June 7, 2022
Have you ever contemplated investing in a startup, but wondered about what sort of terms you should expect or can ask for? Or have you ever been presented with a term sheet in connection with a potential investment, but were curious about the economic implications of certain key provisions, or alternatives to propose when negotiating the structure of the investment?
If so, we compiled the “cheat sheet” below, which can help you start to navigate the intricacies of certain critical matters in a preferred stock term sheet and keep various traps for the unwary on your radar.
- Amount of Financing: Economics are the driving force in most investments. As such, it is imperative to understand: (1) what the aggregate size of the financing round is, (2) what portion of that your investment represents and (3) what percentage of ownership in the company your investment will represent once the round is completed, on a “fully-diluted common stock” basis. A “fully-diluted common stock” basis means the percentage of the company's stock you will own assuming that all outstanding options, warrants and other convertible securities are exercised. For example, let’s say the company has previously issued 8 shares and has granted stock options to purchase 10 shares that have not been exercised, and you purchase 2 newly issued shares. If you disregard the options, then you would be considered as owning 20% of the company (i.e., 2 out of 10 shares outstanding; the 10 options that were granted but were not exercised are disregarded for this calculation). However, on a “fully-diluted common stock” basis, taking into account the 10 outstanding options, you would be considered as owning 10% of the company (i.e., 2 out of 20 shares – 10 issued and outstanding shares plus the outstanding stock options to purchase 10 shares that have not been exercised yet). Throughout your review and negotiation of the investment, it is critical to remain mindful of whether, when discussing your ownership percentage, you are talking about ownership on a “fully-diluted common stock” basis or based upon just the shares that are actually outstanding. This is particularly important when discussing whether the company will have an option pool (or increase an existing option pool) following the closing of the investment.
- Option Pool: As noted above, a key element that can immediately impact your investment is the option pool. You should to talk to the founders, and do your diligence, to understand not only how many options have been granted and to whom, but also how much of the option pool is reserved for future issuances. If you or the founders believe that additional issuances will need to be made in the short term, and if there isn’t a sufficient reserve, then you will want the option pool to be increased before you make your investment – i.e., on a “pre-money” basis – to account for any additional issuances you think might be necessary in the near future. Otherwise, if the option pool is increased after you make your investment, then, unless you negotiate otherwise, your ownership interest in the company will be diluted when the option pool is increased.
- Dividends: While the prospect of regular dividends is rarely, if ever, a driving factor for investment in an early-stage company, the dividend provisions for preferred stock could have a substantial impact on your overall return. There is a variety of approaches to dividends in startups, which your counsel can review with you. Considerations that you should discuss with your counsel include: (1) whether dividends will only be paid when and if declared by the board or if your shares will provide for an annual dividend, (2) whether dividends will be cumulative or non-cumulative, (3) whether cumulative dividends will also be compounding, meaning that any unpaid dividends increase the base amount that the annual dividend percentage is based upon (compounding dividends are less common than “straight” accruing dividends (i.e., where earned but unpaid dividends are not included in the calculation of subsequent dividend accruals)) and (4) when dividends will be paid (e.g., if a company agrees to provide for cumulative dividends, they may require that those dividends are only paid upon a liquidation event) and whether they will be paid in cash (rare, especially prior to a liquidation event) or be converted into additional common stock if and when the preferred stock eventually converts to common stock. Speak with your counsel about the nuances of the dividend structure and additional alternatives and consider whether this is an important point for you to push on.
- Liquidation Preference: As the term “preferred” stock implies, preferred stock entitles the investor, in the case of a sale or liquidation of the company (often referred to as a “liquidation event”), to receive a specified amount in respect of each share before any amounts are distributed to the common stockholders (the “liquidation preference”). The liquidation preference is typically structured as the greater of (1) a multiple of the initial per-share price paid by the investor or (2) the amount the investor would receive if the shares of preferred stock were converted into common stock (meaning, the investor may elect to have their stock treated on an as-converted basis and participate with the common stockholders, if doing so would generate a larger payout than if the investor only received the multiple of its initial per-share price paid). The multiple is often set at just one times the purchase price (i.e., the amount paid by the investor), under the theory that this structure provides the investor with at least a return of the invested capital before any payments to the common stockholders, but is sometimes negotiated to a higher amount (e.g., 1.5 or 2 times the invested amount). Also very important to an investor is whether the liquidation preference will be “non-participating” (i.e., after receiving the liquidation preference the investor does not receive any portion of the remaining liquidation event proceeds, all of which are paid out to the common stockholders) or “participating” (i.e., after receiving the liquidation preference the investor also participates in payment of the remaining liquidation proceeds with the common stockholders). Obviously, “participating” preferred is better for investors and non-participating is better for the company's common stockholders (which will usually include the founders), and this can be a highly negotiated point (with various middle grounds that can be proposed by a potential investor). [The examples in this section assume that the company only has common stock and one class of preferred stock.]
