Founder’s Guide: Series A
- Introduction
- What Is a Series A Round?
- The NVCA Series A Term Sheet
- Security
- Closing Date
- Conditions to Closing
- Investors
- Amount Raised
- Valuation
- Dividends
- Liquidation Preferences
- Full Participation
- Capped Participation
- Voting Rights
- Anti-dilution
- Conversion
- Mandatory Conversion
- Pay to Pay
- Registration Rights
- Management and Information Rights
- Pro Rata Rights
- Special Board Approval
- Non-Competition, Non-Solicitation, Assignment
- Board Matters
- Employee Stock Options
- Right of First Refusal/Right of Co-Sale
- Board of Directors
- Drag Along
- No Shop/Confidentiality
Introduction
Over the past decade, I’ve worked with hundreds of early-stage entrepreneurs to help them move from concept to scale. In that time, I’ve been legal counsel to startups in various industries from food to fashion and ed tech to e-commerce. I’ve learned a lot about raising capital along the way. My goal here is to share that experience with you in this ultimate guide to Series A financing. If you’re picking up this guide, it’s a really exciting time in the life of your startup. You’ve built something that’s working, and you’re looking to grow it. Most entrepreneurs never even make it to this point. Way to go! Since your Series A is often the first time your company will be working from the National Venture Capital Association (NVCA) documents, it’s important to understand the structure and mechanics of the deal. Deal terms can sometimes feel like a foreign language, which is especially daunting for first-time entrepreneurs. Not to worry. I’ll translate for you, and in the process, I’ll help you move from confusion to clarity. This guide will walk you through the NVCA Series A term sheet point-by-point. You can read the whole thing sequentially, or just skip to the section that is relevant to you. My goal is not to be comprehensive here, so this is not legal advice. Rather the goal is to give you base-level understanding so that you can have an informed conversation with your counsel and investors.
What Is a Series A Round?
The next round of equity financing after the Seed Round is a Series A. Generally speaking, a startup has demonstrated product market fit and has some traction in the form of user growth and/or revenue. The Series A funding is about trying to scale the product and the team in order to take the company to the next level. There are a lot of macro-economic and company specific variables. However, in a Series A, the startup will commonly raise between $10 million and $20 million. The investor base will be almost exclusively professional venture capital firms, though a few strategic angels may be involved.
The NVCA Series A Term Sheet
Most Series A rounds in the United States are based on the model NVCA documents. This standard set of documents is a good starting point for negotiations, but there will be many revisions along the way. In the end, the total document set will be hundreds of pages. So, it’s important for founders to have counsel that’s familiar with NVCA docs in order to draft and negotiate on their behalf .
Founders do not need to know every paragraph in the document set. However, it is essential that they have a clear understanding of the term sheet. The Series A term Sheet is a summary of the deal. A founder that understands the term sheet will be able to advocate for themselves in negotiations and clearly communicate their wishes to their counsel.
Below is a standard term sheet based on the model documents on the NVCA website. I will break down terms sequentially.
TERM SHEET
FOR CONVERTIBLE FOR SERIES A PREFERRED STOCK FINANCING OF
[[INSERT COMPANY NAME]], INC.
[__________, 20__]
This Term Sheet summarizes the principal terms of the Series A Preferred Stock Financing of [___________], Inc., a [Delaware] corporation (the “Company”). In consideration of the time and expense devoted and to be devoted by the Investors with respect to this investment, the No Shop/Confidentiality provisions of this Term Sheet shall be binding obligations of the Company whether or not the financing is consummated. No other legally binding obligations will be created until definitive agreements are executed and delivered by all parties. This Term Sheet is not a commitment to invest and is conditioned on the completion of the conditions to closing set forth below. This Term Sheet shall be governed in all respects by the laws of [___________].
