Founder’s Guide: Seed Funding
- Introduction
- What is a Seed Round?
- The Series Seed Docs
- Series Seed Term Sheet
- Securities to Issue
- Aggregate Proceeds
- Purchasers
- Price Per Share
- Liquidation Preference
- Conversion
- Voting Rights
- Documentation
- Financial Information
- Participation Rights
- Board of Directors
- Expenses
- Future Rights
- Key Holder Matters
- Conclusion
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, we’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 the seed round.
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 seed round is often the first time your company will take a direct equity investment, it’s important to understand the structure and mechanics of the deal. Investment speak 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 Series Seed 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 the base-level understanding so that you can have an informed conversation with your counsel and investors.
Sincerely,
Kyle Westaway
Managing Partner, Westaway
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What is a Seed Round?
The definition of a seed round varies, depending on who you ask and when you ask. There are no rules or capital requirements to name any particular round of financing.
In fact, entrepreneurs are often strategically motivated when deciding what to call a particular round of financing. I have seen founders raise as little as $50K or as much as $7 million both call it a seed round. By way of example, in October 2020, 30 companies reported the amount of their seed funding on Crunchbase. The smallest seed round was $75K; the largest was $6 million. The average seed round was $2.5 million. This generally aligns with what we’re seeing in the market.
Whereas a pre-seed round is typically raised from friends and family, high-net worth individuals or angel investors in the form of a SAFE or Convertible Note, a seed round is typically the first round of equity financing, or the first “priced round.” In a seed round, the startup is issuing preferred shares to investors based on a valuation of the company. Since the seed stage company is still very young, arriving at an accurate valuation is incredibly challenging and is often the most heavily negotiated term
Most seed rounds are based on standardized document sets. The Series Seed document set is common for rounds up to $2 million, as the documents are simpler and allow for a quicker fundraising process. For seed rounds above $2 million, it has become common to use National Venture Capital Association (NVCA) docs, which are more comprehensive and have historically been reserved for a Series A financing. This guide will be focusing on the Series Seed docs.
Want to learn more about SAFEs and Convertible Notes? Check out our SAFE guide and convertible note guide.
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The Series Seed Docs
Historically, a company needed to raise at least a few million dollars to create a new product and introduce it to the market. Every year, more tools and services are released to the public, which have dramatically lowered the cost of launching a tech startup. However, the standard set of venture capital legal documents remained complex and expensive. Historically, the typical venture capital investment package consists of five documents: two certificates, a legal opinion and two consents, and was roughly 100 pages long (excluding signature pages). However, that’s overkill to bring in a relatively small amount of money for a relatively early-stage company because many of the rights, obligations and preferences do not become important until the company is much more mature.
Ted Wang, a partner at Fenwick & West, authored and curated the Series Seed Documents in order to create a shorter, simpler version to the full set of documents used in Series A equity financing. While Series Seed documents closely mirror the Series A equity financing documents, they push the expense of negotiating more technical provisions, such as registration rights, that are irrelevant at an early stage to a later date. The idea behind the Series Seed docs is to have a standardized set of documents that will streamline the negotiation process (thus lowering legal fees). It’s designed as a starting point for negotiation, so most deals have some variation.
On SeriesSeed.com, only three essential documents are required to close on Series Seed equity financing. They are (i) term sheet, (ii) stock investment agreement and (iii) certificate of incorporation.
- Term Sheet—The term sheet is a high-level summary of the deal terms that are expected to be negotiated. It frames the universe of terms to be negotiated. Sometimes the entrepreneur leads with their own term sheet. However, it is more common for the lead investor of the round to issue the term sheet.
- Stock Investment Agreement—The Stock Investment Agreement is the central document in the seed round. It is the agreement that lays out the terms of the sale and issuance of Series Seed preferred stock. Because of that, it’s the longest document in the Series Seed documents.
- Certificate of Incorporation—A certificate of incorporation is the document a company files with the state, which affirms a company’s existence as a legal entity under the law of a specified state. Most entrepreneurs will have already filed their certificate of incorporation prior to raising a seed round. But in order to authorize Series Seed preferred shares and confer the rights to those shareholders, the certificate of incorporation will need to be amended and re-filed with the state. Because Delaware is the preferred jurisdiction for most professional investors, the sample certificate of incorporation under the Series Seed docs is under the State of Delaware.
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Series Seed Term Sheet
The Series Seed Term Sheet provides a summary of major deal points. Most negotiations between the entrepreneur and the investor will happen at the term sheet. If the investors are aligned on the term sheet, the drafting of the documents goes much smoother and quicker. Below is the standard term sheet. We will break down each term in the following sections.
TERMS FOR PRIVATE PLACEMENT OF SERIES SEED PREFERRED STOCK OF
[Insert Company Name], INC.
