the stock will be unvested and subject to the agreed upon vesting arrangement). This question of vesting
“credit” is a matter of negotiation between the founder and the investor at the time of the investment.
Time-Based or Performance-Based? Most vesting arrangements for early stage startup companies are
based on vesting periods oriented around the passage of time. This structure is simple to administer by
the company, and is readily understood by employees. Implicit in the time-based vesting arrangement is
the understanding that if the founder’s or employee’s relationship with the company should terminate for
any reason (e.g., death, disability, poor performance, etc.), the vesting of the stock immediately stops.
With the advent of Financial Accounting Standard 123R in January 2006, the accounting penalties that
companies used to face in granting stock with performance-based vesting have largely disappeared. As a
result, many public corporations and some private companies use stock grants that vest, subject to the
continued service of the employee, upon the achievement of identified performance milestones (e.g., first
commercial release of a product, achievement of a specified revenue level, etc.). In the private company
sector, the use of performance-based vesting arrangements requires careful planning. In large part this
seems to be due to the highly changeable nature of the startup company business plan—a performance
milestone that may make sense in June 2008 may be completely irrelevant six months later, or the likely
timeframe in which the milestone was supposed to occur has changed, or the priority assigned to
achieving the milestone has changed in the face of overtaking business objectives. Any of these
circumstances would frustrate the purpose of the performance-based arrangement. In addition, the use of
performance-based vesting arrangements may have unfavorable tax consequences to the employee,
particularly in the circumstance where the stock price continues to increase over the vesting period. As a
result, performance-based vesting arrangements are not commonly used in private early stage
companies.
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No-Fault Vesting. The conventional time-based vesting arrangement is typically set up as a “no-fault”
arrangement; that is, vesting of the employee’s stock stops immediately upon the termination of the
employment relationship, without regard to the circumstances of the termination.
Many founders at least ask to themselves the question upon the issuance of founders’ stock in connection
with the formation of the company—why should this be the case? After all, the founder may have spent
long evenings and weekends over the last several years refining the scope and vision of the business plan,
developing the technology, personally bootstrapping the outlay of capital costs, establishing the customer
and support contacts—effectively putting together all the mission-critical elements of a promising startup
company. Why should the founder accept a no-fault vesting arrangement that potentially could strip the
founder of unvested stock if for any reason the investors on the board of directors decide that the founder
is no longer useful to the company?
Founders who take this view might seek protection in their employment arrangements with the company.
Even in the “at will” employment relationships that are the convention for startup companies with all
founders and employees, the founder may seek severance payment, acceleration of vesting or other
separation benefits in the instance where the founder is terminated without cause, or voluntarily resigns
for “good reason” (which might include a reduction in title or responsibilities or compensation, or
relocation to a different office, etc.).
However, before broaching this matter with the venture investor, it is important for the founder to
understand the investor’s perspective. No-fault vesting, combined with the usual “at will” employment
agreement, is fundamental to what the investor sees as a level playing field. The investor is putting up
equity financing and has no guarantees that the business plan will succeed or that the founders will be up
to the task of executing the plan. If a founder or the company underperforms, or if the investor and the
founder fail to agree on the fundamental growth path of the company, the investor cannot withdraw the
investment. Therefore, the investor has no recourse but to come up with a solution to set the company
back on track—usually hiring a new manager or managers to carry on. The investor believes that
providing the founder with protective separation arrangements that require accelerated vesting in
circumstances where things don’t work out unfairly tilts the playing field in favor of the founder. And this
protective arrangement is at the expense of not just the investor but the company as a whole—stock that,
but for the accelerated vesting, would otherwise be unvested and repurchased by the company for use in
hiring a replacement manager, is now held irrecoverably by the terminated founder and has no further
incentive value to new or continuing employees of the company.
The question as to whether a founder should be entitled to something more than the usual no-fault
vesting arrangement is usually addressed, if at all, in the term sheet investment conditions that are
offered by the interested venture investor. In most instances, founders understand that investors are
planning for success when they make an investment and are betting on the founders as much as they are
betting on the business plan. As a result, the no-fault vesting arrangement continues as an industry
convention for founders and employees alike in venture-backed startup companies.
As commonplace as vesting arrangements are, it is nevertheless important for founders to understand
vesting conventions and the competing philosophies behind them. The implementation of vesting
arrangements in many ways goes directly to the nature of the personal relationships and chemistry that
build between founders and venture investors. These arrangements also directly impact the wealth
objectives of founders, the hiring and retention objectives of the company, and the dilution concerns of
venture investors. As a result, founders need to approach vesting arrangements thoughtfully with all of
these considerations in mind.
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Published online: 27 May 2003, doi: 10.1038/bioent736
The term sheet tango
TERI WILLEY * & DAVID PARSIGIAN **
*Teri F. Willey is managing partner at ARCH Development Partners (tfw@archdp.com).
**David Parsigian is attorney and counselor at law at Miller Canfield Paddock and Stone
(parsigian@millercanfield.com).
Vesting of founder's shares
It's often said that VCs don't invest in ideas; they invest in people. In fact, they
invest in good ideas being driven by people with the knowledge, skill and
determination to turn them into a profitable enterprise. Without those people, the
company isn't worth much and an investment is pointless. So to be sure that the
founders stick around to turn their dream into economic reality, the investor is going
to force the founders to earn the stock that they already own in the company.
As you review the term sheet, you'll find a provision that says that if you fail to stay
with the company, the company may repurchase your founder's shares at the price
you paid for them, with that repurchase right reduced over time. For example, say
you come to the table with 400,000 founder's shares. Based upon a typical four-year
vesting schedule with a one-year 'cliff' and monthly vesting thereafter, your
ownership of the first 100,000 of those shares won't be assured until one year after
the investment closes, and the remainder will cease to be subject to the repurchase
price in equal monthly 'installments' over the next three years.
I once had a founder weep as he read these vesting terms. I was proposing to take
his stock away and he'd barely gotten over the insult of the pre-money valuation I'd
proposed! Nonetheless, expect to see vesting of founders shares in the term sheet.
Focus your energy on how to align interests by exploring the option of accelerating
your vesting based on reaching milestones that add to the company's value.
Just remember, once the deal is done, you and your investors will be sitting on the
same side of the table, trying to grow a successful company. So as you sort out the
terms of the investment, acknowledge where you have a common interest with your
investor and focus the negotiation on the areas where your interests differ from
those of the investor. If you can get those interests aligned, you'll have a good deal.
What should the vesting terms of founder stock be before a
venture financing?
July 19, 2007
I think that founders stock before a venture financing should be subject to the same
general vesting terms as one would expect after a venture financing. A typical
vesting schedule is four year vesting with a one year cliff. This means that 25% of
the shares will vest one year from the vesting commencement date, with 1/48 of the
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total shares vesting every month thereafter, until the shares are completely vested
after four years. The vesting commencement date can be the date of issuance of the
shares, or an earlier date, in order to give the founder vesting credit for time spent
working on the company prior to incorporation and/or issuance of the shares.
Some founders want to accelerate vesting upon a termination without cause or a
constructive termination. (I will get around to defining these terms in future posts.)
I’m not sure that this is really in the best interest of the founders. It is extremely
difficult to terminate someone for cause, so termination of a founder will generally
result in his/her shares being vested. For founders that have never worked with each
other, I would generally counsel against acceleration of vesting upon a termination
without cause or a constructive termination. If personalities clash or things don’t
work out and a founder needs to be forced out, the remaining founder(s) will kick
themselves for allowing the departing founder to leave with a significant equity
stake.