Offering Terms
| Security: |
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| Closing Date: | As soon as practicable, following the Company’s acceptance of this Term Sheet and satisfaction of the conditions to closing (the “Closing”). [Provide for multiple closings, if applicable.] | |
| Conditions to Closing: | Standard conditions to Closing, including satisfactory completion of financial and legal due diligence, qualification of the shares under applicable Blue Sky laws, and the filing of a Certificate of Incorporation establishing the rights and preferences of the Series A Preferred. | |
| Investors: | Investor No. 1: [_______] shares ([__]%), $[_________] Investor No. 2: [_______] shares ([__]%), $[_________] [As well other investors mutually agreed upon by Investors and the Company] |
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| Amount Raised: | $[________], [including $[________] from the conversion of SAFEs/principal [and interest] on bridge notes] | |
| Pre-Money Valuation: | The price per share of the Series A Preferred (the “Original Purchase Price”) shall be the price determined on the basis of a fully diluted, pre-money valuation of $[_____], which pre-money valuation shall include an [unallocated and uncommitted] employee option pool representing [__]% of the fully diluted, post-money capitalization and a fully-diluted post-money valuation of $[______]. |
[Signatures on next page]
CHARTER
| Dividends: |
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| Liquidation Preference: | In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows: First, pay one times the Original Purchase Price [plus [accrued and] declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock. A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) or a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above unless the holders of more than 50% of the Series A Preferred elect otherwise (the “Requisite Holders”). [The Investors’ entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow or indemnity holdback in connection with a Deemed Liquidation Event. | |
| Voting Rights: | The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) so long as 100,000 of the shares of Series A Preferred issued in the transaction are outstanding, the Series A Preferred as a separate class shall be entitled to elect one (1) member of the Board of Directors ([each a] “Preferred Director”), (ii) as required by law, and (iii) as provided in “Protective Provisions” below. The Company’s Charter will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock. | |
| Protective Provisions: | So long as 100,000 shares of Series A Preferred issued in the transaction are outstanding, in addition to any other vote or approval required under the Company’s Charter or Bylaws, the Company will not, without the written consent of the Requisite Holders, either directly or by amendment, merger, consolidation, recapitalization, reclassification or otherwise: (i) liquidate, dissolve or wind-up the affairs of the Company or effect any Deemed Liquidation Event; (ii) amend, alter, or repeal any provision of the Charter or Bylaws in a manner adverse to the Series A Preferred Stock; (iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security unless the same ranks junior to the Series A Preferred with respect to its rights, preferences and privileges, or increase the authorized number of shares of Series A Preferred; (iv) sell, issue, sponsor, create or distribute any digital tokens, cryptocurrency or other blockchain-based assets without approval of the Board of Directors; (v) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, other than stock repurchased at cost from former employees and consultants in connection with the cessation of their service, or as otherwise approved by the Board of Directors; or (vi) create or authorize the creation of any debt security[, if the aggregate indebtedness of the Corporation and its subsidiaries for borrowed money following such action would exceed $100,000 other than equipment leases, bank lines of credit or trade payables incurred in the ordinary course unless such debt security has received the prior approval of the Board of Directors; or (vii) create or hold capital stock in any subsidiary that is not wholly owned, or dispose of any subsidiary stock or all or substantially all of any subsidiary assets. |
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| Optional Conversion: | The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events, and as described below under “Anti-dilution Provisions.” | |
| Anti-dilution Provisions: | 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 = Series A Conversion Price in effect immediately after new issue 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 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) B = Aggregate consideration received by the Company with respect to the new issue divided by CP C = Number of shares of stock issued in the subject transaction The foregoing shall be subject to customary exceptions, including, without limitation, the following: (i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred; (ii) securities issued upon the conversion of any debenture, warrant, option or other convertible security; (iii) Common Stock issuable upon a stock split, stock dividend or any subdivision of shares of Common Stock; (iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors, and other customary exceptions. |
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| Mandatory Conversion: |
Each share of Series A Preferred will automatically be converted into Common Stock at the then-applicable conversion rate in the event of the closing of a firm commitment underwritten public offering [with a price of [___] times the Original Purchase Price] (subject to adjustments for stock dividends, splits, combinations and similar events) and [gross] proceeds to the Company of not less than $[_______] (a “QPO”), or (ii) upon the written consent of the Requisite Holders. |
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| Pay-to-Play: |
Unless the Requisite Holders elect otherwise, on any subsequent round, all holders of Series A Preferred Stock are required to purchase their pro rata share of the securities set aside by the Board of Directors for purchase by such holders. All of the shares of Series A Preferred of any holder failing to do so will automatically convert to Common Stock and lose corresponding preferred stock rights, such as the right to a Board seat if applicable. |
STOCK PURCHASE AGREEMENT
| Representations and Warranties: |
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| Counsel and Expenses: | Company counsel to draft applicable documents. Company and Investor shall each pay their own legal costs. Company to pay all administrative costs of the financing. |
INVESTORS’ RIGHTS AGREEMENT
Registration Rights:
| Registrable Securities: |
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| Demand Registration: | Upon earliest of (i) three (3) to five (5) years after the Closing; or (ii) six (6) months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [one][two] (consummated) registrations by the Company of their shares. The aggregate offering price for such registration may not be less than $[5-15] million. A registration will count for this purpose only if (i) all Registrable Securities requested to be registered are registered, and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company). | |
| Registration on Form S-3: | The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company, Registrable Securities for an aggregate offering price of at least $[3-5 million]. There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than two (2) per twelve (12)-month period. | |
| Piggyback Registration: | The holders of Registrable Securities will be entitled to “piggyback” registration rights on all registration statements of the Company, subject to the right of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [20-30]% on a pro rata basis and to complete reduction on an IPO at the underwriter’s discretion. In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced. | |
| Expenses: | The registration expenses (exclusive of stock transfer taxes, underwriting discounts and commissions) will be borne by the Company. The Company will also pay the reasonable fees and expenses, not to exceed $[______] per registration, of one special counsel to represent all the participating stockholders. | |