[Date]
The following is a summary of the principal terms with respect to the proposed Series Seed Preferred Stock financing of [___________], Inc., a [Delaware] corporation (the “Company”). Except for the section entitled “Binding Terms,” this summary of terms does not constitute a legally binding obligation. The parties intend to enter into a legally binding obligation only pursuant to definitive agreements to be negotiated and executed by the parties.
| Offering Terms | |
| Securities to Issue: | Shares of Series Seed Preferred Stock of the Company (the “Series Seed”) |
| Aggregate Proceeds: | $[_________] in aggregate |
| Purchasers: | [Accredited investors approved by the Company] (the “purchasers”) |
| Price Per Share: | Price per share (the “Original Issue Price”), based on a pre-money valuation of $[____], including an available option pool of [___]% |
| Liquidation Preference: | One times the Original Issue Price plus declared-but-unpaid dividends on each share of Series Seed, balance of proceeds paid to Common. A merger, reorganization or similar transaction will be treated as a liquidation. |
| Conversion: | Convertible into one share of Common (subject to proportional adjustments for stock splits, stock dividends and the like) at any time at the option of the holder. |
| Voting Rights: | Votes together with the Common Stock on all matters on an as‑converted basis. Approval of a majority of the Preferred Stock required to (i) adversely change rights of the Preferred Stock; (ii) change the authorized number of shares; (iii) authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock; (iv) redeem or repurchase any shares (other than pursuant to employee or consultant agreements); (v) declare or pay any dividend; (vi) change the number of directors; or (vii) liquidate or dissolve, including any change of control. |
| Documentation: | Documents will be identical to the Series Seed Preferred Stock documents published at SeriesSeed.com, except for the modifications set forth in this Term Sheet. |
| Financial Information: | Purchasers who have invested at least [$________] (“major purchasers”) will receive standard information and inspection rights and a management-rights letter. |
| Participation Right: | Major purchasers will have the right to participate on a pro rata basis in subsequent issuances of equity securities. |
| Board of Directors: | [___] directors elected by holders of a majority of common stock, [__] elected by holders of a majority of Series Seed and [___] elected by mutual consent. |
| Expenses: | Company to reimburse counsel to purchasers for a flat fee of $10K. |
| Future Rights: | The Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms). |
| Key Holder Matters: | Each key holder shall have four years vesting beginning [_______]. Full acceleration upon “Double Trigger.” Each key holder shall have assigned all relevant intellectual property (IP) to the Company before closing. |
| Binding Terms: | For a period of 30 days, the Company shall not solicit offers from other parties for any financing. Without the consent of purchasers, the Company shall not disclose these terms to anyone other than officers, directors, key service providers and other potential purchasers in this financing. |
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Securities to Issue
Unlike the pre-seed round where convertible notes or Simple Agreements for Future Equity (“SAFE”) are commonly used, Series Seed investors are purchasing preferred stock of the company and thereby becoming partial owners of the company. They are also entitled to key shareholder rights and additional shareholder rights specified in the Series Seed preferred stock documents.
Preferred stock differs from common stock, which most founders hold, because preferred stock comes with negotiated special rights or preferences designed to protect investors for the heightened risk they take on in investing in an early-stage company. Typically, the preferences in Series Seed Preferred Stock include some liquidation preference(s), a right to board seat, some participation rights and future rights, all of which will be explained in detail below.
Historically, purchasers of stock in seed stage startups were individual angel investors. There are a number of professional investors targeting only seed stage companies, including seed funds (e.g., SV Angel and First Round Capital), professional angels (e.g., Ron Conway), and seed funding platforms (e.g., AngelList). However, recently, more established venture capital firms that have only invested in Series A or later are investing in seed rounds.
One upside of the increased interest in seed rounds is that rather than having 50 investors that are investing a small amount, a few investors can cut larger checks and cover the entire round. From the entrepreneur’s perspective, it is preferable to have a few larger investors fill out the round rather than a large group of smaller investors. Having fewer investors means entrepreneurs can save time and effort in investor relationship management, which can be time-consuming and expensive.
In the Series Seed term sheet, the securities to issue are as follows:
Securities to Issue: Shares of Series Seed Preferred Stock of the Company (the “Series Seed”).
Thus the startup will be issuing preferred shares, which will have a number of preferences detailed below over the common shares held by the founders and employees of the startup
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Aggregate Proceeds
The aggregate proceeds in the Series Seed docs is simply the total amount of money the company is setting out to raise in the round of financing.
Entrepreneurs should consider a number of factors when establishing the aggregate proceeds.
First, consider the amount required for the company to reach the next round of funding. The amount of time a startup has before it runs out of money is called the runway. Startup runway provides an essential perspective for budgeting, hiring and strategizing throughout the startup’s lifecycle. Most seed stage startups calculate for about 18 months of runway. Entrepreneurs should calculate the runway (building in a bit of margin) in preparation for fundraising.