If there is acceleration upon a termination without cause or constructive termination,
I think the amount of acceleration should be similar to the amount of severance that
a person may receive in the same situation. If six to 12 months of severance might
be justified if a person is terminated without cause, then six to 12 months vesting
acceleration seems reasonable. Of course, the typical norm in technology companies
is that there is no severance in any situation.
In addition, some founders may want to accelerate vesting upon a change of control.
Single trigger change of control vesting means that the shares accelerate upon a
change of control. This isn’t in the best interest of investors because the fully vested
founders have little incentive to continue to work for an acquiror after a change of
control. In order to incentivize these people, additional options may need to be
granted, which increases the cost of the acquisition to the acquiror, potentially to the
detriment of the investors. Double trigger change of control vesting means that the
shares accelerate upon a change of control AND the founder is terminated without
cause or a constructive termination occurs within 12 months of the change of
control.
The amount of shares that accelerates upon these events can be 100%, or written as
a certain number of months of vesting, such as twelve. I’ve had one VC express a
strong opinion that the amount of vesting upon one of these events should not be
100%, but rather 12 to 24 months of vesting acceleration, due to the fact that it is
extremely difficult to terminate someone without cause. I think that double trigger
100% acceleration for founders or certain executives is fairly accepted among
investors. However, extending that protection to rank and file employees is not
common.
In any event, VCs are likely to impose their own vesting terms and acceleration upon
a Series A financing, so it may not matter what terms are implemented when the
initial founders shares are issued. However, reasonable vesting and acceleration
terms may survive the Series A financing, especially if it would be difficult to
renegotiate with a critical founder in a team with multiple founders.
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Vesting Founders Stock with a Vesting Schedule | Startup
Lawyer
July 2008
If your startup company launches with more than one founder and your startup plans to
eventually be acquired or seek venture funding, your startup’s founders stock should vest
over time according to a vesting schedule.
Founding teams might not stay together. And having a missing founder or two with a nice
chunk of your startup’s common stock is not a scenario your startup wants when it comes
time for an acquisition or venture capital financing.
So instead of the founders getting all their shares of common stock on Day 1, the
founders get their stock according to a vesting schedule. The standard vesting schedule
for startup companies is four years with a one year cliff and monthly vesting thereafter
until the founders reach 100%. The one year cliff means that the founders do not get
vested with regards to any common stock until the startup’s first anniversary. Thereafter,
the founders get vested every month at an amount equal to 1/48th of the their total
common stock.
If a founder leaves before the startup’s first anniversary, the founder leaves without any
common stock. If a founder leaves after 15 months, the founder will have 31.25% of his
common stock vested (25% after the first year, plus the 2.083% vesting each month for 3
months). Thus, the missing founder leaves the startup with much less shares than if the
founders stock had vested immediately. This makes it easier to get the necessary approval
(and other issues) to go forward with an acquisition or venture capital financing.
Get vested for time served
by Nivi on April 19th, 2007, Venture Hacks
Your Series A investors will ask you to give all your founder’s shares back to the
company and earn your shares back over four years. This is called vesting — see
Brad Feld’s article on vesting if you need a primer.
Vesting is a good idea:
You are critical to the company and you have told your investors that you are
committed to the business. They are simply asking you to put your shares where
your mouth is: a vesting schedule demonstrates your commitment to the company.
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Vesting also ensures that a co-founder who leaves the company early doesn’t receive
the same amount of equity as co-founders who stay in the business.
Get vested for time served building the business.
But don’t agree to vest all of your shares just because it is supposedly “standard”.
If you have been working on the company full-time for one year, 25% of your shares
should be vested up-front and the balance of your shares should vest over three to
four years. The best vesting agreement we have seen for a founder in a Series A is
25% of shares vested up-front with the balance vesting over three years.
You should argue that,
“New employees who join the company today will earn all their shares over four
years. Employees who are already here should be credited for their time served.”
We don’t recommend trying to escape a four-year commitment to the company
(including time served). Four years is the typical commitment for a start up, high
school, or college, as well as the span between Olympics and World Cups, and the
term we give our Presidents to start as many wars as possible.
Consider cliffs for newfound co-founders.
Term Sheet Tutorial 129
One-year cliffs are typical for employees but are currently rare for founders.
Nevertheless, consider negotiating one-year cliffs with newfound co-founders whom
you haven’t worked with in the past. If a co-founder leaves the company after three
months, you don’t want him walking out the door with a large chunk of the company.
Over time, your continuing contributions to the company will become relatively less
important to its success. But the number of shares you vest every month will stay
relatively large. Founders generally make their greatest contributions at the early
stages of the business but their vesting is spread evenly over three to four years.
As your relative contribution to the company diminishes, everyone at the company
has an incentive to terminate you and benefit ratably from the cancellation of your
unvested shares. Nevertheless, in our experience, founders are allowed to vest in
peace unless they are incompetent, actively harmful to the business, or clash with a
new CEO.
You will probably be terminated if you clash with a new CEO.
By definition, a new CEO is hired to change the way things are and provide new
leadership to the business. That he might clash with founders who previously ran the
business is predictable. The CEO usually wins any disagreements or power struggles
— he is the decider and he decides what is best.
The investors, board, and management will almost certainly agree to fire your ass if
you continuously clash with a new CEO and you will lose your unvested shares upon
termination.
Accelerate your shares if you are terminated.
50% to 100% of your unvested shares should accelerate if you are terminated
without cause or you resign for good reason.
Cause typically includes willful misconduct, gross negligence, fraudulent conduct, and
breaches of agreements with the company. ‘Clashing with the CEO’ is not cause.
Good reason typically includes a change in position, a reduction in salary or benefits,
or a move to distant location. Detailed definitions are included in the Appendix
below.
Make sure you receive this acceleration whether or not your termination or
resignation is in connection with a change in control of the company, such as a sale
of the business. You can clash with your acquirer too.
Term Sheet Tutorial 130
Justify acceleration with the reciprocity norm.
Acceleration may cause consternation among your investors but it is easy to justify:
“A founder’s most important contributions generally occur in the early stages of a
business but he earns his shares evenly over time. If I clash with a new CEO and he
terminates me, I should receive the equity I earned with those contributions. Which
will make me much more comfortable with hiring a new CEO.
The founders agreed to a vesting schedule to demonstrate our long-term
commitment to the business. You have told us that the founders are critical to the
company — that we are the DNA of the business. Acceleration demonstrates the
company’s long-term commitment to our continuing contribution.”
This argument is an application of the reciprocity norm which requires your opponent
to be fair to you if you are fair to him. Your vesting schedule locked you into a
commitment to the company — that was fair — now acceleration locks the company
into a commitment to you.
It is even easy to justify 100% acceleration if you are the sole founder of the
business:
“Right now, I own 100% of my shares. After the financing, I will have to earn these
shares back over the next four years — I’ve agreed to that. But if I’m removed from
Term Sheet Tutorial 131
the business, I lose the right to earn my shares back. In that case, I should walk out
the door with the shares I came in with.”
Avoid unfair termination with a democratic board.
As usual, the best way to avoid unfair termination and avoid hiring a bad CEO is to
create a board that reflects the ownership of the company with hacks like making a
new board seat for a new CEO.