| Lock-up: | Investors shall agree in connection with the IPO, if requested by the managing underwriter, not to sell or transfer any shares of Common Stock of the Company held immediately before the effective date of the IPO for a period of up to 180 days following the IPO (provided all directors and officers of the Company [and [1 – 5]% stockholders] agree to the same lock-up). [Such lock-up agreement shall provide that any discretionary waiver or termination of the restrictions of such agreements by the Company or representatives of the underwriters shall apply to Investors, pro rata, based on the number of shares held.] | |
| Termination: | [Upon a Deemed Liquidation Event [in which similar rights are granted or the consideration payable to Investors consists of cash or securities of a class listed on a national exchange]] [and/or after the IPO, when the Investor and its Rule 144 affiliates holds less than 1% of the Company’s stock and all shares of an Investor are eligible to be sold without restriction under Rule 144 and/or] [T][t]he [third-fifth] anniversary of the IPO. No future registration rights may be granted without consent of the holders of [a majority] of the Registrable Securities unless subordinate to the Investor’s rights. |
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| Management and Information Rights: | A Management Rights letter from the Company, in a form reasonably acceptable to the Investors, will be delivered prior to Closing to each Investor that requires one. Any [Major] Investor (who is not a competitor) will be granted access to Company facilities and personnel during normal business hours and with reasonable advance notification. The Company will deliver to such [Major] Investor (i) annual, quarterly [and monthly] financial statements, and other information as determined by the Board of Directors; [and] (ii) thirty days prior to the end of each fiscal year, a comprehensive operating budget forecasting the Company’s revenues, expenses, and cash position on a month-to-month basis for the upcoming fiscal year[; and (iii) promptly following the end of each quarter, an up-to-date capitalization table]. [A “Major Investor” means any Investor who purchases at least $[______] of Series A Preferred.] |
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| Right to Participate Pro Rata in Future Rounds: | All [Major] Investors shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans), to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet and shares issued in an IPO). In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares. | |
| Matters Requiring Preferred Director Approval: | So long as the holders of Series A Preferred are entitled to elect a Director, the Company will not, without Board approval, which approval must include the affirmative vote of [at least one/each of] the then-seated Preferred Directors: (i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including any employee or director, except advances and similar expenditures in the ordinary course of business [or under the terms of an employee stock or option plan approved by the Board of Directors]; (iii) guarantee any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; [(iv) make any investment inconsistent with any investment policy approved by the Board of Directors]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) hire, fire or change the compensation of the executive officers, including approving any option grants; (vii) change the principal business of the Company, enter new lines of business or exit the current line of business; (viii) sell, assign, license, pledge or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; or (ix) enter into any corporate strategic relationship involving the payment contribution or assignment by the Company or to the Company of assets greater than [$________].] |
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| Non-Competition Agreements: | Founders and key employees will enter into a [one] year non-competition agreement in a form reasonably acceptable to the Investors. | |
| Non-Disclosure, Non-Solicitation and Developments Agreement: | Each current, future and former founder, employee and consultant will enter into a non-disclosure, non-solicitation and proprietary rights assignment agreement in a form reasonably acceptable to the Investors. | |
| Board Matters: | [Each Board Committee/the Nominating and Audit Committee shall include at least one Preferred Director.] Company to reimburse [nonemployee] directors for reasonable out-of-pocket expenses incurred in connection with attending Board meetings. The Company will bind D&O insurance with a carrier and in an amount satisfactory to the Board of Directors. Company to enter into Indemnification Agreement with each] Preferred Director with provisions benefitting their affiliated funds in a form acceptable to such director. In the event the Company merges with another entity and is not the surviving entity, or transfers all of its assets, proper provisions shall be made so that successors of the Company assume the Company’s obligations with respect to indemnification of Directors. | |
| Employee Stock Options: | All [future] employee options to vest as follows: [25% after one year, with remaining vesting monthly over next 36 months]. |
RIGHT OF FIRST REFUSAL/CO-SALE AGREEMENT
| Right of First Refusal/ Right of Co-Sale (Take-Me-Along): : |
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VOTING AGREEMENT
| Board of Directors: | At the Closing, the Board of Directors shall consist of [______] members comprised of (i) [name] as [the representative designated by [____], as the lead Investor, (ii) [name] as the representative designated by the remaining Investors, (iii) [name] as the representative designated by the Common Stockholders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the other directors]. |
| [Drag Along: | Holders of Preferred Stock and all current and future holders of greater than [1]% of Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options) shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred and which is approved by [the Board of Directors] the Requisite Holders [and holders of a majority of the shares of Common Stock then held by employees of the Company (collectively with the Requisite Holders, the “Electing Holders”), so long as the liability of each stockholder in such transaction is several (and not joint) and does not exceed the stockholder’s pro rata portion of any claim and the consideration to be paid to the stockholders in such that a transaction will be allocated as if the consideration were the proceeds to be distributed to the Company’s stockholders in a liquidation under the Company’s then-current Charter, subject to customary limitations.]] |
OTHER MATTERS
| No-Shop/Confidentiality: | The Company and the Investors agree to work in good faith expeditiously toward the Closing. The Company and the founders agree that they will not, for a period of [______] days from the date these terms are accepted, take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company [or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company] and shall notify the Investors promptly of any inquiries by any third parties in regard to the foregoing. The Company will not disclose the terms of this Term Sheet to any person other than employees, stockholders, members of the Board of Directors, and the Company’s accountants and attorneys and other potential Investors acceptable to [_________], as lead Investor, without the written consent of the Investors (which shall not be unreasonably withheld, conditioned or delayed). |
| Expiration: | This Term Sheet expires on [_______ __, 20__] if not accepted by the Company by that date. |
Security
The securities being issued in this round will be shares of Series A preferred stock in the company. The stock is preferred, which means it comes with additional rights compared to the common stock in the company most commonly held by founders. Every investor in this round of funding will get the same rights, which are generally negotiated by the lead investor. The rest of the term sheet summarizes those preferences. Then they are finalized in the document set.