Second, entrepreneurs must consider how much equity they are selling for the amount of investment they are receiving. Most experienced investors would ask for no more than 20-25% of the startup. This is because selling a large chunk of a startup at an early stage would easily demotivate the founders to keep growing their startup. The purpose of most seed stage investors is to test their investment hypothesis, be it on the founding team, the product or the market. Thus, the venture capitalists know not to ask for too much as it would be contradictory to their purpose of investment. From an entrepreneurial perspective, anything more than 20-25% can be giving up too much control of the company. This would not only affect the bargaining power in raising future rounds of financing but also affects the founders’ control over the company, which could hinder the founders from taking the company in the direction they envision.
In the Series Seed term sheet, the aggregate proceeds are as follows:
Aggregate Proceeds: $[_________]in aggregate.
Thus, after calculating the runway and the equity percentage, the startup will set the size of the seed round here.
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Purchasers
Unfortunately, the Securities and Exchange Commission (SEC) does not allow a startup to raise capital from just anyone. Startups should only fundraise from Accredited Investors.
First, it’s important to understand some basic concepts. The general SEC rule is that if you are raising money, you need to register with the SEC—an incredibly expensive process. But the good news is that there are exemptions to that rule for startups under Regulation D, known as Reg D. In order for the exemption to apply, the startup must meet certain criteria, including only allowing “accredited investors” to invest in the company.
So who are these accredited investors? The major categories of accredited investors include:
- certain institutional investors (e.g., banks and SEC-registered investment companies and broker-dealers),
- certain business entities with assets greater than $5 million,
- certain entities (including Native American tribes, governmental bodies, funds, and entities organized under the laws of foreign countries) that own investments in excess of $5 million,
- directors and officers of the seed stage startup, and
- individuals with annual incomes greater than $200K (individually) or $300K (household), or a joint net worth of greater than $1 million (excluding equity value of primary residence).
Securities law assumes accredited investors that meet the above criteria are sufficiently sophisticated, knowledgeable parties that do not require any additional disclosures. But they assume that people that do not meet the accredited investor standard might be easily tricked, so they require much more disclosure.
The quickest, cheapest ways to raise money for your startups under the Reg D exemption are Rule 506(b) and Rule 506(c). Under 506(c) non-accredited investors are barred from investing. Period.
Under Rule 506(b), you can also take investments from accredited and non-accredited investors, but there’s a huge catch. In a 506(b) offering, if you want to take funds from even one non-accredited investor, your disclosure obligations go through the roof (and your legal bills do as well). By taking just one non-accredited investor, you can easily triple your legal expenses. In practice, it’s not worth it.
Putting forth that amount of money and time just to raise a small amount of funds from a small amount of non-accredited investors is just not worth it.
In the Series Seed term sheet, the purchasers are listed as follows:
Purchasers: [Accredited investors approved by the Company] (the “purchasers”).
Thus, the startup will only take investments from accredited investors it approves.
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Price Per Share
How much is your company worth? It’s often the most important, most contentious (and often the most subjective) question in any negotiation between entrepreneurs and investors.
At the seed stage, any attempt at valuation is highly speculative. Most companies have little or no revenue, a very early version of their product, only a tiny user base, and a small team. Both the entrepreneur and the investor generally try to build a financial model to justify the value of the company. Typically, those models are based on so many speculative assumptions as to render them practically useless in the real world. So, valuations are often based on non-financial factors such as:
- the valuations of comparable companies that have raised recently,
- founder experience,
- macroeconomic conditions,
- what sectors investors find sexy at the moment and,
- investors’ fear of missing out (FOMO).
All of these factors can swing seed stage valuations wildly. Whatever that valuation number is, it’s important for every entrepreneur to understand how the math impacts the ownership of the company.
There are two ways to express the value of a company: pre-money valuation or post-money valuation. Pre-money valuation is the valuation of the startup right before the round of financing, and post-money valuation is the valuation of the startup immediately after the round of financing.
Post-money = Pre-money + Investment
Pre-money = Post-money – Investment
Investor Percentage = Investment / Post-money
For example, say a startup is raising $1 million at a $10 million pre-money valuation.
Post-money: $11 million = $10 million + $1 million
Pre-money: $10 million = $11 million – $1 million
Investor Percentage: 9.09% = $1 million / $11 million
Expressing the valuation of a company in pre-money or post-money terms will impact the amount of equity the investor will receive for their investment. So, if an investor offers to invest $1 million at a $10 million valuation.
The investor usually means post-money.
Post-money: $10 million = $9 million + $1 million
Investor Percentage: 10% = $1 million / $10 million
However, the entrepreneur usually means pre-money.
Pre-money: $11 million = $10 million + $1 million
Investor percentage: 9.09% = $1 million / $11 million
In the post-money calculation, the investor gets a higher percentage of the company. Thus the founders get a lower percentage. Entrepreneurs can avoid a well-intentioned miscommunication (or potentially a sneaky VC trap), by simply asking, “Ten million pre- or post-money?” Remember pre-money is always better.
