Understanding the Investor Term Sheet (Part 2)

As your startup grows and you realize that you need to scale, raising money from investors or VCs is an option to consider. However, it’s important to understand the technicalities of getting investments, and particularly, the term sheet. Here’s the second (and final) part of this series. Read Part 1 here!

1. Voting Rights: An investor may (and most likely will) require voting rights when taking part ownership of the company. The shares issued to the investor would confer the voting rights of the shares to the investor or whomever the investor appoints. Certain classes of stock may confer voting rights, while others may not. This nature of voting rights in relationship to ownership of the company or classes of stock is up to the discretion of the investors and founders of the company. Almost always, investors will require voting rights. Investors can also require that certain decisions, like significant expenditures or practices out of the norm, require approval of the shareholder, even if they do not occupy the majority of the board.
2. Dilution (or Anti-Dilution): Dilution of stock value is basically means the decrease in value of the company’s stocks once new shares are issued or converted to a different type of stock. It’s basic economics; a sudden increase in supply will result in a sudden drop in price. Investors and founders want to make sure that they don’t lose monetary value of their total stake in the company when these shares are issued. Also, if the shares are being converted to a different instrument (as the shareholders’ agreed) and dilution might be necessary to sell new stock for financing purposes, these ‘anti-dilution’ measures will ensure that the parties of the agreement do not lose a significant stake in their investment. In other words, when the new shares are issued and dilution of the stocks’ value takes place, investors and founders want to be sure that their percentage ownership in the company has not changed, the total value of all their shares has not changed, and their rights as shareholders has not changed. There are several different alternatives for these provisions. The first one is to do nothing. This is a risky choice, since all power is placed in the hands of those who have the power to issue more shares on the company’s behalf. If a stakeholders’ shares become very diluted, they can lose serious value of their shares’ monetary value and their power/rights within the company. The second most common option is known as “Full Ratchet.” Full ratchet is an adjustment ratio applied to all the shares of the company after issuing a new stock or security. The third most common option is to use a “weighted average” formula which adjusts the conversion price (or the price at which shareholders’ will exchange their old stock for the new) to bring about a specific monetary value in which shareholders can fairly exchange their shares.
3. Right to Participate in Future Rounds: This provision gives the “pro rata”(or proportional) right to shareholders to invest the company during future investment rounds based on their equity stake in the company. These do not include specific shares that have specific “anti-dilution” provisions attached to them that related to future rounds of investment. In other words, when the new round of funding takes place, it will be the shareholders’ right to participate in that round (by giving money) based on the percentage of their ownership equity. For example, if an investor already own 25% of a given company, that investor has right to put up 25% of the new round of funding and is entitled to provisions in the new funding round. This applies to all future rounds of funding, so long as the investor continually participates.
4. Board Composition: Upon signing on as an investor in the company, it is likely that the shareholder will require representation on the company’s board of directors. This provision of a term sheet is closely tied to the Voting Rights provision, as it is often the case that those eligible to vote on company proceedings are those on the board of directors. The amount of seats allotted to the shareholder may or may not depend on the amount of equity the shareholder acquires based on their investment, it is entirely up to negotiation. This amount can also change throughout the duration of the shareholder’s investment. For example, an early stage investor may not desire a majority presence on the board until the company’s valuation increases. The shareholder itself can elect to occupy one of their given seats, if it is a singular person, or it can elect representatives. It is not always the case that the company has an input on who is added to their board of directors, however someone that the company trusts can only aid in creating a productive atmosphere.
5. Registration Rights: If given registration rights, this allows the investor to require that the company registers their securities, documentation that a share has been sold, with the U.S. Securities and Exchange Commission. Registering with the SEC enables investors to more easily sell their shares in the company. Registration rights can manifest in two ways: demand or piggyback. With demanded registration rights, the investor has the power to decide when the company goes public without the consent of the company founders. Conversely, piggyback registration rights allow the investor to attach their shares to the company’s initial public offering, whenever the company itself decides to go public. The company’s success can determine if a shareholder chooses to exercise their demand registration rights, as it provides the possibility for a clear exit out of the shareholder’s investment. However, exercising these rights can complicate the relationship between the shareholder and the company members if the company does not wish to go public at that time.
6. Right to Information: The right to information primarily gives an investor access to all records of the company’s proceedings. This can include, but is not limited to, budget forecasts, financial statements, minutes from the board of directors’ meetings, and inspecting the company premises. This provision can go as far as to detail when each of the above mentioned records needs to be delivered to the investor and how often. This is an essential section to an investor because it enables them to keep a constant watch over the company to ensure that their money is being spent properly and wisely, as they may or may not be present for all company activity.
7. Option Pool: The purpose of an option pool is to put aside common shares of the company for future employees of the company, such as officers or managers. This is a method used by private companies to attract potential employees and usually accounts for 15–20% of the company’s shares. Shares in an option pool usually cannot vest until a certain amount of time has elapsed. However, the size of the option pool can be adjusted down the line once it has more funding. In an investor term sheet, this provision commonly states that these shares are to have no effect on the investor’s equity and instead will be pulled from the founder’s shares. Investors can also require that the size of the option pool is determined based on the company’s valuation before or after their investment is made. Overall, option pools are thought to increase the health of the company because its employees are more invested in its success.
8. Participation Rights: Participation rights allow preferred stockholders to recoup their investment before any other shareholders. Additionally, participation rights enable the investor to fully participate in proceeds that remain after all the investors have recouped their investments, otherwise known as pro-rata. Ideally, founders would negotiate to not include participation rights in an investor term sheet as it reduces the amount of money that they themselves can profit from or filter back into the company. Investors, on the other hand, often negotiate intensely to include this provision in their term sheet. A common compromise is a participation cap, which prevents a shareholder from receiving more than a certain, pre-approved amount of the remaining profits after their initial investment has been recouped.
9. Drag Along Rights: This provision accounts for the right of a majority shareholder to demand that a minority shareholder sell their shares of the company in the event of a third party purchaser, acquisition, merger, or liquidation. Conversely, tag along rights enable a minority investor to sell their share of the company if the majority shareholder sells theirs, which is only applicable if the drag along rights have not been exercised. This is a particularly important term for an investor because it aids in protecting their exit strategy. This is because if a company is being sold, it is often the case that the purchaser will want to buy all the shares of the company. Without drag along rights, a minority shareholder could possibly prevent the company from being sold, thus blocking the majority shareholder’s ability to recoup their investment.
10. Right of refusal/First sale rights: If any other investor wants to sell their shares, the company can get the first chance at buying the shares, and if the company doesn’t exercise these rights, Series A investors may get second pick. This condition controls who owns the majority of the shares in the company.
11. Right of co-sale: Also known as tag along rights, this allows the venture investor to participate in the sale based on the number of shares held by the participating founders so investors can make a partial exit if the right opportunity arises for the founders. If over 50% of the shares are sold, and there is a change in control, the co-sale agreements may require that the total proceeds be divided among the selling stockholders like the transaction is a “liquidation event,” giving the investors liquidation preference.