For some startups, this will be the second time they will be issuing preferred shares, as they may have raised their seed round on the Series Seed docs. (For a full overview, see the Founder’s Guide to Seed Funding.) For some startups, this will be the first time they’re issuing preferred shares to investors, as it has become more common to raise pre-seed and seed funding on SAFEs. (For a full overview, see the Founder’s Guide to SAFE.)
Closing Date
The closing date is the date that the round of funding is finalized. It will be the date in which the investors execute the investment documents and wire the money. There’s always a flurry of activity happening right before close as last-minute issues seem to come up in almost every round of funding. So, founders may want to build in a little buffer when you set this date. For instance, if you think you can close by February 1, you may want to set February 5 or 10 as the official closing date, while still pushing your counsel to have everything ready by February 1.
Conditions to Closing
Before a deal closes, there are often a number of conditions that need to be met. Some are legal in nature; some are not. The conditions listed in this term sheet are fairly standard.
Satisfactory completion of financial and legal due diligence—Typically, after the investor has signed the term sheet but before the deal is closed, they will want to conduct a more in-depth review of the company to understand its health. The due diligence process includes financial analysis, team, intellectual property, key contracts and ensuring that your current legal documents are in good shape, among other things. Click here to see what a typical Series A Due Diligence Checklist looks like.
Qualification of the shares under applicable Blue Sky laws—This means that the shares have been filed with the relevant state securities offices.
Filing of a Certificate of Incorporation —This will increase the number of shares in the company, as well as establish the rights and preferences of the Series A Preferred.
Investors
The investors listed in the term sheet are generally the lead investors of the Series A. If there is a co-lead or other known investors, their names may appear in this section. In some cases, the lead investor will request approval of all other investors in that round. Founders should resist this term if possible as it’s best to have complete control over who you want or don’t want on your cap table.
Amount Raised
The Amount Raised refers to the total amount of capital the company is intending to raise in this round of financing. In many cases, the total amount raised will include any SAFEs or convertible notes (Convertible Securities) that are converted into equity in the Series A.
Convertible Securities that convert in a Series A are often converted in a “shadow series” or “subseries” of preferred stock. This shadow series is often labeled A-2 to distinguish itself from the series of preferred stock issued to the new investors. This shadow series is usually identical to the new round security except with respect to the amount received on liquidation.
Valuation
The valuation is the value of the company agreed on between the investor and the founder. The valuation is often the most hotly contested and heavily negotiated term in the term sheet. When a founder and investor agree to exchange a fixed amount of money for a fixed amount of ownership in a company, the investor is setting the price per share.
The price per share can be expressed in a number of ways.
- Price Per Share—Sometimes the term sheet will state the price per share (ex. $2.19 per share) explicitly in the term sheet.
- Percent of Ownership—In other cases, the term sheet will state the percentage of ownership in the company that the investors will take. For instance, it may say “an aggregate of $20 million, representing a 20% ownership position on a fully diluted basis.”
- Valuation—In most cases, the term sheet will include a valuation of the company.
The valuation may be expressed in two ways: pre-money and post-money. The pre-money valuation refers to what the investor is valuing the company prior to the investment. On the other hand, the post-money valuation is the value the investor is assigning to the company once the round has closed. To calculate the post-money valuation, simply take the pre-money valuation and add the amount raised in this round.
When an investor says, “I’ll invest $X at $Y valuation,” they usually mean the post-money valuation. At the same time, the founder often understands the valuation as pre-money. As you’ll see below, the interpretation of the valuation matters:
$20 million at a $100 million post-money valuation would result in the investors owning 20% of the company.
$20 million at a $100 million pre-money valuation would result in the investors owning 16.67% of the company.
Most negotiations begin verbally, so it’s important for founders to explicitly state that the valuation is pre-money or post-money. Founders that eliminate the ambiguity on this term up front demonstrate that they have an understanding of the basic terms of the deal and earn the respect of the investors in the process.
The next key provision in this term is the employee pool. In most cases, a decent amount of the money raised in a Series A will go toward building out a team to help scale the product. As a founder, you’ll want to hire top-tier talent. Since most startups can’t compete with established companies on salary, they’ll need to attract talent by granting them stock in the company. It’s in the founder’s and investor’s interest to ensure that the company has enough stock to incentivize future hires. The stock set aside to compensate these employees is known as the employee stock option pool, employee pool or option pool.
A large option pool may seem like a good idea. However, founders should be aware that the option pool impacts the effective pre-money valuation of the company. This is a common way for investors to negotiate the valuation down through the back door.
Founders should run the numbers to understand how the size of the pool is diluting their ownership in the company before they commit to the size of the employee pool. Every company is different, so there’s no hard and fast rule of what size the employee pool should be. A 10% option pool is fairly normal for a Seed and Series A round, but the percentage falls in subsequent rounds. An average Series B is around 7%, Series C 6% and Series D 5%.