- Board of Directors: In connection with a financing round, the company will often increase the size of its board of directors such that the new investors will have the right to appoint one or more directors. How many directors the investors can appoint will depend on several factors, including the overall size of the board and whether or not the preferred directors will constitute a majority of the board. Even if the directors elected by the preferred investors do not constitute a majority of the board, it is often possible to require the approval of those particular directors on certain matters that materially affect the company and the investors. These actions typically involve hiring/firing of key officers, dividend declarations, engaging in another round of financing, etc. Note, however, that directors may be subject to a fiduciary duty to act in the best interest of the company, not just the preferred investors. Thus, even having specific actions requiring approval of the directors elected by the preferred investors does not guarantee that those directors will vote in a manner that benefits the preferred investors.
- Preferred Investor Protective Provisions: Given the directors' fiduciary duties as noted above, investors will often require that certain company actions must also be approved by a majority of the investors (based upon their respective preferred stockholdings). Unlike board directors, preferred stockholders are generally permitted to vote or consent on company matters in any manner they wish, taking into account only their own interests. These preferred stockholder voting provisions will also establish (1) those matters on which the preferred investors vote with all other stockholders and (2) those matters on which the preferred investors vote separately as a single class. The key consideration in these provisions is that the preferred stockholders want to avoid being outvoted by common stockholders in certain situations where the common stockholders’ interests and the preferred stockholders’ interests do not align. Typically, preferred investors have separate votes for corporate actions involving a liquidation event and corporate actions that would adversely change such preferred investors’ specific rights as preferred investors.
- Information Rights: It is important for investors to ensure that they will be able to obtain important information regarding the company, particularly financial reports and business performance reports. Investors will typically negotiate in the investment documents for the right to receive the company's annual and quarterly financials, and annual budgets. Depending on the nature of the company's business, you may want to receive other, more specific information from the company. If so, consider specifying that further information in the term sheet.
- Preemptive Rights: Preemptive rights give you the right to participate in future equity financings of the company. They can be structured in a variety of ways, but commonly they are structured to give investors (or a specified group of investors) the ability to maintain their percentage interest in the company by giving the investors the right to purchase additional shares offered in the financing. Although uncommon, companies sometimes attempt to include a “pay-to-play” type provision in the investment documents. “Pay-to-play” provisions create consequences for preferred stock investors who do not participate in future equity financings, such as some or all of the investor’s shares converting to common stock if they choose not to exercise their preemptive rights in full. Most investors will strenuously resist such a “pay-to-play” provision and if you encounter one you should discuss it with your counsel. Alternatively, investors may see “use it or lose it” provisions in a term sheet, which generally provide that if an investor does not exercise his/her/its preemptive rights in full, then the investor losses his/hers/its ability to exercise the preemptive rights in any future equity financing.
- ROFR: Right of First Refusal (ROFR) provisions generally provide that before a stockholder can sell any of its shares of common stock, it must first offer the company the opportunity to buy those shares, at the same price as offered to third parties. Most ROFR provisions also provide that if the company does not exercise its ROFR rights in full, other stockholders (sometimes limited to specific other stockholders) have ROFR rights, so the selling stockholder must then offer the shares to such other stockholders before it can transfer its common stock to any third party. ROFRs, as well as tag-alongs (a minority stockholder protection; typically drafted to provide that the minority stockholders can elect to sell their shares alongside the majority stockholder in a sale to a third party) and drag-alongs (a majority stockholder protection; typically drafted to provide that the majority stockholder can require the minority shareholder to sell their shares alongside the majority shareholder in a sale to a third party), are very common for preferred stock investments and should not, in themselves, necessarily be controversial. However, the devil is in the details when it comes to these provisions and you should consult with your counsel about the precise structure and wording of both to ensure that they are crafted fairly and consistently with accepted standards.
Additional Items for Consideration:
The below considerations are outside of the scope of this alert but should be discussed with counsel before you sign the term sheet:
- Anti-Dilution: Preferred stock investments will typically include anti-dilution protective provisions that protect your interest if the company issues shares at a per-share price lower than the price you paid for your shares. The actual anti-dilution formula can vary, but most investments use a "broad-based weighted average" calculation. Your counsel should be able to confirm that a typical “broad-based weighted average” calculation is the formula that is being used. If another formula is to be used, you will want to discuss it with your counsel and question why the company is proposing to use the different formula.
- Closing Conditions: Consider whether there are any conditions that must be met prior to closing. Typical closing conditions involve requiring that the founders and/or other key employees enter into restrictive covenant agreements, the investors completing due diligence on the company, the board entering into indemnification agreements, obtaining any necessary governmental or regulatory approvals, etc.
- Amendments to Investment Documents: Be aware of how the terms of the preferred stock can be amended. Typically, changes to the investment documents that negatively impact a specific class of preferred stockholders must be approved by a majority (or a higher specified threshold) of the preferred stockholders of that class. However, that is not always the case. Keep an eye out for investment documents that provide for less stringent approval requirements to amend preferred stockholders’ rights, so that the basic terms of your investment cannot be revised without your having a meaningful right to consent.
This client alert provides a brief overview of certain considerations for negotiating a Term Sheet for Preferred Stock. It is not intended to be a comprehensive list or summary of the above noted issues or other issues that should be considered when negotiating a Term Sheet for Preferred Stock. For additional details or relevant forms to help address the needs of a specific business transaction, please contact Lindsay Kaplan at email@example.com or Kirk Haynes, Jr. at firstname.lastname@example.org