The Option Pool
In the Series Seed term sheet, there are two parts to the definition of price per share: The valuation is the most important, but the last clause about the option pool is also meaningful.
What is an option pool? The option pool is a set number of shares that are designated exclusively for stock options and grants to employees and advisors of the startup. It is designed to incentivize and attract talent to work for or stay with a startup. Increasing an option pool can help the company compensate and motivate its workforce, but it also dilutes the other shareholders. The general rule is decreasing the size of an option pool increases the valuation of the founder’s percentage of the company (see table below).
| Pre-money valuation | |
| No option pool | 5 million |
| 25% option pool | 3.75 million [5 million* (1-0.25)] |
| 20% option pool | 4 million [5 million* (1-0.2)] |
| 10% option pool | 4.5 million [5 million* (1-0.1)] |
Though the standard Series Seed docs list the valuation of the company as a pre-money valuation, it’s important to note that the option pool is expressed as post-money. (A little confusing, I know.) So, when it’s expressed as a percentage, that means a percent of the total number of shares after the funding closes. A founder can counterbalance the negative impact on the value of your stock in two ways:
- Increase the pre-money valuation to account for the value lost from the option pool; or
- Decrease the percentage of the option pool.
Before entering a negotiation, it’s helpful to have a hiring plan and the amount of options you are planning to grant to each hire. This can help entrepreneurs negotiate an appropriate option pool size with the VC. Increasing the option pool size might not be necessary if the company is not planning to increase hiring between current and next anticipated financing date. Similarly, the entrepreneur might want to take into account a larger option pool if there are plans to increase hiring before the next round of financing.
In the Series Seed term sheet, the price per share is as follows:
Price per share: Price per share (the “Original Issue Price”), based on a pre-money valuation of $[____], including an available option pool of [___]%.
Thus, upon negotiation with the investor, the startup will set the pre-money valuation investor along with the option pool.
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Liquidation Preference
What is a liquidation preference?
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:
1. Preference—The money distributed to the stockholder prior to distribution to other classes of stockholders.
2. 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 Seed financing is a 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 be participating 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.
The investor would first get $1 million, but how will the other $20 million be distributed? 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). The 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 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 welcomed by entrepreneurs. In general, nonparticipating liquidation preference is more common than participating liquidation preference at the seed stage.
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 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:
|
| 2x preference, nonparticipating | Receives $100 million:
|
| 1x preference, participating | Receives $80 million:
|
| 1X preference, participating (3x cap) | Receives $80 million:
|
In the Series Seed term sheet, the liquidation preference is as follows:
Liquidation Preference: One times the Original Issue Price plus declared but unpaid dividends on each share of Series Seed, balance of proceeds paid to Common. A merger, reorganization or similar transaction will be treated as a liquidation.
Thus, the investor will receive a 1x non-participating preference.
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Conversion
A conversion is the right of preferred shareholders to convert their shares into common stock at any time.
The most common conversion rate is 1:1, which means that one share of preferred stock will convert into one share of common stock. Once a preferred share is converted into a common share, there is no provision to converting it back. 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 entrepreneur.
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 stock in a liquidity event. 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% of the 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, preferred shareholders automatically convert to common stock. The function of the automatic conversion is to force all preferred shareholders to convert into common stock as 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 IPO. A qualified IPO would include a public offering of common stock of the company of 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.
In the Series Seed term sheet, the conversion preference is as follows:
Conversion: Convertible into one share of Common (subject to proportional adjustments for stock splits, stock dividends and the like) at any time at the option of the holder.
Thus, the investor has the option to convert each share of preferred stock into a share of common stock at any time.
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Voting Rights
Voting rights is a governance term, which means it relates to who has decision-making power in the startup.
On general matters, Series Seed investors vote on an “as-converted basis.” For the purposes of voting on general matters, the preferred shares are treated as if they are converted into common shares for vote tallying purposes, but no actual conversion occurs. Assuming a 1:1 conversion rate, that means that on most matters, investors have no more power than founders. Each of their shares carry the same weight, so their votes are all equal.
For example, if an investor has 30K preferred shares and the founders collectively have 70K common shares, for the purpose of voting on general matters, the 1:1 conversion ratio would give the investor 30% voting power and the founders 70%. The number of preferred shares is deemed converted simply for the purpose of calculating the quantity of votes. This would not affect other specially negotiated rights of the preferred shares.
Matters Requiring Investor Approval
While most seed stage investors respect the founding team and would not want to interfere with the daily operations of the startup, 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)), which require the approval of a majority of investors.
Since most seed stage 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.
