Negotiating Series A Term Sheets

Negotiating Series A Term Sheets

04.04.12

Benjamin M. Hron

[email protected]

617.449.6584

@HronEsq

Rick M. Lucash

[email protected]

617.449.6568

@RickLucash

What is a Term Sheet

♦ Control Terms v. Economic Terms♦ Standard Agreements

– Stock Purchase Agreement– Charter– Investor Rights Agreement– Voting Agreement– Right of First Refusal and Co-Sale Agreement

♦ Term Sheet to Closing

Part I: Control Terms

♦ Voting Rights and Board Seats♦ Investor Protective Provisions♦ Information Rights♦ Vesting of Founders’ Equity♦ Right of First Refusal and Co-Sale♦ Drag-Along

Voting Rights and Board Seats

The Series A Preferred shall vote together with the Common Stock on an as-converted basis, except:

1. [so long as [#####] shares of Series A Preferred are outstanding, the Series A Preferred as a class shall be entitled to elect [1 or 2] members of the Board, and

2. as required by law.

At the initial Closing, the Board shall consist of [5] members 1. one representative designated by [investor],2. one representative designated by the remaining Investors,3. one representative designated by the Founders, 4. the Chief Executive Officer of the Company, and5. one person not employed by the Company and mutually acceptable to

[the Founders and Investors][the other directors].

Voting Rights and Board Seats

♦ On most matters Series A votes with Common♦ Typically 5 Directors (3 for smaller financings)

– 2 Investor Directors– 1 Founder Director– CEO– 1 Independent Director

♦ Avoiding a “Captured” Board– Veto over election of CEO and Independent– Veto over approval of major corporate actions– Employment contract for founder/CEO

Investor Protective Provisions

Matters Requiring Approval of Series A Stockholders[So long as [####] shares of Series A Preferred are outstanding,] the Company will not, without the written consent of the holders of at least [50-67]% of the Series A Preferred:

1. liquidate, dissolve or wind-up the affairs of the Company, or effect any merger or consolidation or any other Deemed Liquidation Event;

2. amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred];

3. create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred;

4. purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred;

5. create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit]; or

6. increase or decrease the size of the Board of Directors.


Matters Requiring Approval of Series A Director(s)The Company will not, without Board approval, which approval must include the affirmative vote of the Series A Director(s):

1. make any loan or advance to, or own any stock or other securities of, any entity unless it is wholly owned by the Company;

2. make any loan or advance to any person, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors;

3. guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business;

4. make any investment inconsistent with any investment policy approved by the Board;

5. 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;


Matters Requiring Approval of Series A Director(s) (cont.)6. enter into or be a party to any transaction with any director, officer or employee of the

Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[$$$$] per year];

7. hire, fire, or change the compensation of the executive officers, including approving any option grants;

8. change the principal business of the Company, enter new lines of business, or exit the current line of business;

9. sell, assign, license, pledge or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; or

10. enter into any corporate strategic relationship involving the payment contribution or assignment by the Company or to the Company of assets greater than [$$$$$$$].


♦ Investor Approvals:– Significant corporate events (ex. sale)– Actions that could adversely impact Series A– More $$ � More Protections

♦ Series A Director Approvals– Lending/Borrowing– Insider transactions– Hiring/Firing Key Employees

♦ Key Issues– Stockholder v. Series A Director approval– % of stockholders required to approve

Information Rights

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: 1. annual, quarterly, [and monthly] financial statements, and other

information as determined by the Board;2. 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

3. 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.

Information Rights

♦ Right to receive periodic reports♦ Management Rights Letters♦ Key Issues

– Which investors have rights to information– Frequency (quarterly or monthly)– Consequences for failure– Confidentiality

♦ Nobody ever complies with information rights!

Vesting of Founders’ Equity

All Founders to own stock outright subject to Company right to buyback at cost. Buyback right for [__]% for first [12 months] after Closing; thereafter, right lapses in equal [monthly] increments over following [__] months.

Vesting of Founders’ Equity

♦ Right to repurchase shares if Founder leaves♦ Term: 3-4 years; 25% after 1 yr, then monthly♦ Key Issues

– Credit for time served?– Repurchase of vested shares in some situations?– Acceleration on:

� Change of Control (single/double trigger)� Termination without Cause� Leaving for Good Reason

Right of First Refusal and Co -Sale

ROFR: Company [first and Investors second] will have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by Founders [and future employees holding greater than [1]% of Company Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)][, with a right of oversubscription for Investors of shares unsubscribed by the other Investors].

Co-Sale: Before any person may sell Common Stock, he will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors.

Right of First Refusal and Co -Sale

♦ ROFR: – Right to buy shares offered for sale by others– Usually company has first right; investors second– Investors may have over-subscription right– May be “all or none”– May be applied to investors as well

♦ Co-Sale (aka Tag Along): – Right to sell alongside (subject to ROFR)– May be applied to investors as well

Drag-Along

Holders of Preferred Stock and the Founders [and all 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] [and the holders of [50-67]% of the outstanding shares of Preferred Stock, on an as-converted basis], 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 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 Certificate of Incorporation.

Drag-Along

♦ Compels subject stockholders approve a sale♦ Facilitates exit where interests differ♦ Key Issues

– Threshold for exercising– Is consent of common or founders required?– Is Board approval required?