Dividends
Dividends are payments made to investors from the profits of the company. They are seen as an inducement to buy and hold a certain company’s stock in the public markets. But they rarely come into play in startups. After seeing the dividends term, an uninitiated investor or founder might believe that the company must pay a dividend to the investor. However, this is rarely the case.
There are two key points in a Series A dividends provision. First, the company has no obligation to pay dividends. Second, if the company decides to pay dividends, the Series A stockholders will participate alongside the common stockholders. This term doesn’t force the company to pay dividends; it ensures that if the company decides to pay dividends, they must also pay them to the Series A investors.
A word of caution for founders: If you see the words “cumulative dividends” in this clause, the investor is requiring the company to pay a dividend to them. This is non-standard and should not be accepted by the founder.
Liquidation Preferences
A liquidation preference dictates the order in which investors are paid out upon a liquidity event. A liquidity event usually means the sale of a company or the majority of a company’s assets. In short, the liquidation preference determines how much the preferred shareholders will be paid from the proceeds of that liquidity event before the other shareholders are paid. It is designed to ensure that investors make money or at least break even in a liquidity event.
There are two major components in a liquidation preference:
- Preference—The money distributed to the stockholder prior to distribution to other classes of stockholders.
- Participation—Whether and how the stockholder receives the money distributed to stockholders after the preference has been paid.
Let’s first start with the preference. Preferences are stated in terms of multiples on the money an investor invested. For instance, 1x would mean the preference is for 100% of the amount invested, whereas 1.5x would mean 150% of the amount invested.
The most common liquidation preference in Series A financing is 1X. So, if an investor invested $1 million into your company at a liquidation event, they will be paid back $1 million before the common shareholders get paid back anything.
Next, let’s look at the participation. After the preference is paid to the investor, the question becomes if and how they will participate in the remainder of the distribution to shareholders. If an investor invested $1 million in your company with a 1x liquidation preference and you sold it for $21 million, then the investor would first get $1 million. But how will the other $20 million be distributed? Well, that depends on the investor’s participation right. There are three types of participation: (i) no participation, (ii) full participation and (iii) capped participation.
No Participation
No participation, commonly referred to as a nonparticipating liquidation preference, indicates that the preferred shareholders receive their liquidation preference but no additional proceeds from the liquidation event. In this instance, the investor can elect to either take the preference of their original investment or the proceeds from the sale price based on their ownership percentage in the company.
Take the example where the investor invested $1 million into a startup in exchange for 10% of the company. If the company is sold for $9 million, the investor may elect either to receive $1 million (1x the amount you invested) or 10% shares of the company, which is worth $900K (10% x $9 million). The rational choice would be to receive $1 million. However, if the company is sold for $100 million, the choice would be different. The investor can either receive $1 million or 10% shares of the company, which is worth $10 million (10% x $100 million). In that scenario, t he investor would obviously take the $10 million.
Full Participation
Full participation indicates that the investor receives their preference (the multiple of the original investment) first, then receives their percentage of the remaining proceeds from the sale. Full participation means the investor is allowed to fully participate with other shareholders on the remaining balance as common shareholders. Sometimes referred to as “double-dipping,” participating in a liquidation preference gives shareholders the right to receive payout from the proceeds pool and to “participate” in the remaining proceeds in proportion to their ownership.
For example, if an investor invested $1 million into a startup with a 1x participating liquidation preference in exchange for 20% of the ownership, and the company is sold for $2 million, then the investor will receive the first $1 million (1x the amount invested). In addition, the investor will receive 20% “participation” of the remaining balance. Twenty percent of the remaining balance ($2 million – $1 million) is $200K (20% x $1 million). In total, the investor will walk away with $1.2 million and the common stockholders—the founders and employees—will split the remaining $800K. Participating liquidation preference inflates the exit value for investors and is not founder-friendly. In general, nonparticipating liquidation preference is more common than participating in a liquidation preference at the Series A stage. Founders should negotiate hard to ensure that investors don’t get full participation.
Capped Participation
Capped participation is a variation of full participation, where the investors get to take their liquidation preference, as well as the proceeds from the sale price based on their ownership percentage, just like full participation. But the twist is that the total payout is capped at a certain amount. The cap sets the ceiling amount that an investor would receive under participating liquidation preference. For example, if an investor invested $1 million with a 1x participating liquidation preference on a 3x cap, then they will receive a maximum $3 million in total payout (3 x $1 million).
Take the scenario where the investor has invested $50 million and owns 60% of the company. The company is now faced with a $100 million acquisition. The table below illustrates how each type of liquidation preference produces a different result.
|
Type of Liquidation Preference |
Payout |
|
1x preference, nonparticipating |
Receives $60 million: ● $50 million (1 x $50 million); or ● $60 million (convert into common and take 60% of $100 million) |
|
2x preference, nonparticipating |
Receives $100 million: ● $100 million (2 x $50 million); or ● $60 million (convert into common and take 60% of $100 million) |
|
1x preference, participating |
Receives $80 million: ● $50 million (1 x $50 million); and ● $30 million ( 60%* ($100 million – $50 million)) |
|
1x preference, participating (3x cap) |
Receives $80 million: ● Same as 1x preference, participating because the company receives less than $150 million (3x cap of $50 million investment) |
Voting Rights
There are certain decisions that are so essential to the value of their investment that investors insist on approving them. The term sheet highlights a list of issues (i) – (vii) that require the approval of a majority of investors.