Approval of a majority of the Preferred Stock required to adversely change rights of the Preferred Stock
The company can’t change the terms of the preferred stock. Seed stage investors have spent a lot of time and effort to negotiate the rights attached to the preferred shares, and the shares are valued accordingly. Similarly, the entrepreneur 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 of investment. The negotiations and the details of the rights represent 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 prevent the entrepreneurs from changing these rights without approval.
Approval of a majority of the Preferred Stock required to change the authorized number of shares
The company can’t change the number of total shares authorized. Increasing the authorized number of shares will dilute the shareholder ownership and reduce the value of each share. Take the example where an investor owns 20% of your company with a total of 10 million authorized shares. The entrepreneurs may issue 5 million new shares for themselves after the investment and the investor would only own 13% (2 million/15 million) of the company after the issue. This would significantly reduce the value of the preferred shares. Originally, the preferred share value was negotiated based on the value of the startup, so the investor paid a price based on the 20% value of the startup. Allowing a simple majority to approve the issue of new shares is equivalent to giving entrepreneurs the power to dilute the investor’s ownership. Thus, issuing new shares requires approval from a majority of preferred shareholders.
Approval of a majority of the Preferred Stock required to authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock
The company can’t give the same or better rights to other shareholders. Similar to changing the authorized number of shares, authorizing a new series of preferred shares senior to or on par with the existing preferred shares will decrease the economics and control for the investor. So, they don’t want that to happen without their approval.
Approval of a majority of the Preferred Stock required to redeem or repurchase any shares (other than pursuant to employee or consultant agreements)
Don’t buy back shares. Redeeming or repurchasing shares is another way to dilute an investor. Through redeeming or repurchasing shares from other shareholders (e.g., investors), the entrepreneurs are able to dilute the investor ownership and own more of the company than the investor would like. Redemption or repurchase of shares from employee or consultant agreements refer to shares from an option pool that are accounted for when the investment was made, which is excluded from the required approval.
Approval of a majority of the Preferred Stock required to declare or pay any dividend
Don’t pay out money to shareholders. Declaring or paying dividends is extremely rare for seed stage startups. This is because at seed stage, any capital the startup earns is expected to be reinvested into the company so the company can continue to grow and scale. Seed stage investors are not looking to make a return from dividend payments. Dividends are also not a tool for entrepreneurs to pay themselves a salary. Seed stage 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 preferred shareholders.
Approval of a majority of the Preferred Stock required to change the number of directors
Don’t change the board size. The board of directors is the highest level of legal authority in the company. It is responsible for making important corporate decisions, and there is a separate section in the term sheet that addresses the composition of the board. A change in the number of directors would alter the composition of the board and the required majority to pass a board decision. Most board decisions are passed by simple majority. This means that the influence an investor has through having one board seat on a three-person board can be very different to having one board seat on a five-person board. Therefore, the preferred shareholders would want to protect their negotiated rights through preventing a change in the number of directors.
Approval of a majority of the Preferred Stock required to liquidate or dissolve, including any change of control
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. A change of control in the company typically refers to 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.
In the Series Seed term sheet, the voting preference is as follows:
Voting Rights: Votes together with the Common Stock on all matters on an as‑converted basis. Approval of a majority of the Preferred Stock required to (i) adversely change rights of the Preferred Stock; (ii) change the authorized number of shares; (iii) authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock; (iv) redeem or repurchase any shares (other than pursuant to employee or consultant agreements); (v) declare or pay any dividend; (vi) change the number of directors; or (vii) liquidate or dissolve, including any change of control.
Thus, on general matters the investors vote along with the founders. However, on the matters (i)–(vii), a majority of the investors must approve in order for the company to take those actions.
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Documentation
Whereas, the traditional venture capital investment package is five lengthy documents, the Series Seed approach is condensed into three essential documents. They are the (i) term sheet, (ii) stock investment agreement, and (iii) certificate of incorporation. The three documents will be identical to the documentations published on the Series Seed website. Where there are modifications in the term sheet, the two other documents will be modified to reconcile with a term sheet. One of the major benefits of using the Series Seed set of documents is that the term sheet sets forth a concise framework for negotiations. It streamlines the process, and thereby reduces the time and expense required for the transaction.
In the Series Seed term sheet, the documentation required is as follows:
Documents will be identical to the Series Seed Preferred Stock documents published at SeriesSeed.com, except for the modifications set forth in this Term Sheet.
Thus, the definitive set of documents that the investors and founders will approve as a part of the financing will be the latest version on SeriesSeed.com. However, it’s worth noting that almost every deal will have some nuance, so counsel for both the startup and the investor will likely edit these documents. But at least a shared starting point should make that process much more efficient.
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Financial Information
Major investors want to understand what’s happening at the startup they invested in, and rightly so. This term ensures that the founders are committed to provide certain investors (i.e., major purchasers) standard information, inspection rights and management rights letter (collectively referred to as information rights). Major purchasers can be defined as investors who invested above a certain negotiated threshold. Generally, the entrepreneur wants this threshold to be high to limit the number of people privy to sensitive financial information. Financial Information includes (i) information rights, (ii) inspection rights and (iii) management rights letter.
