Negotiating the Term Sheet

Negotiating the Term Sheet

Springboard: New England Bootcamp

October 13, 2004

Common Vs. Preferred Stock• Management tends to hold common stock

– Founders stock – Options

• Professional investors, both angels and venture capitalists, want preferred stock– More control over decisions– Better economic terms

• Interests of common and preferred differ and management will be negotiating against venture investors during financing or sale of company– Every new round of financing dilutes founder shares

Objectives

• The purpose of the presentation is to – Provide an understanding of the

common methods used by preferred investors to protect their investment

– Look at the impact of the terms on common shareholders

– Make you an educated negotiator

Preferred Stock ProvisionsLiquidation Preference

– In the event of liquidation or sale, preferred stockholders are entitled to amount of original purchase price (or some multiple) before common shareholders

– Participating preferred continues to participate with common on “as converted” basis

– If not enough cash to pay all preferred at original price, share pro rata with other preferred stockholders (though priority issues among different series of preferred)

Concerns of Common Stockholders– If payout to preferred stockholders is very high before any payments to

common stockholders, will management continue to be motivated?

Preferred Stock Provisions (cont.)Anti-dilution Protection

– If the company issues new shares at a price below the conversion price of the preferred stock, the conversion price is adjusted to eliminate the dilutive effects of the new stock, although “pay-to-play” requires investors to keep investing to maintain this provision

– This gives more shares on conversion: full ratchet (adjust at last round price) vs. weighted average

Concerns of Common Stockholders– Market conditions may require a “down round”, but unless

“pay-to-play” clause, preferred shareholders get more shares without contributing more cash

Anti-Dilution ExampleFull RatchetFirst Round: $2 millionConversion price: $2/shareCommon shares on conversion: 1,000,000

Second Round: $1 millionConversion price: $1/shareCommon shares on conversion: 1,000,000

New conversion price First Round: $1.00Additional shares 1,000,000Total shares on conversion: 3,000,000

Weighted Average RatchetFirst Round: $2 millionConversion price: $2/shareCommon shares on conversion: 1,000,000

Second Round: $1 millionConversion price: $1/shareCommon shares on conversion: 1,000,000

New conversion price First Round: $1.50Additional shares 333,333Total shares on conversion: 2,333,333

Preferred Stock Provisions (cont.)

Participation in Future Rounds of Financing– Preemptive Right - the preferred stockholders have the right

to maintain their pro rata interest in the company– Right of First Offer - the preferred stockholders as a whole

can take the entire amount of the financing

Concerns of Common Stockholders– This provision limits the flexibility to bring in new

stockholders that might add more value than existing preferred stockholders


Right of First Refusal– In the event of sale of new equity, the company

must first offer the shares to preferred stockholders to allow them to maintain their pro rata interest

– This is the opposite of Liquidation Preference Concerns of Common Shareholders

– This provision limits the flexibility to bring in new shareholders that might add more value than existing preferred stockholders

Preferred Stock Provisions (cont.)Dividends

– Cumulative - dividends may accrue at some fixed rate until paid (typically upon liquidation or redemption, sometimes conversion)

– When and If Declared - dividends may be paid at a specific rate only when and if declared by the Board

– Parri Passu with Common - no cash dividends paid to common stockholders unless the preferred stockholders receive comparable dividend on an “as converted” basis

Concerns of Common Stockholders– Common stockholders stand behind preferred stockholders when

sharing profits. If dividends accrue, may be difficult for common to get any return.

Preferred Stock Provisions (cont.)Protective Provisions

– Long list of items must be approved by 51- 67%(or more) of preferred stockholders, including: sale, merger or liquidation of company; sale of shares with equal or more rights; issuance of debt over some $ amount; increase in board size; amendment to charter; payment of dividends on common, etc.

– Preferred stockholders may elect majority of board seatsConcerns of Common Stockholders

– Takes some control away from management and puts preferred stockholders in position to block certain transactions, including the sale of the company


Voting Rights– Preferred stockholders have right to vote shares

on an “as converted” basis – Except for election of directors and Protective

Provisions, vote with common as single class

Concerns of Common Stockholders– Preferred stockholders have rights of ownership

as well as benefits of priority over common

Preferred Stock Provisions (cont.)Redemption - May be Optional or Mandatory

– Company must repurchase preferred stock (generally in annual installments) at election of preferred after some period of time (typically 3-6 years), or upon a date certain, at the redemption price (e.g., original purchase price plus dividends or some stated fixed return)

– Penalties for failure to redeem (reduction in conversion price, control of the Board)

Concerns of Common Stockholders– This provision treats preferred stock like debt, which needs

to be paid back with interest


Automatic Conversion– Preferred stock always has right to convert to common stock

at any time, and will automatically convert into common stock upon IPO above certain dollar amount and share price. However, if dollar thresholds not met, IPO must be approved by preferred stockholders

Concerns of Common Stockholders– Unless company can meet required dollar amount and share

price of IPO, preferred can hold up offering and demand special rights


Rights of First Refusal/Co-Sale on Founder Sales– Right of First Refusal - if Founder receives bona fide 3rd

party offer for his or her shares, the preferred stockholders have the right to purchase shares on the same terms as the 3rd party

– Co-Sale Rights - the preferred stockholders can sell on a pro rata basis some of their shares to the 3rd party

Concerns of Common stockholders– This may limit the ability of Founders to attract willing buyer

for their stock


Drag-Along Right– Typically requires all stockholders to vote for and participate

in any sale transaction approved by a specified percentage of the preferred stock

Concerns of Common stockholders– Allows preferred stockholders to force a sale of the company

which may be on terms that do not provide any return to the common stockholders


Vesting of Founders’ Stock– Preferred stockholders may impose vesting restrictions on

Founders’ stock such that if the Founder leaves the company before her stock has fully vested, the company may repurchase the unvested shares at their original cost

Concerns of Common Stockholders– Founders want to be rewarded for their sweat equity and prefer

that at least a portion of their stock be vested immediately. What happens in the event of termination without cause or death or disability? What is the right vesting period? Timely 83(b) tax filings are critical.


Registration Rights– Even after conversion to common in an IPO,

preferred stockholders may have rights requiring the company to register their common shares for sale and pay their expenses

Concerns of Common Stockholders– The sale of these shares can depress stock price

and compete with company in raising funds

Impact of Options• Venture rounds can reduce management equity

and often compensate with large option packages• Must balance management ownership/dilution• Investors consider stock options when looking at

shares outstanding• Investors focus on “overhang” or options granted

but not exercised as percentage of total shares• If overhang is too high, it may be difficult for

company to sell new shares

Other Agreements• Repurchase Agreement:

– Management/employees agree to sell shares back to company if leave before certain date

– Concern: may lose benefit of sale or IPO

• Tag-Along Agreement:

– Management agrees will not sell stock without giving other investors right to pro rata participation in sale

– Concern: Need to find buyer for more stock

Other Agreements (cont.)

• Warrant Agreement:– Investors get the right to buy stock at a set

price. Can be contingent on certain conditions such as company not meeting numbers.

– Concern: Additional dilution with no up-front cash put into company

Negotiating Term Sheet

• Some terms are entirely non-negotiable

• Others depend on competitive situation

• Best case: receive several term sheets and see who is offering best deal

• Need good venture lawyer

• Make the term sheet as complete as possible

• Do not want any surprises in documents

Negotiating the Term Sheet

Documents

Transcript of Negotiating the Term Sheet