Since most Series A investors own around 20-25% of the startup, it is unlikely that they would be able to influence the majority when voting on an as-converted basis. Instead of gaining more equity and potentially demotivating the entrepreneurs from running the company, the term sheet includes a set of issues that require approval from a majority of preferred shareholders. These issues mainly relate to corporate actions that could affect the value of the preferred shares (e.g., anti-dilution and protection of special rights negotiated). The major reason why investors are asking for the right to approve these issues is to protect their investment (i.e., the value of the preferred shares). The seven issues that are considered essential to protect their share value and justify the preferred status are discussed individually.
Liquidate, Dissolve or Wind-Up the Affairs of the Company
Don’t shut down or sell the business. Having invested considerable time and money into a startup, it is understandable that the investors would want the ability to block an immature liquidation or dissolution of the startup. Liquidating and dissolving signifies a total loss of investment. The investor would want the ability to prevent such actions if there are other ways or directions that the entrepreneurs could take before giving up on the startup (e.g., selling to potential buyers at a loss). Furthermore, liquidation or dissolution would trigger the liquidation preferences that are a big part of the special rights negotiated. This liquidation includes a change of control in the company or an acquisition of the company by another company. This is the moment that investors are waiting for—when the company sells, they make their money back. It’s not surprising that they would want to make sure that the company is getting the best acquisition deal.
Adversely Change Rights of the Preferred Stock
The company can’t modify the bylaws or the charter in a manner that would change the terms of the preferred stock. Investors have spent a lot of time and effort to negotiate the rights attached to the preferred shares, and the shares are valued according to the rights that have been negotiated. Similarly, the founder has also gone through a lengthy process of evaluation to decide how much of the startup he or she is willing to give up for a specific amount to invest. The negotiations and the details of the rights represent an agreement after formal negotiations. Changing these rights would affect the value of the preferred shares. Thus, it is understandable that the investors want to protect these rights. Requiring a majority of preferred shares to approve adverse changes to the preferred shares prevents the entrepreneurs from changing these rights without approval.
Create New Securities that Have Equal or Senior Rights
The company can’t give the same or better rights to other shareholders without the approval of the Series A investors. Authorizing a new series of preferred shares senior to or on par with the existing preferred shares will decrease the economic potential and control for the investor. So, they don’t want that to happen without their approval.
Issue Tokens
Many startups are pivoting to Web3 business models. In doing so, the value of the company often shifts from the company’s stock to the digital token that the company issues. If the company decides to tokenize, the investors don’t want to get left behind. They will likely want a certain amount of tokens for their investment. Thus, it’s important for them to approve a token offering to protect their value.
Declare or Pay Any Dividend
Don’t pay out money to shareholders. Declaring or paying dividends is extremely rare for startups. This is because until a company is much more mature, any capital the startup earns is expected to be reinvested into the company so it can continue to grow and scale. Series A investors are not looking to make a return from dividend payments. Dividends are also not a tool for entrepreneurs to pay themselves a salary. Investors expect their investments to be used to grow and scale the company. They also expect any profits made to be reinvested into the development of the company. Thus, declaring or paying any dividend requires approval from a majority of Series A shareholders.
Take on Excessive Debt
It’s common for startups to take on some level of debt, depending on the industry. The Series A investors want to ensure that the company doesn’t take on excessive debt in case it cannot comfortably service. If the company can’t pay its debt, the company will liquidate and the debt holders will be paid before the investors. So, it’s common for Series A investors to set a cap on the amount of debt that the startup can take on without their approval.
Subsidiaries
There are a number of ways that value can be stripped away from an investor either by creating, holding stock or dissolving subsidiary companies. In order to avoid this, Series A investors require approval for these actions.
Anti-dilution
The anti-dilution clause is there to protect an investor if the company has a “down round.” A down round is a round of financing in which the company is raising at a lower valuation than the previous round of financing. Down rounds should be avoided if possible as they are generally seen as a signal that the company is not doing well.
The anti-dilution mechanism enables investors to convert their share price to a new price that allows them to maintain their stock ownership percentage prior to the down round. There are two major categories of anti-dilution provision: full rachet or weighted average.
Full ratchet is essentially a “do over” for the investors. It retroactively prices the original shares, which may have been purchased years earlier, at the new share price in the down round. If the investor bought 100,000 shares at $2 / share in an earlier round and the down round price is $1 / share, then the investors’ initial 100,000 shares would be converted into 200,000 shares at $1 / share. The founders and employees are diluted heavily with full ratchet, so it’s seen as incredibly investor-friendly.
Weighted-average is a more reasonable approach to anti-dilution. Weighted average also adjusts the amount of investors’ shares. But rather than a pure share price adjustment, weighted average accounts for the amount of shares sold in the down round relative to the total outstanding shares. If the down round is a small offering, then the impact will be less negative for the founders and employees than if the company had a larger offering.