Acceleration for co-founders can do more harm than good.
If you have a team of founders, acceleration upon termination can do more harm
than good.
A co-founder with acceleration upon termination who wants to leave the company
can misbehave and engender his termination. If the company decides to terminate
him without cause to avoid possible lawsuits, your co-founder will walk away with a
lot of shares. In California, it is actually very difficult to prove cause unless an
employee engages in criminal activity.
If you trust your co-founders absolutely, you should negotiate as much acceleration
upon termination as you can. Otherwise, you need to decide which is worse: the
expected value of misbehaving co-founders who leave with a lot of shares or the
expected value of leaving a lot of shares behind after your termination.
Your vesting should accelerate upon a change in control of the company, such as a
sale of the business.
Negotiate both single and double trigger acceleration.
Your options for acceleration upon a change in control, from best to worst, include
1. Single trigger acceleration which means 25% to 100% of your unvested stock
vests immediately upon a change in control. Single trigger acceleration does not
reduce the length of your vesting period. It only increases your vested shares (and
decreases your unvested shares by the same amount).
2. Double trigger acceleration which means 25% to 100% of your unvested stock
vests immediately if you are fired by the acquirer (termination without cause) or
you quit because the acquirer wants you to move to Afghanistan (resignation for
good reason). The hack for acceleration upon termination already provides double
trigger acceleration and provides sample definitions of termination without cause
and resignation for good reason.
3. Zero acceleration which is a little better than getting shot in the head by the
Terminator:
Term Sheet Tutorial 132
The most common acceleration agreement these days combines 25% - 50% single
trigger acceleration with 50% - 100% double trigger acceleration. The median of this
range is probably 50% single trigger combined with 100% double trigger.
Justifying single trigger acceleration.
You can justify single trigger acceleration by arguing that,
“We didn’t start this company so we could work at BigCo X for two or three years.
We’re entrepreneurs, not employees. We’re willing to work at BigCo, but not for that
long.
If we sell the company after two years, that just means we did what we were
supposed to do, but we did it faster than we were supposed to. The investors will be
rewarded for an early sale by receiving their profits earlier than they expected. We
shouldn’t be penalized for an early sale by having to work at BigCo for years to earn
our unvested shares.
Single trigger acceleration reduces the effective time we have to work at BigCo and
rewards us for creating profit for the investors ahead of schedule.”
Justifying double trigger acceleration.
You can justify 100% double trigger acceleration by arguing that,
“The aim of vesting is to make me stick around and create value — not to put me in
a situation where I am deprived of the opportunity to vest because I am terminated
for reasons beyond my control or I resign because the environment is intolerable.
Term Sheet Tutorial 133
So, if I am terminated with no cause by the acquirer, I should vest all my stock. Or if
the conditions at the acquirer are intolerable and I resign for good reason, I should
vest all my stock.”
The risk of termination at an acquirer is much greater than the risk of termination in
a startup. Investors are generally investing in the future value of a startup — they’re
investing in people. Acquirers are generally investing in the existing value in a
startup — they’re investing in assets.
Acceleration agreements give you leverage upon a sale.
When you sell a company, the acquirer, founders, management, and investors will
renegotiate the distribution of the chips on the table. It isn’t unusual to renegotiate
existing agreements whenever one party has a lot of leverage over the others. To
quote the fictional Al Swearengen,
“Bidding’s open always on everyone.”
Negotiating your acceleration agreement now gives you leverage in this upcoming
multi-way negotiation.
If an acquirer doesn’t like your acceleration agreement, they can decrease the
purchase price and use the savings to retain you with golden handcuffs. A lower
purchase price means less money for your investors. This provides you with negative
leverage against your investors — you can decrease your investor’s profit if you
refuse to renegotiate your acceleration.
Or, the acquirer can increase the purchase price in return for reducing your
acceleration. A higher purchase price means more money for your investors. This
provides you with positive leverage against your investors — you can increase your
investor’s profit if you agree to renegotiate your acceleration.
Visible contributors benefit the most from the renegotiation.
After this renegotiation, the CEO and key members of the management team often
end up with better acceleration agreements than everybody else. That’s not a big
surprise — the CEO is leading the renegotiation.
Founders who are perceived as major contributors by the board and acquirer may
also benefit from the negotiation. If you’re the Director of Engineering, you’re
probably invisible to the acquirer — if you’re the VP of Engineering and involved in
the negotiations, you may do much better.
As always, the best defense against these shenanigans is to create a board that
reflects the ownership of the company and to make a new board seat for a new CEO.
Term Sheet Tutorial 134
Supersize your vesting with these microhacks
By Babak Nivi and Naval Ravikant, April 27, 2007
We offer a few “microhacks” for leveraging your vesting plan in various termination
situations.
1. Reclaim a terminated co-founder’s unvested shares.
A terminated co-founder’s unvested shares are typically cancelled. The resulting
reverse dilution benefits the founders, employees, and investors ratably.
Instead of canceling the shares, divide them among the remaining co-founders and
employees ratably. You should argue that,
“Cancelling a terminated co-founders shares puts a lot of pre-money into the investor’s
pocket. Those shares should be distributed among the founders and employees who
created that pre-money valuation.”
This argument will carry more water if you offer to put a portion of the reclaimed shares
into the option pool to hire a replacement for the co-founder.
Reclaiming a terminated co-founder’s shares does not create an incentive for cofounders to terminate each other. Co-founders have an incentive to terminate each
other even if the shares are cancelled. In our experience, this incentive is never a
factor. Founders are almost always allowed to vest in peace unless they are
incompetent, actively harmful, or clash with a new CEO.
2. Run screaming from the right to purchase vested stock.
Some option plans provide the company the right to repurchase your vested stock
upon your departure. The purchase price is ‘fair market value’. Guess whether the
definition of fair market value is favorable to you or the company…
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Founders and employees should not agree to this provision under any circumstances.
Read your option plan carefully.
3. Accelerate your vesting upon hiring a new CEO.
If you are having trouble applying any of the other vesting hacks, trade those chips
in for six months of acceleration upon hiring a new CEO. Investors are usually eager
to bring in “professional” management. They should agree to this term because it
aligns your interests with theirs.
4. Keep vesting as a consultant or board member.
If you have a lot of leverage, you may be able to negotiate an agreement to keep
vesting if you are terminated but retained as a consultant or a board member. For
example, the company may terminate you but keep you as a consultant to help
decipher your spaghetti code.
Some companies have been known to sneak this term into their closing documents.
We’re not big fans of that approach.
Again, if you are having trouble applying any of the other vesting hacks, you may be
able to trade those chips in for this one.
What entrepreneurs need to know about Founders’ Stock
September 15, 2008
This is a guest post by John Bautista. John is a partner in Orrick’s Emerging Companies Group in Silicon Valley. John
specializes in representing early stage companies.
Term Sheet Tutorial 136
When entrepreneurs start a company, there are four things they need to know about their stock in the company:
• Vesting schedule
• Acceleration of Vesting
• Tax traps
• Potential for future liquidity
VESTING SCHEDULE
The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not
vesting until the employee has remained with the company for at least 12 months (i.e. a one year “cliff”). Vesting stops
when an employee leaves the company.
Even Founders’ stock vests. This is to overcome the “free rider” problem. Imagine if you start a company with a cofounder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is
sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for
much of the hard work. Founder vesting takes care of this issue.
