The EIR Corner

A term sheet is a letter of intent from a VC that outlines the structure and objectives of their investment in your company. Presented below are brief explanations of selected term sheet topics that are often confusing to entrepreneurs.

As with any legal document, it is essential you employ an attorney that is well versed in this subject matter and has experience negotiating from an entrepreneur’s perspective.

Preferred Stock

The majority of VC investments are structured as preferred stock , which carries a higher ranking relative to the company’s common stock. Founders typically receive common stock, employees receive either common stock or options to purchase common stock and the VC’s receive preferred stock.

The preferred stock will often carry an annual dividend rate which is intended to reflect the time value of money. Because early stage companies are cash constrained, dividends are not usually paid on an annual basis, but accrue over the years and may become part of the liquidation preference (described below).

When a company raises venture capital, the shares of preferred stock sold in each financing are designated with a letter (e.g., shares sold in the first financing are “Series A”, the second “Series B”, the third “Series C”, etc.). Shares of the same series all have the same rights, but shares of different series can have different rights.

Liquidation Preference and Participation Rights

The liquidation preference helps ensure VC’s get their money first when a company is sold or liquidated. Under this clause, preferred shareholders will receive the value of their investment, plus accrued and unpaid dividends, before any money is distributed to common shareholders. Most VC’s also include a “participation right” that enables them to share any proceeds that remain after the payment of their liquidation preference on a pro rata basis with the common stockholders.

In the event of an IPO, the investor’s preferred stock is converted to common shares and proceeds are shared equally among the shareholders.

Redemption Rights

Investors do not want to be in a situation where a company is doing well enough to be an ongoing business after several years, but is not at a level where it can be sold or go public. To create a potential exit path in this situation, investors will retain the right to redeem their stock plus unpaid dividends if the company has not sold or gone public in five years.

Although this may be necessary to offer some protection to the limited partners of the venture fund, it is rarely exercised because the company may not have the ability to pay, or pursuing this option could place a significant financial burden on the company.

Anti-Dilution Provisions

VC’s expect the value of your stock to increase at each subsequent round of financing. But, if things don’t go as planned and you have a “down round”, the anti-dilution provision helps protect VC’s by retroactively reducing the per share purchase price of preferred stock. This is accomplished by increasing the number of shares of common stock into which a share of preferred stock will convert. The two main types of anti-dilution calculations are the “ratchet” and weighted average methods.

The ratchet method lowers the VC's previous per-share price to the new share price being offered. Because this tends to be highly dilutive to common shareholders and heavily favors investors, it is not commonly used.

The broad-based weighted average adjustment is the most common and company-friendly because it considers the effect of a dilutive issuance based on the broadest possible scope of existing equity interests. A narrow-based weighted average may exclude existing interests such as options or warrants and is typically better for the VC.

Drag Along

Drag along allows the investors to take advantage of an attractive exit opportunity without requiring approval from every shareholder.

This provision requires all shareholders to agree in advance to not withhold their approval of a future sale or merger of the company if the board and a specified majority of the shareholders (usually preferred and sometimes common) support this action. The minority shareholders would receive the same price, terms and conditions as the majority.

Pay-to-Play Provision

This provision ensures investors agree in advance how they will participate in future financings. To keep his preferred stock from being converted to common shares, an investor must keep participating in future board approved financings on a pro rata basis. If this condition is not met, the conversion may be applied to all his preferred shares, or to just the portion that fell short of the pro rata requirement.

Protection Provisions

Although VC’s fully expect company management to be ethical and responsible, they will retain the right to ensure all actions have a legitimate corporate purpose. Typical actions requiring VC approval include: amendments to the company’s charter and bylaws, issuing additional stock, the declaration and payment of dividends, changes to the company’s stock option pool, expenditures in excess of approved budgets, the incurrence or guarantee of debt, and the sale of the company.