There are two ways to calculate weighted-average: broad-based or narrow-based. The broad-based calculation includes the total shares outstanding, as well as all options, warrants and shares issuable under convertible securities. On the other hand, narrow-based doesn’t include those interests in the calculation.
Without getting into the mathematical formulas, the upshot is that broad-based, weighted-average, anti-dilution is better for founders / employees than narrow-based, as it will generally produce less severe conversion price adjustments.
So, the best-case scenario for founders is to remove anti-dilution from the deal. However, this is highly unlikely, so founders should instead focus on ensuring that the anti-dilution provisions are broad-based weighted-average. Fortunately, this has become the most standard version of the term.
Conversion
A conversion is the right of preferred shareholders to convert their shares into common stock at any time.
The most common conversion rate, and the one set forth in this term sheet, is 1:1, which means that one share of preferred stock will convert into one share of common stock. This term is standard and really one of the only truly nonnegotiable terms. The conversion is a relinquishing of all the rights and privileges of preferred shares, so this doesn’t have a negative impact on the founder.
So, why would a shareholder choose to give up their preferences? A preferred shareholder is usually motivated to convert his or her shares into common shares upon a liquidity event. As discussed in liquidation preference, a preferred shareholder has the right to convert in a liquidity event if it produces a better-off outcome. Assuming the conversion rate is 1:1, a preferred shareholder who owns 60% of the company can convert his or her shares into common shares and still own 60% of the company. After the conversion, the preferred shareholder can take 60% proceeds of a sale of the company. However, the converted shareholder would lose all the special rights negotiated under the preferred shares. In some rare occasions, a preferred shareholder might choose to convert into a common shareholder in order to control a vote on a certain issue.
In some instances discussed below, preferred shareholders automatically convert to common.
Mandatory Conversion
Mandatory conversion terminology usually appears when a company is closer to going public. The function of the automatic conversion is to force all preferred shareholders to convert into common shares. Most companies go public with a single class of common stock as opposed to multiple classes of stock. Some components of an automatic conversion are negotiable, and the most critical element is the threshold for the automatic conversion.
The trigger of an automatic conversion is usually referred to as a qualified initial public offering (IPO). A qualified IPO would include a public offering of common stock of the company at no less than a negotiated price per share. This negotiated price acts as a threshold for conversion to protect preferred shareholders from being forced to convert if the price per share is too low.
Pay to Play
The pay to play provision is a mechanism to incentivize the Series A investors to continue to invest in the startup in future rounds of financing. In the event that the investor fails to purchase their pro-rata percentage of stock in future rounds, their shares are automatically converted from preferred shares to common shares. This provision functions as a penalty for investors that are not in the company for the long haul.
Registration Rights
A registration rights provision ensures that the investors will have the opportunity to sell their shares in the public markets at an initial public offering (IPO). This is obviously important to venture capitalists as their business model is predicated upon buying a startup’s stock early, working with them to grow, and taking the company public at which time they are able to cash out and return funds to their limited partners.
These rights spell out company obligations to ensure that investors’ shares do not remain unregistered, restricted securities following a company’s IPO. In an IPO, a company issues new shares, which are registered to be sold on the public markets. The registration rights require the company to also register the existing investors’ shares, for which they will not receive proceeds at the IPO. This allows investors’ shares to become publicly tradable.
These clauses are fairly dense, so founders should ensure that counsel has reviewed and approved. Fortunately, most Series A registration clauses are in line with the standard NVCA language. It’s worth noting that, practically speaking, it’s the investment bankers taking the company public that ultimately determine the registration issues.
Management and Information Rights
Investors want to stay informed about the operations of the companies they invest in. So, this clause ensures they have the right to do so. The management rights letter is legally required by many investment firms under a regulation known as the Employee Retirement Income Security Act (ERISA) of 1974. They are generally a few pages and give investors the rights to, among other things, receive information, inspect company documents, consult with management and otherwise be informed about the company’s operations. These rights are fairly neutral. Though it’s possible for founders to negotiate some of the specifics of the information rights, the management rights letter is unlikely to be modified as it’s driven by regulatory requirements.
Pro Rata Rights
Pro rata rights, sometimes called preemptive rights or the right to participate in future rounds, is the right of an investor to invest in future rounds of funding in order to maintain their ownership percentage. Almost every Series A financing will have this term because investors want the ability to double down on a company that’s a winner. Note that this is a right to invest in future rounds but not an obligation for the investor to invest in future rounds. Just because investors have pro rata rights, it doesn’t mean they are going to use it.
There is an upside for the founder to include pro rata rights. If the investor exercises this right, they have an easier time getting capital committed for the next round. However, this cuts both ways. If everyone has pro rata rights and exercises them, then there will be less space for new investors in the next round.
Because of this, sometimes founders negotiate to give this right only to major investors—those investors who invest above a certain threshold. Though this solves the problem of crowding out your next round, it’s unfriendly to angels who are cutting smaller checks. Without pro rata rights, angel investors see their small equity shrink even further in each round.