Even if you’re the sole founder, investors will want to see your founder’s stock vest. Your ability and experience is one
of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company’s
development and funding process, want to make sure that you are committed to the company long term. If you leave,
the VCs also want to know that there is sufficient equity to hire the person or people who will assume your
responsibilities.
However, many times vesting of founders’ shares will follow a different schedule to that of typical startup
employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history
working with each other, and know and trust each other. In addition, most founders will start vesting of their shares
from the date they actually started providing services to the company. This is possible even if you started working on
the company prior to the issuance of founders’ stock or even prior to the date of incorporation of the company. As a
result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.
This vesting is balanced by investors’ desire to keep the founders committed to the company over the long term. In
Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the
three or four years following the date of a Series A investment.
ACCELERATION OF VESTING
Founders often worry about what happens to the vesting of their stock in two key circumstances:
1. They are fired “without cause” (i.e. they didn’t do anything to deserve it)
2. The company gets bought.
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There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if
they both occur (double trigger acceleration).
“Single Trigger” Acceleration is rare. VC’s do not like single trigger acceleration provisions in founders’ stock that
are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s
services are terminated then the founders’ stock should not continue to vest. This is the “free rider” problem again.
In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the
founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the
company’s headquarters are moved). However, under most agreements, there is no acceleration if the founder
voluntarily quits or is terminated for “cause”. A 6-12 month acceleration is also usual in the event of the death or
disability of a founder.
VC’s similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the
company to a buyer. Acquirors typically want to retain the founders, and if the founders are already fully vested, it will
be harder for them to do that. If founders and VC’s agree upon single trigger acceleration in these cases, it is usually
25-50% of the unvested shares.
“Double Trigger” Acceleration is more common. While single trigger acceleration is often contentious, most VC’s
will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the
enterprise from the acquiring company’s perspective. It is arguably in the acquiring company’s control to retain the
founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event
of involuntary termination by the acquiring company. In Orrick’s experience, it is typical to see double trigger
acceleration covering 50-100% of the unvested shares.
TAX TRAPS
If things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news.
But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests,
and before you have the cash to pay those taxes.
There is a way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your
Founder’s shares and paying your tax early on those shares. One of the most common mistakes I’ve encountered with
founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating
future tax obligations and/or delaying a venture financing of the company.
Fortunately, over the years, I’ve developed a number of work-arounds (depending on the circumstances) and we can
many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed.
Nevertheless, this is one of the first things that your lawyer should check for you.
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Of course, you’ll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I’m sure
you’ll be able and happy to pay!
POTENTIAL FOR FUTURE LIQUIDITY
Founders’ stock is almost always common stock because VC’s purchase preferred stock with rights and preferences
superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new
security for founders which we call “Founders’ Preferred” which enables founders to hold some of their shares in
the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale.
The “Founders’ Preferred” is a special class of stock that founders can convert into any series of preferred stock sold by
the company to VC’s in a future round of financing. The founders would only choose to convert these shares when they
plan to sell those shares to VC’s or other investors in that round of financing. This special class of stock is convertible
into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock
is identical to common stock.
The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple
problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price.
Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as
opposed to common stock.
“Founders’ Preferred” can usually only be implemented at the time of the first issuance of shares to founders.
Therefore, it is important to address the advantages and disadvantages of issuing “Founders’ Preferred” at the time of
company formation. I normally recommend for founders who want to implement “Founders’ Preferred” that such
shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance
of “Founders’ Preferred” remains a new development in company formation structures. Therefore, it’s important to
consult legal counsel before putting this special class of stock into effect.
Many VCs do not like to see Founders’ Preferred in a capital structure.
CONCLUSIONS
As discussed above, there are a number of issues to address when issuing founders’ stock. In addition to business terms
associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate
important legal and tax considerations. My advice to founders is to make sure to “get it right” the first time. Although
here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it
is important that founders get the right business and legal advice, and not just use pre-packaged forms.
This advice should begin at the time of company formation. A little bit of advice can go a long way!
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Ted Wang: Fenwick & West
November 2006
[Editor's note: Ted Wang is an attorney at Silicon Valley law firm Fenwick & West.
Disclosure: VentureBeat is a client of Fenwick's, though does not have a relationship
with Ted.]
The release of our firm’s Trends in Terms of Venture Financings shows that this
remains a strong market for entrepreneurs to raise venture capital. The survey finds
that valuations have continued to increase, while some tough terms negotiated by
venture capitalists such as multiple liquidation preference and “ratchet” anti-dilution
remain comparatively rare.
There is, however, a danger that the current climate is encouraging entrepreneurs to
go too far. We are increasingly hearing requests for odd-ball terms such as very
short vesting schedules (2 years?!) and founders’ protective provisions that recall the
heady days of the Bubble.
In my opinion founders should resist the temptation to think outside the box with
respect to the terms in their founders’ agreements and financing documents.
Obviously, valuation and liquidation preference are key areas of negotiation, but for
other areas I am a strong believer in plain “vanilla” terms.
If the market is good, why shouldn’t founders get the best terms that they can? My
rationale is as follows:
• Standard venture financing terms represent a compromise between investors
and entrepreneurs that is informed by years of experience.
• Developing and negotiating unusual terms is a waste of a company’s two most
precious resources, time and money. Unique terms are highly unlikely to provide any
return on investment and are certainly not correlated to the potential success of the
enterprise.
• With respect to founders’ vesting, the people who build the company are the
most likely to be the ones who lose out with “creative” vesting schedules. Most
founders think about how to protect themselves from being ejected by VCs, however,
the vast majority of the time, it’s the founders who get rid of one another when
someone is behaving badly or not pulling his or her weight. With aggressive vesting,
this can result in an ex-founder owning a huge chunk of stock, while the remaining
founders work like dogs to make it valuable.
Someone out in the blogosphere has surely already begun typing, “Fenwick
represents Kleiner, Sequoia and others and you’re just a shill for the VCs. Founders
should get what they can, when they can!”
In response, I note first that the vast majority of my clients are on the company (as
opposed to the VC) side. Second, and far more importantly, this is the same advice I
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give to my company clients. It may seem counterintuitve not to push for the “best”
terms, but in my experience the marginal value of improved terms is not worth the
investment in time and effort required to incur such gains.
This is an excellent time to form a start-up and raise venture capital. Use standard
vesting, get a good valuation with a low liquidation preference and spend your time
and effort building a great company.
Posted on April 13, 2009 by Joseph M. Wallin
Vesting Imposed On Founder Stock In Connection with
Financing--Section 83(b) Election Required?
It is fairly common in connection with a financing that an investor will require a
founder to agree to place a certain number of the founder's fully vested and owned
founders shares under an at-cost repurchase restriction, which at-cost repurchase
right lapses over a new vesting period.
The question that this raises from a federal income tax perspective is whether the
founder should or needs to file a Section 83(b) election upon the imposition of the
new vesting conditions. The IRS answered this question in Revenue Ruling 2007-49.
"In Situation 1, in connection with the new investment, the substantially
vested shares of Corporation X stock owned by A are subjected to a restriction
causing them to be “substantially nonvested”. Because the substantially vested
shares of Corporation X stock are already owned by A for purposes of § 83,
there is no “transfer” under § 83. Thus, the imposition of new restrictions on
the substantially vested shares has no effect for purposes of § 83."
