Commonly Negotiated Terms in Venture Fundraising
During the course of your discussions with early investors looking at your venture company, you will have to come to an agreement on some important topics, such as how much money you’ll raise right now, how much the company is worth, who’s in charge of major decision making, and who gets paid first when the company is sold.
In ten years, after your company is bought by an industry giant, these are the terms that you’ll either be thankful for or wish you had done differently.
Amount of investment
Two main values are listed here: the amount of capital being raised and the percentage of the company that the investor will own after the investment has occurred. If a regularly scheduled return is expected, generally in the form of a dividend, that would be discussed in this section. (Dividends are a distribution of profits to all shareholders based on a set percentage per share. Some companies have dividends for shareholders, and some do not.)
Determining how much of the company to sell to the investor in exchange for his or her investment is a hard thing to do. You have to determine how much your company is worth before the investment occurs. This is called pre-money valuation.
Liquidation preferences describe who gets paid first when the company is sold. Liquidation can occur when the company is dying and any assets are sold to cut losses. Terms to consider in this section include investor preference, participation, and multiples:
Preference: Describes the order in which the stockholders get paid back when the company sells. People holding preferred stock typically get their invested money back before everyone else.
Participation: Describes whether the stockholder is eligible to get paid back in a certain way.
Multiples: Describes how much of the initial investment the stockholder is eligible to get back in the preferred payout. Sometimes its only 1X (“1 times), but it can be higher. Although it can happen, seeing a multiple over 2X in today’s market is rare.
Board of directors
The board of directors has the right to make big decisions about the fate of the company. The board approves budgets and acts as the boss for the CEO. This part of the term sheet defines who gets representation on the board.
This line item can be more important than the pre-money value of the company but is sometimes overlooked, even though what’s determined here has important implications. If the board is made up entirely of people elected by the investors, then the investors control the company. If the investors don’t get representation on the board, they have no control over the company.
Protective provisions allow shareholders to block certain actions in the company, akin to veto power. These provisions require a vote by a subset of shareholders before the company can go forward with a large decision. Here are some standard provisions addressing the major issues of company structure and ownership:
Selling the company assets, merging, or being acquired
Change the number of shares in the company
Redeeming or repurchasing stock shares
Changing the number of board members
Taking on any new significant debt
Changing the dividends for any class of stock
When any of these events are proposed, the people holding the protected stocks get to vote to determine whether the event will actually occur.
Although most protective provisions are reasonable, some past protective provisions block any new deals from happening with a company. In one case, the investor required that she approve all checks over $1,000, which put an operational stranglehold on the company and was a red flag to investors.
Companies that intend to raise multiple rounds of funding have to reassure early investors that future investment rounds won’t dilute their investment. This dilution most often happens in down rounds (the stock is at a lower price than in the previous round) or flat rounds (the stock is at the same price as the previous round).
A lower share price can happen because the company’s value decreased. Following are two main ways that a company’s shares would be lower in the current round than in previous rounds:
The company’s value was artificially high due to a misunderstanding of company valuation, investor speculation, or a bubble in the economy.
The company has lost value due to poor performance or poor management.
With full ratchet anti-dilution, an investor who purchased shares in a Series A round receives additional shares if a subsequent round comes in at a lower price.
A few problems exist with full-ratchet anti-dilution, most notably that, if the company is experiencing a down-round, investors will be hesitant to come in if all of the previous investors are receiving additional shares. The Series B investors are effectively being diluted before they even invest.
The second challenge is that if the company is not doing well, the Series B may be much smaller. So even if the company raises only $100,000 in a Series B that follows a $2 million Series A round, then all of that Series A stock will double, even though it is disproportionately large relative to the new stock issuance. Weighted-average anti-dilution is one way around this problem.
Weighted average anti-dilution
Weighted-average dictates that if the Series B is smaller than the Series A, then Series A shares will increase only in proportion to the size of the Series B raise.
Although you can go through the math if you like (it involves a rather ugly formula; see the nearby sidebar entitled “Weighted-average anti-dilution math”), the important part is that, with weighted average anti-dilution, your shares will only go down in value in proportion to the amount of new capital raised
If your company is successful in going through multiple rounds of financing, you may see a pay-to-play term in the term sheet. Pay-to-play refers to situations where first round investors need to continue making investments in future rounds in order to maintain their current percent of ownership.
Various scenarios can happen in which investors can pay for only a portion of their pro rata round or where they may want to be able to assign that right to others. In many cases, if the investor doesn’t participate in the next round, her stock will convert from preferred to common stock.
The drag-along agreement comes into play when a majority of preferred stockholders want to sell or liquidate the company either through an initial public offering (IPO), merger, or acquisition.
When the majority want to do the deal but the founders, who may now be minority stockholders, do not, the majority has the right to “drag” the minority along into the deal whether the minority wants to do it or not. This investor-friendly term prevents the founders from turning the company into a low-growth company (or lifestyle company) with no hope for a liquidity event for the investors.
Usually you see a no-shop agreement only with VCs, although some angel groups require them as well. The agreement says that if you sign the term sheet, you agree not to continue to look (or shop) for financing with other investors until either your deal is declined, your deal is funded, or a set period of time elapses.
The reason for this agreement is that, at a certain point, the investor will be investing time and money through legal and due diligence work; she wants to make sure that when she’s ready to invest you won’t have given the deal to another investor.