Information Rights
Information rights specify what information the startup must provide to the major investors and what frequency they must deliver that information. For instance, standard series information rights require the company to provide quarterly and annual unaudited financial reports to major investors. It’s the investors’ responsibility to use that information to give feedback and advice to the founders, and of course to keep it confidential.
Inspection Rights
Inspection rights allow the major purchasers to inspect the startup should they find the need to. Inspection rights simply means that the Company will permit each major purchaser to visit and inspect the Company’s properties, to examine its accounting and records and to discuss the Company’s affairs, finances and accounts with its officers, all at such reasonable times. This right just allows investors to do what they should be doing, communicating with the entrepreneurs and staying informed about the business.
Management Rights Letter
For regulatory purposes, investors often ask for a management rights letter. This letter generally grants investors additional rights and / or access to the company’s financial information and governance. Investors need a management rights letter in order to obtain an exemption from the regulations under Employee Retirement Income Security Act (“ERISA”). ERISA requires these funds to have “management rights” of the operating companies (i.e., to “substantially participate in, or substantially influence the conduct of, the management”) that these funds invest in. ERISA also requires these “management rights” to be contractual and in writing.
The management rights letter is usually presented in a one- to two-page written contractual agreement that is separate from the Series Seed documents. VC funds that invest with pension plan assets always request for management rights letters as a best practice. Obtaining a management rights letter is a common practice in the U.S., and it rarely becomes a controversial matter.
In the Series Seed term sheet, the financial information preference is as follows:
Purchasers who have invested at least [$________] (“major purchasers”) will receive standard information, and inspection rights and management rights letter.
Thus, once the major purchaser threshold is set, any investors that meet that threshold have the right to information and inspection. The company also agrees to enter into a management rights letter with them.
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Participation Rights
A participation right is the right of existing investors to participate in future rounds of financing. Sometimes referred to as a pro rata right, this participation right may show up in the seed round and is usually limited to major purchasers. The participation right gives the current set of investors the right to purchase their pro-rata share of any new stock being sold by your company. The participation right gives investors the right to keep their same percentage of equity as the company raises future rounds. The reason why it is limited to major purchasers is because this right can become burdensome as the investor base grows. Very often, a seed round may include a large group of minor investors such as family and friends. The legal fees for calculating the pro rata rights for minor investors can be more expensive than the investment’s worth. Thus, the participation right is limited to major purchasers in the Series Seed term sheet.
The pro rata participation rights is important to investors because it helps them protect their ownership percentage in the startup. A participation right ensures the investor is able to participate in a subsequent round on a pro rata basis. This means that for as long as the investor continues to invest, his or her ownership of the startup will not be diluted.
From an entrepreneurial perspective, the participation right is a neutral concept because founders usually welcome investment. Furthermore, it is always positive for the startup to signal that prior investors are participating in future rounds. However, this is usually a right that the current set of investors want but the incoming investors dislike (or prefer the right to be somehow limited). This is because the participation right will affect the ownership percentage the incoming investor could purchase while existing investors want to ensure their ownership percentage would not be reduced. As your investor base grows, the participation rights could cause tension between investors from different series.
The participation right gives the current set of investors the right to participate in future rounds on the same terms offered to the subsequent round of investors. Pro rata participation right does not guarantee that the investor’s shareholding will not be reduced, it simply offers the investor an opportunity to participate in the subsequent round of financing.
For example, an investor invests $500K in a seed round and owns 25% of the startup. The next round is a $1 million round ($2 million pre money valuation and $3 million post money valuation). The investor is given the right to participate and buy 25% of the round (i.e.,$250K), so the investor can continue to own 25% of the startup. Otherwise, the investor will be diluted and own around 17% of the startup. Therefore, the pro rata participation right does not guarantee the investor always owns 25% of the startup. You can see how administratively burdensome it could be to calculate the pro rata participation rights of everyone in a large group of minor investors and to obtain their response on whether to participate.
In the Series Seed term sheet, the participation right is as follows:
Participation Rights: Major purchasers will have the right to participate on a pro rata basis in subsequent issuances of equity securities.
Thus, major purchasers have the right to purchase enough shares in the next round of financing to ensure that they maintain their current equity ownership percentage.
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Board of Directors
A board of directors, often simply referred to as “the board,” has the highest level of legal authority in the operation of a company. It is responsible for making important corporate decisions, such as budgets, option plans and declaring dividends. The board also decides on the exit paths for a startup as it approves the company’s plan on mergers or IPOs. Furthermore, it has the power to fire the CEO. The board is considered the most powerful element in a company’s management structure. Under state law, a board must be put in place when the company is incorporated. Most seed stage companies will have a small board consisting of only the founders (and less than a handful of employees).