Excerpts from the Revenue Ruling:
Issues:
1) Is there a transfer of substantially nonvested stock subject to § 83 of the
Internal Revenue Code where restrictions imposed on substantially vested
stock cause the substantially vested stock to become substantially nonvested?
FACTS
Investors form Corporation X in 2004, by contributing $1,000 each to
Corporation X in exchange for 100 shares of Corporation X stock. In exchange
for Individual A’s agreement to perform services for Corporation X, Corporation
X issues 100 shares of its stock to A. The fair market value of the Corporation
X stock on that date is $10 per share. The shares of Corporation X stock
transferred to A are “substantially vested” within the meaning of § 1.83-3(b) of
the Income Tax Regulations.
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For the 2004 taxable year, the amount included in A’s income under § 83(a)
is $1,000 (the fair market value of the stock ($10 x 100 shares) less the
amount paid ($0)). A’s basis in the stock is $1,000.
Situation 1. In connection with its plan to start a new business
venture, Corporation X seeks financing from Investor M on July 9, 2007.
Investor M agrees to invest funds in Corporation X in exchange for a specified
number of shares and the further requirement that A agree to subject A’s
shares to a restriction that will cause the stock to be “substantially nonvested”
within the meaning of § 1.83-3(b). Under this restriction, if the employment of
A with Corporation X terminates before July 9, 2009, A must sell the shares to
Corporation X in exchange for the lesser of $150 per share (the fair market
value of Corporation X stock on July 9, 2007) or the fair market value at
the time of forfeiture. In addition, the shares are nontransferable before that
date. A remains employed with Corporation X, and on July 9, 2009, the fair
market value of Corporation X stock is $250 per share.
In Situation 1, in connection with the new investment, the substantially
vested shares of Corporation X stock owned by A are subjected to a restriction
causing them to be “substantially nonvested”. Because the substantially vested
shares of Corporation X stock are already owned by A for purposes of § 83,
there is no “transfer” under § 83. Thus, the imposition of new restrictions on
the substantially vested shares has no effect for purposes of § 83.
Note to Founders: Have Vesting
07/22/2007
Not vesting their stock is a common legal mistake new startup founders make.
Early on in our funding cycles, I help the founders set up all the initial legal and
incorporation paperwork. (I’m not a lawyer, but I’ve gone through it about 60 times by
now.) Y Combinator’s philosophy on legal paperwork is that it should be as simple and
straightforward as possible. We hate it as much as founders do. When we first started out,
we didn’t include vesting in the paperwork because we didn’t want to be overbearing
investors.
Boy, am I singing a different tune more than 2 years and 5 funding cycles later. It’s like
I’ve taken a “Scared Straight” course in corporate law. I’m exaggerating a bit, but the
point is that there are so many disasters looming out there for startup founders, why not
arrange to avoid one?
What is vesting? It’s when the founders voluntarily agree that instead of getting all their
stock up front, they’ll earn it over time. There's no set rule for vesting schedules, but the
most common are 25% per year (vesting monthly or quarterly) over 4 years, or 20% per
year over 5. Usually there's a 1-year "cliff," meaning people who leave after less than a
year get nothing.
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Once you’ve issued your stock, you then need to file a form called an 83(b) election with
the IRS. You have 30 days to do this or you can face hideous tax repercussions. Many
paperwork oversights can be fixed later, but this one can’t.
Yawn. You must now realize why founders don’t want to deal with all this: it’s boring!
Why attend to legal paperwork when you can be working on your software and planning
to take over the world? Because if you don’t have vesting and one of the founders leaves
with a large chunk of your startup’s stock, you will waste a lot of time and money to fix
this situation. One YC-funded startup that didn’t have vesting had one of its founders
leave within the first year. Here’s what one of the remaining founders told me about the
aftermath:
“The biggest thing by far was the legal and accounting fees we had to incur (+$20k) and
the time and stress associated with dealing with something like this. Hours and hours on
the phone, reading over documents that weren't explained well by lawyers, trying to
understand from an accounting and tax perspective what we were getting ourselves into,
etc. If we had the vesting agreement, it would have ALL been unnecessary.
Everything is roses when the company is first starting-- you're excited, you're even
thinking about the people you're working with differently, i.e. any misgivings you may
have you're lessening in a ‘let's see how it goes’ attitude, or ‘things will be fine once we
get started’ attitude, so obviously you don't worry about it as much.”
Several of our startups have had founders leave early on. For those groups without
vesting, some founders gave back the stock voluntarily and some didn’t. But you don’t
want to have to rely on your cofounder’s opinion about how much stock he/she deserves
to keep. You want to be clear from the start about what someone will walk away with if
they leave.
I couldn’t blame someone for leaving. It usually means things aren’t going well for the
startup-- you can’t get users, you can’t get funding, your bank account is dwindling, you
are demoralized-- and you need to pay your bills after all. But what about the founder
who sticks around, making huge sacrifices to keep the startup alive a la Evan Williams?
How would that founder like to be broke and working around-the-clock on the startup
while the founder who left is sharing equally in the upside? Kind of embittered I think.
Also, think of your future investors. It will be a major red flag if you have to inform them
that someone who owns 25% of the company now works elsewhere and doesn’t have
anything to do with the startup. They don’t like it when someone owns a large portion of
stock and isn’t “adding value.” They’d want (as you should too) that stock to be
motivating a new employee who would be busting his hump on the startup.
Professional investors expect vesting and will likely impose it upon the founders anyway
as part of their investment.
If you are lucky enough to afford lawyers to set up your corporation, they will obviously
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help you with all this. But many founders can’t afford their fees so early on. If you are
using online services to incorporate (which I wouldn’t recommend), make sure you set up
vesting. If you have already issued stock to the founders without vesting, look into setting
it up retroactively. I think it’s pretty easy to do.
Most founders don’t think they are going to need vesting, but roughly 20% of the startups
we’ve funded had a founder leave within the first year. So if you are thinking, “We don’t
need vesting,” you are in the company of a lot of people who were wrong.
MIT Blog:
Editor's Article
By James L. Woodward, Editor
Three Questions - Part ll
(Did you miss Part l?)
Recently I was asked three good questions by one of the Founders of a company I’m
mentoring. Space allows only one answer per month -- this is number two.
Question: “What does it mean to be a Founder, legally ... pros/cons for having more
or fewer founders.”
Disclaimer: I’m painting with a very broad brush here -- there are complications and
exceptions in both corporation law and tax law that can apply.
----There is no particular legal meaning to the term "Founder" -- but let's assume that
we mean "someone who buys stock before the corporation receives outside
financing" -- that is, at the time when it's arguably worth only the modest amount
the Founders pay for their shares (and modest it will be -- the last time I bought
Founders’ shares, the total amount paid by all the Founders was US$100.)
As a legal matter, as a Founder (or any other investor) you are not generally
responsible for the actions of the corporation. So, if you pay attention to the tax
rules, there is no downside to being a Founder, except, of course, the possible loss of
your modest investment and the time you invest in getting the business going. Note,
however, that this very general statement applies to you only in your role as
Founder/investor. Being a Founder does not give you a blanket exemption from
responsibility for actions taken as an Officer or Director of the corporation.
Any transfer of shares can have tax consequences. Buying shares at the beginning is
almost free from the tax man’s evil eye, so it is the best time to put shares into the
hands of the people who matter. Any later transfer must be at fair market value or
there will be taxes -- as the corporation grows and prospers this can be considerable.