Special Board Approval
This term requires board approval for the company to take certain actions. This concentrates power at the board and away from the founder and executive team, thus limiting flexibility.
Depending on the founder’s leverage in the negotiation, they may want to push back on this. There are two ways to approach this.
First, some versions of this clause require the Series A board member to approve the action. So, even if a majority of the board approves, but the Series A director does not approve, the company cannot take the action. So, in this instance, the Series A director has an effective veto over the action. The founder should remove the Series A director veto and seek to have a simple majority approval. Secondly, the founder should attempt to strike as many of the actions as possible in order to grant the management team as much flexibility as possible while operating the company.
Non-Competition, Non-Solicitation, Assignment
The non-competition and non-solicitation term ensures that when a founder or key employee leaves, they won’t immediately start working for a competitor or steal the company’s clients or talent. Though it restricts a founder’s freedom after leaving the company, it is a reasonable term. It’s important to note that state law may not prohibit the enforcement of these clauses as many states choose to protect employees’ right to freely find work. For instance, this clause would likely be unenforceable in California and Washington.
Proprietary rights agreements ensure that anything an employee or contractor is creating for the company is owned by the company. Since so much of the value in many startups are based on the intellectual property created by their team, from day one, it should be standard practice to ensure all employees and contractors have assigned these rights to the company. For that reason, this is a reasonable term for founders.
Board Matters
This term requires the company to offer certain inducements to members of the board of directors. Reimbursing reasonable expenses incurred in connection with board meetings and obtaining director and officer insurance are reasonable and standard requests. However, founders should push back on the requirement for a Series A investor to have a seat on all or certain committees. Ultimately, the company is best served by filling any board committees with directors that have the best skill set for that committee. The board should have the flexibility to appoint the best people to each committee whether or not they are Series A investors.
Employee Stock Options
This term requires a specific vesting schedule for future stock option grants to employees. All things being equal, founders would likely prefer to retain the flexibility to issue stock options on a vesting schedule agreed upon between the company and the employee. But the reality is that it’s the norm for a Series A startup to standardize vesting schedules with employees. The most common vesting schedule is four years with a one-year cliff. Founders should likely accept this standard term.
Right of First Refusal / Right of Co-Sale
The right of first refusal requires any shareholder with over 1% of shares who is interested in selling their shares to first offer those shares to the company. If the company does not elect to purchase, then the shareholder must offer to the investors, which is known as the second right of refusal. If the investors also refuse to purchase, then the shareholder can sell to an outside buyer. Though it slows down the sale of stock, this is a term that is generally good for the founders and the investors because it allows for stock ownership to be retained among the current shareholders as opposed to a random third party.
The right of co-sale allows investors to sell their stock under the same terms and at the same time as the selling shareholder on a proportional basis. Co-sale rights are standard, and founders should not spend energy attempting to negotiate them out of the deal.
Board of Directors
The board of directors has the highest level of decision-making power in the company. The board must approve all major actions (as seen above). They have the power to hire and fire the CEO. They shape the direction of the company. So, this may be one of the most important terms in the whole term sheet.
Founders should keep two goals in mind when negotiating this term.
First, the founder should optimize for voting power. Founders want to maintain a strong ratio of friendly board members versus investors. Let’s assume that prior to the round, the board consists of four board members: three founders and one investor from the seed round. If the company accepts an additional investor on the board in this round, then the balance shifts from three founders to two investors. This is not a bad situation for the founders. Assuming the three founders agree, then they should be able to pass anything they wish. However, the general rule of thumb is that the lead investor in each round will get a seat on the board. So, at Series B, the founders and investors will each have three seats. At Series C, the founders will have three seats, and the investors will have four. Founders should consider the long-term impact of delegating board seats in the Series A.
Second, the founder should optimize for good people. At the end of the day, the board members are the people you’ll be in the trenches with, working through challenging decisions together. You want people in the room that understand the vision, have a unique perspective / expertise to add and are great to work with.
Drag Along
Drag along rights may allow the Series A investors to force a sale of the company. The drag along rights allow a certain set of Requisite Holders or Electing Holders to force the rest of the shareholders to sell the company. This term is investor-friendly, so the best possible outcome would be to negotiate this term out of the deal.
In the event that the investors insist on the term, then the founder should attempt to negotiate for the decision-makers to be a broader set of shareholders. The most investor-friendly version of this clause allows a majority of Series A investors known as the Requisite Holders to unilaterally make the decision to sell the company. In some cases, this could mean that literally one VC firm could force a sale. It’s better for founders if that decision-making power is diffused. So, founders should negotiate to add approval by the board of directors as well as holders of a majority of shares held by employees of the company. This entire group of decision makers would be known as the Electing Holders.
The most investor-friendly version of this term puts the life or death of the company in investors’ hands. Since it may pose an existential threat to the company, it is a term that founders should spend energy negotiating.
No Shop / Confidentiality
This term simply requires founders to keep the terms of the term sheet confidential and not use it to shop around against other investors. The best case for founders would be to remove this term. But in many contexts, it’s become fairly standard. So, if the investors won’t budge on the term, then founders should seek to limit the time frame as much as possible.