For smaller rounds, investors may not ask for a board seat. But for more significant rounds, the rule of thumb is generally that the lead investor for each round will take a board seat.
Under the board in the Series Seed term sheet, there are three items to be negotiated, which includes the number of directors to be elected by (i) a majority of common stock, (ii) a majority of the Series Seed investors and (iii) mutual consent. The negotiation outcome of this clause indicates the balance of the composition in the board.
Historically, it was common for the board to be composed exclusively of the founders until Series A. However, as the size of seed rounds have increased, it’s become more common for investors to request a seat on the board. Simply put, if they are cutting a big check of more than $1 million, for instance, they want some control. For smaller seed rounds, it’s common to not give investors any board seats.
If you have a round that is large enough, then you want to ensure you have a balanced board. A typical structure is:
- one founder (elected by a majority of common stock),
- one representative from the investors (elected by a majority of Series Seed investor), and
- one independent director. The independent director should be mutually agreed between the founders and the investors.
The goal is to maintain a proper balance in the board. The independent director represents an outside representation who should not be a major investor or executive in the company. Independent directors are usually experienced personnel from relevant industries the company participates in. The independent directors are expected to help the company with networking and provide insights to the board on major trends in the industry. They are an important source of impartial opinions in the board, and they can help resolve conflicts that arise between founders and investors.
In the Series Seed term sheet, the participation right is as follows:
Board of Directors: [___] directors elected by holders of a majority of common stock, [__] elected by holders of a majority of Series Seed and [___] elected by mutual consent.
Thus, the founders and the investors will negotiate the seats on the board. If the round is relatively small, the founders may insist on keeping all board seats.
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Expenses
Under expenses in the Series Seed term sheet, the startup agrees to reimburse the investors (purchasers) a flat fee of $10K for counsel expenses. The founders are essentially agreeing to reimburse all the investors of the seed round for a one-off legal fee. The fee is set as a fixed charge of $10K. Using the Series Seed document for a financing round is considered highly standardized work from a legal perspective. The legal fee is usually deducted from the wire transfer that the startup receives upon the closing of the financing.
To further lower your overall legal fees, read our guide on legal startup mistakes.
An Abuse of Power
To put it bluntly, this term is bullsh*t. The wealthy investors/firm are asking the startup that’s struggling to stay alive to pay not only their own legal bills but the legal bills of the investor. We find this term to be a highly offensive abuse of the investor-entrepreneur power dynamic. This is hands down the most short-term, unnecessary, power-grabbing term in the Series Seed term sheet. In our opinion, it should be struck from the standard term sheet.
This clause forces the startup to pay the legal fees of the counsel that is negotiating against their best interest. Additionally, opposing counsel has the power to drag out the diligence process and negotiations of the deal, which increases their legal bill. Unlike company counsel, the startup has no ability to rein in costs. The startup is left covering a legal bill they had no control over.
If investors don’t have the money to pay legal fees, they shouldn’t be investing.
In the Series Seed term sheet, the expenses right is as follows:
Expenses: Company to reimburse counsel to purchasers for a flat fee of $10K.
This term should be removed from the standard term sheet, but for now it’s in there. Founders should do whatever they can to remove this term altogether. If deletion is not a possibility, then at least negotiate for a low cap on legal fees and do not consent to any legal fees in future rounds.
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Future Rights
Future Rights in the Series Seed term sheet give the investors the same rights if the new investors in a subsequent round of financing get better rights. This means that if the new investors in the subsequent round of financing successfully negotiate for better protection, the Series Seed investors will receive the same level of protection. This applies to both pre-existing rights the Series Seed investors enjoy as well as rights that are not covered in the Series Seed term sheet.
For example, if the Series Seed investors secure a 1x nonparticipating liquidation preference in the seed round and the new investors in the subsequent round of financing get a 2x nonparticipating liquidation preference, the preferred shares in the Series Seed round will be entitled to a 2x nonparticipating liquidation preference. When using the Series Seed set of documents, a lot of rights that the new investors might ask for are not covered, such as registration rights or price-based anti-dilution. This Future Rights term ensures the Series Seed investors will also get these rights. For example, there is no price-based anti-dilution in the Series Seed term sheet. If the new investors successfully negotiate for broad-base weighted average anti-dilution, the Series Seed investors will also get the same anti-dilution protection.
The Future Rights entitlement will be adjusted in accordance with the number of shares each Series Seed investor holds after the new investment. It merges the differences between the Series Seed round and the subsequent financing round to create a single set of preferred shares with an identical set of rights.This term aligns with an earlier term Participation Rights which provides the Series Seed investors the right to participate in the subsequent round on the same terms as the new investors.
In the Series Seed term sheet, the future rights are as follows:
Future Rights: The Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms).
Thus, the investors will be receiving the same preferences of the inventors in the next round.