Therefore, you want to make sure that everyone -- at least those that you’ve
identified -- that will be a part of the future of the corporation buys his or her shares
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at the beginning. On the other hand, it's a zero sum game and more players mean
fewer shares for everyone. Dividing up the shares is the subject of the third
question, a future column.
All of this brings us to vesting -- the concept that an employee -- Founder or not -should not automatically get his or her shares unless he or she works for the
corporation for some time -- usually four or five years.
Founders object to this, “I founded the company. Why shouldn’t I get all my shares
even if I leave.”
The simple answer is “fairness”. One of my companies had no vesting plan and a
Founder who had 20% of the initial shares. A few months after the company was
incorporated, he got an offer from another startup and left us. We had to struggle to
fill his position and give a significant number of shares to his replacement. Four
years later he got a check for a couple of million dollars for his few months of night
and weekend work.
So, I like a vesting schedule for everybody -- a straight monthly vest over sixty
months for Founders (each month one-sixtieth of the shares vest) and a sixty month
schedule with a one year cliff (one fifth of the shares vest on the first anniversary
and the rest one-sixtieth per month after that) for everyone hired after the
Founders. If any of your fellow Founders objects, tell him or her my story and that
outside investors, angels or VCs, will almost certainly insist on it.
I should add that there’s a complication that needs attention with Founders’ vesting - since you bought the shares for fair market value (close to nothing, but the
company has nothing, so that’s fair) there would be no tax consequences to the
purchase except for the vesting. The IRS treats vesting shares as not bought until
the vesting lapses, so you become taxable on the value of the shares (much more
than you paid, we all hope) that vest over the five years. You can avoid this by filing
an 83b election -- ask your lawyer -- it’s costless under these circumstances, but
must be done promptly. I should note that although we’re talking about Founders’
shares here, an 83b election is usually a good idea for all shares that have a vesting
schedule.
So, more Founders are generally OK. Vesting is good, as it protects those who put in
the work against those who Found and run. There are wrinkles, so good counsel is
always a good idea.
The Making of a Winning Term Sheet: Understanding What
Founders Want - Part II. Vesting Acceleration, Reallocation of
Founder's Stock, Option Pool Dilution and Founder Liquidity
By Jonathan D. Gworek (December 2007)
Know your target market. It is one of the most fundamental principals of any successful
marketing strategy. Investors who understand what the founders of a startup really care
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about will stand a better chance of winning the competitive deal. This article, which is the
second in a two part series, will discuss several provisions that investors can use to make a
term sheet more attractive to founders of a startup. Specifically this article describes the
following: acceleration of vesting for founders' shares; the re-allocation of unvested founders
shares upon a founder's termination; sharing the dilutive impact of the option pool, and
founder liquidity. While these terms are seen with varying degrees of frequency, and are not
necessarily what would be considered "market", they all have precedent. And for investors the
timely use of any one or more of these provisions might be the difference between winning or
losing a highly sought after investment opportunity. In the end, giving up marginal deal
protections will prove a shrewd strategy if the result is a stronger portfolio of companies.
Forfeiture of Unvested Stock
One of the great and unpleasant surprises to many founders is the realization that venture
investors will require that their stock be subject to vesting. In short, this means that the
founders need to earn the right to keep their stock after the financing is complete by
continuing as an employee. The vesting period is typically three or four years, with the stock
vesting on monthly or quarterly basis over this period. Once the stock is vested, the founder
typically retains the stock even if he leaves the company. But if the founder leaves the
employment of the company before this time period has elapsed, the founder forfeits the
unvested portion of the stock. This vesting requirement puts all founders at risk that they
could be divested of a significant portion of their stock if the board of directors determines that
a founder is no longer a "good fit". Risk of forfeiture of unvested stock also arises in the
context of an acquisition. For a full discussion of stock vesting, see "Founders' Equity," by
Mary Beth Kerrigan and Shannon Zollo, VC Spotlight, Q3 07.
Underlying the question of whether and when stock should be forfeited is the fact that in most
cases the forfeited stock returns to the status of authorized but unissued common stock. As a
result, a founder's loss inures to the benefit of all the remaining stockholders, both common
and preferred, whose ownership percentages in the company all increase proportionately. In
this way, vesting creates an inherent conflict between founders and those who might benefit
from their termination. This dynamic is not lost on well informed or advised founders, and
heightens a founder's sensitivity to the risks of forfeiture.1
Acceleration Upon Termination Without Cause
To alleviate a founder's legitimate and very real concerns, an investor could agree to allow the
founder to retain all or a significant portion of his unvested stock — in essence "accelerating"
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the founder's vesting schedule — if the founder is terminated without "cause".2 While the
definition of "cause" becomes critically important in this context, if the founder avoids conduct
that constitutes cause, the founder maintains control of his own destiny as it relates to stock
retention. The downside to the company and the investors is that a departed founder will need
to be replaced, and the person replacing the departed founder will require equity. While this is
likely to be true, given the disproportionately high equity stakes that founders have, it is
unlikely that the founder's replacement will require as much equity as was accelerated upon
termination without cause.3
Acceleration Upon Change of Control
Founders may also be at risk of forfeiting equity in connection with an acquisition or other
change in control of the company. At the time of such an event the founder's stock may only
be partially vested under the original vesting schedule. The question arises at this time as to
what should happen to the unvested stock of the founder, and more specifically whether such
stock should be treated as though it was either fully or partially vested and therefore
participate in the proceeds distributed out at the time of the acquisition.4
Venture capitalists often resist "acceleration" upon an acquisition. A number of rationales may
be offered. Investors will argue that the purpose of vesting is to keep founders incentivized for
the agreed upon period of the vesting schedule, and that the founder has not "earned" his
stock until this period has elapsed. Investors might add that if the founder is allowed to
accelerate, the founder may have "walk away" money thereby impairing the enterprise value
to a potential acquirer who will be required to pay extra to retain the founder going forward.
In theory it is also possible that the founder may not be retainable at any cost because of the
"walk away" money that results from acceleration. Alternatively stated, the acceleration will
require the buyer to offer incentives for the founder which costs the buyer will need to factor
into the cost of acquiring the company. This in turn will depress the aggregate consideration to
the other stockholders. Another reason that investors may resist acceleration upon a change
in control is that to the extent unvested equity is forfeited, the ownership percentages of the
other equity holders goes up proportionately. While a windfall of this nature would certainly be
a nice result to the investors even if unplanned and unanticipated, investors should not be
planning on this outcome when they make their investment decision so this rationale seems to
be without any strong, underlying principal.
The founders naturally have a different perspective. They argue that the purpose of vesting is
to keep them invested through a successful liquidity event,5 and that once this objective is
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satisfied the vesting no longer serves any meaningful purpose. Moreover they feel that their
hard efforts contribute significantly to the company's ability to attract a buyer, and the
founder should be compensated for these successful efforts and contributions. In addition,
founders will point out that they may not realize "walk away" money upon an acquisition, or
alternatively that they could retain a high level of passion and personal motivation for
additional monetary or other reasons. They may also question the validity of a rationale that
suggests that they should bear their own cost of retention post-acquisition believing that this
cost is more appropriately borne by the buyer. Finally, they may point out the conflict
described above and the fact that the forfeiture of their unvested stock benefits the investors
by increasing their ownership stake.6
Any venture firm seeking to win a deal with a group of founders that appreciate the
implications of vesting can improve their prospects with the founders by allowing the founders
to vest, either in whole or in part, if they are terminated without cause. Similarly, the terms of
a venture financing can be made more attractive to founders if their stock accelerates in whole
or in part upon an acquisition.