Control Terms: Key Takeaways

♦ Board composition and director election determines who controls the company

♦ Obtaining approval of actions from directors is simpler than obtaining consent from investors

♦ Limit investor right to “drag” other stockholders♦ If founders’ equity is subject to vesting, get credit

for time served

Part II: Economic Terms

♦ Valuation and the Option Pool Shuffle♦ Dividends♦ Liquidation Preference♦ Anti-dilution♦ Pre-emptive Rights and Pay-to-Play♦ Redemption Rights♦ Registration Rights

Valuation and the Option Pool Shuffle

The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully-diluted post-money valuation of $[______] (including an employee pool representing [15-20]% of the fully-diluted post-money capitalization).

Valuation and the Option Pool Shuffle

♦ Valuation – Just one of several the economic terms– Need to consider terms as a package– Model outcome in various exit scenarios

♦ Option Pool Shuffle– Option pool is typically 15-20% of post-FDC– If included in pre-money FDC

� reduces the effective valuation� “phantom” increase to the post-money valuation� shifts dilution to existing stockholders

Dividends

Alternative 1: Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and if paid on the Common Stock

Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, the Series A Preferred will participate with the Common Stock on an as-converted basis.

Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.

Dividends

♦ Range from 5-10%♦ Typically convert when Series A converts♦ Key Issues

– Try to eliminate/delay accruing dividends– Fight cumulative dividends– Strongly resist compounding dividends

♦ Value of dividends can add up– Most important in middle-of-the-road exit

Liquidation Preferences

In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

Non-participating Preferred Stock: First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. The balance of any proceeds shall be distributed pro rata to holders of Common Stock.]


In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

Full participating Preferred Stock: First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

Cap on Preferred Stock participation rights: First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).


Deemed Liquidation Event: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) and 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, thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise]. [The Investors' entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow in connection with a Deemed Liquidation Event.]


♦ Most important economic term after valuation♦ 3 Types

– Non-participating – Founder favorable– Full Participating – Very Investor favorable– Capped Participating – Investor favorable

♦ Investors get 1-3x (plus dividends) before others♦ Participating preferred also shares with Common♦ Applies to any exit, not just liquidation (ex. sale)

Anti-dilution

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:

Weighted Average:CP2 = CP1 * (A+B) / (A+C)

CP2 = Series A Conversion Price after new issueCP1 = Series A Conversion Price prior to new issueA = Shares deemed outstanding prior to new issue B = Consideration received for new issue divided by CP1

C = Shares issued in the subject transaction

Anti-dilution

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:

Full-ratchet: The conversion price will be reduced to the price at which the new shares are issued.

Anti-dilution

♦ Conversion Ratio = Conversion Price / Sale Price♦ Adjusts conversion price for “down” rounds♦ Weighted Average:

– Proportionate to size and price of down round– May be “broad” or “narrow”

♦ Full Ratchet: – Adjusts conv. price to equal price in down round– Red Flag: investor is aggressive on terms

♦ Exceptions for certain share issuances

Pre-emptive Rights and Pay -to-Play

Pre-emptive Rights: All [Major] Investors shall have a pro rata right to participate in subsequent issuances of equity securities of the Company (with standard exceptions). 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.

Pay-to-Play: [Unless the holders of [50-67]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors. All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat, if applicable].

Pre-emptive Rights and Pay -to-Play

♦ Types of Pre-emptive Rights– Right to maintain %– Right to purchase a multiple of %– Right to purchase (collectively) 100%

♦ Over-Allotment Right♦ Limitations

– Major Investors– Pay-to-Play– Use or Lose (Pay-to-Play Lite)

Redemption Rights

The Series A Preferred shall be redeemable from funds legally available for distribution at the option of holders of at least [50-67]% of the Series A Preferred commencing any time after [the fifth anniversary of the initial Closing Date] at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in three equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].

Redemption Rights

♦ Right to force redemption after ~5 years♦ Creates an “exit” option, but rarely (never?) used♦ May create leverage to force other exits♦ Key Issues

– Optional v. Mandatory– Time before right matures– Length of time allowed for payout– Consequences of failing to redeem

Registration Rights

Demand Registration: Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [1 or 2] (consummated) registrations by the Company of their shares.

S-3 Registration: 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.

Piggy-back Registration: The holders of Registrable Securities will be entitled to “piggyback” registration rights, 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]% 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.

Registration Rights

♦ Demand: Usually limited to 1 or 2♦ S-3: Usually limited to 1 or 2 per year♦ Piggy-back♦ Issues

– Threshold % to exercise Demand rights– Earliest date Demand rights may be exercised– # of Demand rights and frequency of S-3 rights– Minimum IPO price for Demand rights

♦ Founders may be able to get subordinate S-3 and Piggyback rights

Economic Terms: Key Takeaways

♦ Dividends and liquidation preferences can have significant impact on economics

♦ Option pool should be sufficient for near future♦ Understand if option pool is in pre-money♦ Full ratchet anti-dilution is very investor favorable♦ Pay-to-Play helps mitigate anti-dilution in down-

round financing♦ Pre-emptive Rights should not prevent the

company from raising more money♦ Don’t sweat Registration Rights

Other Terms

♦ Tranches and Milestones♦ Conditions to Closing♦ Reps & Warranties♦ Payment of Investor Expenses

– Should be contingent on closing– Cap (typically $35K-$50K)

McCarter & English LLP

Benjamin M. [email protected]

617.449.6584@HronEsq

Questions?

Rick M. [email protected]

617.449.6568@RickLucash

Negotiating Series A Term Sheets

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Transcript of Negotiating Series A Term Sheets