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Key Holder Matters
There are three parts under Key Holder Matters in the Series Seed term sheet: (i) a four-year vesting, (ii) a full acceleration upon “Double Trigger” and (iii) all relevant IP assignments before closing.
Vesting
Investors want to ensure that founders are incentivized to stay at the company and work hard to increase the value of the company. One tool commonly used to achieve this objective is to ensure that the founders’ shares are vesting. This means that even though the founders own their shares, the company can repurchase some shares if the founder quits or gets fired. The number of shares the company can repurchase is limited to the number of shares that have not yet vested. Vesting happens on a schedule, in this case over four years. So as time passes, the number of shares the company has the right to repurchase (upon termination) decreases, and the amount of shares the founder owns free and clear increases.
Take the example where the founder has 100 shares and a four-year monthly vesting with a one-year cliff. The one-year cliff means the founder will receive 25 shares (1/4 of 100) after one year. After the cliff, the remaining three years are separated into 36 months (3 x 12). Thus, after one year, the founder will receive approximately 2 shares (1/36 of 75) every month (1/48 of the original grant).
The four years vesting commences on a date to be negotiated. A point of negotiation is when to start the vesting provision. The investor would want that date to be as late as possible, to ensure the founder is incentivized for as long as possible. However, anybody who has founded a company knows how much blood, sweat and tears it takes to get to the seed stage investment. They are most often living off savings, eating instant noodles and working every waking hour. There is a very fair case to be made that this type of sacrifice should certainly count toward the vesting schedule. So, founders should push for the founding of the company (or even the date you started working on the project full time) as the commencement of the vesting period.
Double Acceleration
What happens if your company is acquired before you fully vest? That’s where the double trigger acceleration comes into play. Once the company is acquired (first trigger) you continue to vest your shares on the same schedule until you are terminated (second trigger), then all of your shares vest immediately.
The double-trigger requires that (i) the company is acquired, and (ii) the founder’s employment has been terminated without cause after the acquisition, in order for the shares to be fully vested. Typically, the qualifying termination means ending employment by the company without “cause,” but can also include resignation by the employee for “good reason” (e.g. a cut in pay, mandated relocation or significant downgrade of duties). The occurrence of these two events will give founders ownership of all the shares they are entitled to. The acceleration is designed to protect the founders from finding themselves in a vulnerable position where their employment is terminated by an acquirer.
Intellectual Property Assignment
The assignment of intellectual property from founders or employees to the company is essential for any startup. Most startups’ only asset is their intellectual property, so it’s crucial that there is no question as to the ownership of such intellectual property. Ideally the founders should have assigned relevant intellectual property upon incorporation, and each employee or consultant should have done so upon hiring. This is generally achieved through an agreement known as the Confidentiality and Inventions Assignment Agreement. The investors are just ensuring that this has been done. This is a good thing for both investors and the startup.
Why care about Key Holder Matters
Once the shares are vested, the founders retain the shares even if they leave the startup. However, the founders will lose the right to the unvested portion of the shares if they leave employment before all the shares are vested. Investors want a vesting schedule because it incentivizes the founders to stay with the startup and keep growing the business. Most of the time, seed stage investors invest based on the talent of the founding team. Seed stage startups usually have little sales or growth data to justify investment alone. A large portion of the investment value is in the founding team; thus, investors want the team to stay with the startup and keep growing its business. A vesting schedule prevents the founders from leaving the startup prematurely.
Additionally, a company with double trigger vesting schedules is a more attractive acquisition target. When an established company is acquiring a startup, oftentimes one of the most valuable elements of the acquisition is the talent, specifically the founders. Therefore, a company is more likely to sell (and make money for investors) if the founders are incentivized to stick around after the acquisition.
Lastly, since the core value of the startup is often in its intellectual property, the investors want to ensure that the company actually owns it.
In the Series Seed term sheet, the future rights are as follows:
Key Holder Matters: Each Key Holder shall have four years vesting beginning [_______]. Full acceleration upon “Double Trigger.” Each Key Holder shall have assigned all relevant IP to the Company before closing.
Thus the company is required to put the following restrictions on the founders. It is in the founders’ best interest to negotiate for either removal of the vesting restrictions or to ensure the starting date on the vesting schedule as early as possible.
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Conclusion
The Series Seed documents are designed to streamline the process of fundraising for an early-stage company. Hopefully, this guide helps entrepreneurs get a basic understanding of the terms. Though the guide is designed to educate, it is not legal advice and does not replace the need for counsel. Skilled counsel will help you understand which terms to negotiate and how to negotiate them. They will also ensure that the deal points on the term sheet are accurately reflected in the definitive documents.
I’m wishing you the best on your entrepreneurial journey.
Want to avoid common pitfalls as you scale? Check out our guide How to Avoid 10 Rookie Legal Mistakes.
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