Reallocation of Founders Stock Among Founders Upon
Forfeiture
As discussed above, unvested stock that is forfeited by a departing founder is typically
repurchased by the company at nominal cost as a result of which all the stockholders end up
with a higher ownership percentage. But this is not the necessary result, and founders often
question whether this outcome is the right one. While certainly not common, an alternative
would be to have the stock that would otherwise be forfeited be automatically transferred to
the other founders rather than reverting back to the company. This would result in no change
in ownership to the venture capitalist, the departing founder would end up with the correct
percentage he had earned, and the remaining founders' ownership would increase.
Investors may object to this reallocation scheme for several reasons in addition to the fact
that it is not customary. Investors point out that the departing founder's stock needs to be
recaptured by the company so it can be re-deployed to find a replacement. Investors may also
feel that the reallocation approach would result in a windfall to the remaining founders who
have no greater a claim on the forfeited stock than any other stockholder. And as mentioned
above, there is also the underlying fact that investors prefer the more customary approach as
a result of which their percentage ownership would go up substantially.
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These points all have merit as do the typical founder responses. As noted above it is very
unlikely that the full block of forfeited stock would be needed to hire the departing founder's
replacement. The broader question is whether it is fair that all ownership positions, including
the investor's, should go up proportionately if a founder forfeits stock. There is no correct
answer to this question and perceptions of fairness predictably turn on whether one is an
investor or founder. The fact is that the founders allocated their stock between themselves
before the investors became involved in the business, and that such allocations were based on
the assumption that the founders were committed to the enterprise. Any founder who was not
committed or well suited to the enterprise would not have gotten as much equity at the outset
had this information been known at the time of formation. Rather, that founder's share of the
initial equity would have been allocated to the other founders who by definition accounted for
one-hundred percent of the initial equity. On this basis founders rationalize that the stock of
any founder which is forfeited should revert to the other founders and that otherwise the
investors enjoy an unfair windfall.
A venture firm seeking to do a deal with a group of founders that are sensitive to this reallocation issue can improve their prospects with the founders by allowing the founders to reallocate forfeited stock among themselves. To be clear this is by no means customary. If
investors are open to this idea but concerned about the need to attract a replacement for the
founder, a middle position can be agreed upon whereby the departing founder's forfeited stock
is re-allocated to the other founders except for that amount that is necessary to attract his
replacement. This amount would revert to the company so that it can be re-deployed for that
purpose.
Sharing the Dilutive Impact of the Option Pool
The size of the equity plan reserve required in a venture transaction is often a point of heavy
negotiation. Investors typically insist that an equity plan be established in order to attract and
retain future employees. This pool of shares is then factored into the pre-investment
capitalization when arriving at the price per share of preferred stock to be paid by the
investors.7 When calculated this way, investors are not diluted by grants out of the plan, only
the pre-existing shareholders-the founders in particular — are diluted. Founders are often
unaware of this very significant term until they learn about it in their first venture financing
and it can be a very unpleasant realization. As a result, the number of shares reserved under
the equity incentive plan is of high importance to both investors and common stockholders
alike.
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While this approach is typical, there is no requirement that the option pool dilute only the
founders in the manner described above. To improve the terms for the founders, investors
might agree that the dilutive impact of the option pool reserve will be borne by both common
stockholders and preferred stockholders equally after the funding. Alternatively, part of the
dilutive impact can be shared by the preferred stockholders.
Founder "Liquidity"
In certain venture financings, in particular later stage financings, it is not unusual for
investment proceeds to be distributed out to existing stockholders as part of a redemption
offer. This distribution of proceeds out to founders is common in early stage financings other
than in situations in which there is significant deferred salary or founder that has been used to
fund operations. But founder liquidity does not necessarily need to be reserved for later stage
venture transactions. Like most terms, this too is a matter of negotiation. Since founders are
typically very much aware of the riskiness of the business enterprise, they might well be
motivated by the offer of some liquidity. Offering founder liquidity might also result in the
investors getting more of the company which in the end might prove to be benefit for the
investors.
Summary
While some of these terms may negatively impact the return on investment with respect to
underperforming investments, if the result is that a fund includes a higher percentage of
winners in its portfolio, the overall return on investment to the fund should be improved. In
addition, developing a reputation as an investor that is "founder friendly" will result in more
deal flow in the long run.
(Footnotes to above article)
1. For example, assume a company with two founders each of whom own 50.00% of the company.
Also assume that this company completes a round of venture financing after which each of the
founders owns 25% of the company and the venture capitalist owns 50% of the company. Now
assume that one of the founders, who was also the chief technical officer, leaves the company
before all of his stock is vested as a result of which 1/2 of his stock, or 12.5% of the stock of the
company, reverts to the status of authorized but unissued stock. If this were the case, the rest of
the issued and outstanding stock, including the venture capitalists stock and the departing founder's
earned stock, would all increase as a percentage of the company by 12.5%.
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2. While beyond the scope of this article, provision can also be made for acceleration in the event of
constructive termination or what is commonly referred to as resignation for "good reason".
3. To continue the example from footnote 1, the founding CTO was terminated and forfeited 12.5%
of the capital stock of the company, but in most cases it is unlikely that the company will need to
use the full 12.5% forfeited to attract a replacement CTO for a venture backed company.
4. While outside of the scope of this article, there are a number of ways of dealing with acceleration
upon a change in control including the so-called double trigger by which stock vests only upon some
second trigger following an acquisition-typically termination without cause or resignation for good
reason. The double trigger approach really is best suited for situations in which the target option
holders are offered substantially equivalent replacement equity in the buyer. This is often not the
case such as in an all cash deal. While cash escrows can be established to mirror the continued
vesting of stock in cash deals, such arrangements can become complicated and cumbersome.
5. As a result, it is not unusual to see definitions of "acquisition" that distinguish true liquidity
events, such as an IPO or cash or public company stock acquisition, from lesser liquidity events
such as a private stock deal. Alternatively, though less common, "acquisition may be defined by
reference to a dollar threshold.
6. The investors are not the only stockholders who are potentially conflicted in this way. Any
stockholder whose stock is not subject to vesting may be conflicted as they stand to have their
ownership interests, and share of the acquisition proceeds, increase proportionately to the extent
unvested stock is forfeited.
7. For example, assume that the venture investors are putting in $5,000,000 at a $5,000,000 premoney valuation for a 50% ownership stake in the company. Further assume that the venture
investors will require a 25% option pool post-funding. These requirements imply that the "rest" of
the capitalization at the time of the funding must be comprised of 2,500,000 founder shares, and
2,500,000 shares reserved for future issuance under an equity incentive plan.
Section 83 (b) Issues:
What is an 83(b) election and how does it work in practice?
Introduction
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Founders in a startup ought to have a working knowledge of the 83(b) election and
this faq seeks to give it to them.
This is a complex tax area and what is presented here is intended only to give a
general picture of how 83(b) works. Work with skilled tax professionals in this area
to avoid the landmines.
Here is the working rule for founders: 83(b) applies only where a founder owns stock
and can potentially forfeit its economic value. Where these conditions exist, it is
normally vital that a founder file the 83(b) election within 30 days of getting the
stock grant or face potentially bad tax consequences.
That's the general picture. The tax theory and a more detailed explanation follows.
IRC Section 83 Applies to Service Providers Who Receive
Property in Exchange for Services
Section 83(b) is part of Internal Revenue Code section 83, which specifies how
service providers who receive property in exchange for their services are to be taxed
on the value of that property.
Section 83(b) is intimately connected with section 83(a) and works really only to
modify certain tax consequences that would otherwise apply to service providers
under 83(a).
Therefore, 83(b) cannot really be understand without a basic understanding of 83(a).
Section 83(a) Specifies How and When Such ServiceRelated Income Is Taxed
Under 83(a), if I get property in exchange for my services, I pay tax on the excess of
the fair market value of that property over what I paid for it.
Section 83(a) applies, then, to service providers who take property as payment for
services. Who is the major service provider in a startup? No, it is not the outside
consultant. It is the founder who works for sweat equity.
But let us take the cases in sequence.
If I am a consultant, and I get $5,000 worth of stock for my work done for a startup,
I pay tax on $5,000 worth of service income - that is, on the difference between the
worth of the stock ($5,000) and what I paid for it ($-0-). That difference is taxable
to me.
So far so good. That much is intuitive.
But 83(a) is more complex than that.
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The founder who has to earn his shares over time is also treated by the IRS as a
service provider under 83(a). The founder may pay nominal cash for the shares and
may own them, but as long as that ownership can be forfeited when the founder’s
service relationship to the startup is terminated, the IRS sees the stock as having
been granted in exchange for services.
Thus, founder grants that must be earned out (i.e., are subject to a risk of forfeiture)
fall within and are subject to tax under 83(a).
But 83(a) does not impose an immediate tax on such grants at the time they are
made. It has a special rule that taxes such grants only when they are no longer
subject to a "substantial risk of forfeiture."
It is this special rule that creates traps for the unwary in the startup context.
The Nightmare Tax Scenario for Founders
Let's assume that a founder is granted 2 million shares at $.001 per share and pays
$2,000 for them. The shares vest ratably over 4 years at the rate of 1/48th per
month. How does 83(a) apply to this scenario? Under 83(a), the tax authorities see
the grant initially as being 100% "subject to a substantial risk of forfeiture." Thus, no
tax arises at the outset. But what then happens each month as 1/48th of the shares
vest? Well, those shares are no longer subject to any risk of forfeiture as they vest.
Under 83(a), then, each incremental vesting event creates a potentially taxable
event for the founder holding such shares.
The risks to the founder may be slight at first when the stock remains priced by the
company at the $.001 per share level. But what happens on first funding? Of course,
the price of the stock goes up, often dramatically. Let’s say, after a Series A round,
the company prices its common stock at $.20 per share. Once that happens, under
83(a) the founder holding the original grant is required to pay tax at each of his
vesting points.
How is he taxed? On the difference between the then fair market value of the stock
which has just vested (because the forfeiture restrictions lapsed as to that stock), on
the one hand, and the price he paid for that stock, on the other. In our example, this
would mean the founder realizes taxable income on the difference between $.20 per
share and $.001 per share for each of the shares that vest each month. If another
funding occurs, and the common stock is re-priced to $1.00 per share, then all of the
founder’s shares that vest after that re-pricing event trigger a tax on the difference
between $1.00 per share and $.001 per share. In other words, the founder finds
himself in the middle of a potential tax nightmare. With each of his multiple
remaining vesting points, he faces a new and potentially large tax hit. He would have
12 taxable events during the final year alone of his vesting cycle and (assuming the
common stock were valued at $1.00 per share during that period) would realize
taxable income of just a shade under $500,000 - all for the privilege of holding a
piece of paper which he could not liquidate even if he tried!
With this background, we can understand the importance and the essence of an
83(b) election.
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Section 83(b) Comes to the Rescue
While 83(a) sets out the general rules for how service providers are taxed when they
exchange services for stock, 83(b) gives them an out from the nightmare tax
scenario just noted.
Under 83(b), a recipient of stock that is subject to a substantial risk of forfeiture can
make a one-time election to have his entire interest taxed once-and-for-all at
inception instead of having it taxed incrementally over time as the restrictions on
forfeiture lapse.
This means that, if the founder mentioned above makes a timely 83(b) election on
his 2 million share grant, he elects to pay tax on the difference, as of the date of
grant, between the fair market value of the property received (i.e., the stock, valued
at $.001 per share), on the one hand, and the amount he paid for it ($.001 per
share), on the other. In other words, the founder will pay tax on the difference
between the $2,000 that the stock is worth and the $2,000 he paid for it. Since there
is no difference between the two, the tax is $-0-. This 83(b) process is in lieu of the
83(a) treatment that would otherwise apply and eliminates the nightmare tax
scenario discussed above.
With the 83(b) election once made, the founder pays no tax on the grant at inception
and incurs no taxable income as the shares vest over time. His holding period
commences at inception for capital gains purposes and the only tax that would apply
to such shares would be a capital gains tax at the time of sale.
So much for theory.
Tips for How 83(b) Applies in Practice
What does this mean in practice for founders?
1. Many founders
their stock grants
required in cases
which is a form
termination of his
routinely assume they need to do 83(b) filings in connection with
because "that is how startups work." In fact, 83(b) filings are only
where the founder grants consist of so-called "restricted stock,"
of stock where the founder’s stock is subject to forfeiture on
service relationship with the company.
2. If unrestricted stock grants are made to founders or others, 83(b) elections do not
apply because the stock is not subject to a substantial risk of forfeiture.
3. While not often used in startups, in conventional buy-sell agreements, if a
company can buy back even the vested stock of a departing founder at its fair
market value on termination of a service relationship, 83(b) doesn't apply. If the
buy-back is at fair market value, there is no substantial risk of forfeiture of the
economic value of the stock. Thus, no 83(b) filing is necessary.
4. When a startup grants stock options to its key people, vesting is almost invariably
used. Options in themselves are subject to a complex set of tax rules but 83(b) has
no bearing on any of them except for one special case. If options are granted to key
people who are given the right to exercise them early, and such right is in fact
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exercised, such recipients will get stock that is subject to forfeiture in the event they
do not earn it out through a prescribed period of service. Because of the risk of
forfeiture, an 83(b) election needs to be filed at the time such options are exercised
or these recipients may wind up being taxed incrementally at every vesting point,
just as described in the example above with the founder. Apart from this special case
of early-exercise options, 83(b) does not apply to stock options.
5. Not every 83(b) election will wind up benefitting the service provider. Sometimes
an employee in a mature startup is granted restricted stock at a steeply discounted
price and that employee, by filing an 83(b) election, elects to pay an immediate tax
on the spread between the market value of the stock and the discounted price paid.
During the bubble era, such grants were often made anticipating that the recipient
would profit after a company went public. In such a case, the recipient may wind up
paying a substantial tax in connection with making the 83(b) election - a tax paid, in
essence, for the privilege of holding a piece of paper. If the company then fails, the
83(b) election in such a case can lead to payment of a gratuitously high tax for
nothing (a tax payment which is not deductable either). An 83(b) election needs to
be made very carefully whenever a significant tax becomes due upon its making.
6. Procedurally, an 83(b) election must be made within 30 days of the date of grant.
This is done by a filing with the IRS. The election must be signed by the recipient
and any spouse. The taxpayer must also file a copy of the 83(b) election with his tax
return for that year. These rules are strict and must be complied with to the letter.