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I’m going to keep tonight’s term sheet post short and sweet, especially since I’m still reeling from the horrifyingly bad War of the World movie I just saw. Jason and I are almost done with the term sheet series (yeah, we know we keep promising that) but – like the Spielberg tragicomedy I just watched, it’s not over until it’s over (sorry – that cliche just snuck its way in – I was helpless against it – the aliens made me do it.)
Occasionally a term sheet will have – buried near the back – a short clause concerning “founders activities.” It usually looks something like:
“Founders Activities: Each of the Founders shall devote 100% of his professional time to the Company. Any other professional activities will require the approval of the Board of Directors.”
This should be no surprise to a founder that your friendly neighborhood VC wants you to be spending 100% (actually 120%) of your time and attention on your company. If this paragraph sneaks its way into the term sheet, the VC has either been recently burned or is suspicious and / or concerned that one or more of the founders may be working on something besides the company in question.
Of course, this is a classic no-win situation for a founder. If you are actually working on something else at the same time and don’t disclose it, you are violating the terms of the agreement (and – breaching trust before you get started – not a good thing as it’ll eventually come to light.) If you do disclose it – or push back on this clause (hence signaling that you are working on something else), you’ll reinforce the concern that the VC has. So – tread carefully here. Our recommendation – unless of course you are working on something else – is simply to agree to this (why wouldn’t you, unless you don’t believe in the thing you are asking the VC to fund?)
In situations where I’ve worked with a founder that already has other obligations or commitments, I’ve always appreciated him being up front with me early in the process. I’ve usually been able to work these situations out in a way that causes everyone to be happy and – in the cases where I can’t get there – I’m glad that the issue came up early so that I didn’t waste my time or the enterpreneurs’ time.
While there are situations where VCs get comfortable with entrepreneurs working on multiple companies simultaneously (usually with very experienced entrepreneurs or in situations where the VC and the entrepreneur have worked together in the past), they are the exception, not the norm.
I had good intentions earlier this week to try to crank out the balance of the term sheet series, but it turned into a busy week. Since I’m still muddling through the set of terms that either don’t matter much and/or are hard to negotiate away (e.g. chose you battles wisely), I didn’t expect anyone would be waiting on the edge of their seats for these. However, for completeness, it’s worth going through the stuff that shows up on the last few pages of a standard VC term sheet. Jason and I aren’t quite done, but with this post, we are one (tedious) step closer.
Almost every term sheet we’ve ever seen has a “Restrictions on Sales” clause in it that looks something like:
“Restrictions on Sales: The Company’s Bylaws shall contain a right of first refusal on all transfers of Common Stock, subject to normal exceptions. If the Company elects not to exercise its right, the Company shall assign its right to the Investors.”
Management / founders rarely argue against this as it helps control the shareholder base of the company which usually benefits all the existing shareholders (except possibly the one who wants to bail out of their private stock.) However, we’ve found that the lawyers will often spend time arguing how to implement this particular clause. Some lawyers feel that putting this provision in the bylaws is the wrong way to go and prefer to include such a provision in each of the company’s option agreements, plans and stock sales. Personally, we find it much easier to include in the bylaws.
Next up is the ubiquitous proprietary information and inventions agreement clause.
“Proprietary Information and Inventions Agreement: Each current and former officer, employee and consultant of the Company shall enter into an acceptable proprietary information and inventions agreement.”
This paragraph benefits both the company and investors and is simply a mechanism that investors use to get the company to legally stand behind the representation that it owns its intellectual property. Many pre-Series A companies have issues surrounding this, especially if the company hasn’t had great legal representation prior to its first venture round. We’ve also run into plenty of situations (including several of ours – oops!) where companies are loose about this between financings and – while a financing is a good time to clean this up – it’s often annoying to previously hired employees who are now told “hey – you need to sign this since we need it for the venture financing.” It’s even more important in the sale of a company, as the buyer will always insist on clear ownership of the IP. Our best advice here is that companies should build these agreements into their hiring process from the very beginning (with the advice from a good law firm) so that there are never any issues around this, as VCs will always insist on it.
Finally, a co-sale agreement is pretty standard fare as well.
“Co-Sale Agreement: The shares of the Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange their stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis. This right of co-sale shall not apply to and shall terminate upon a Qualified IPO.”
If you are a founder, you are probably asking why we did not include the co-sale section in the “really matter section.” The chance of keeping this provision out of a financing is close to zero, so we don’t think it’s worth the battle to fight it. Notice that this only matters while the company is private – if the company goes public, this clause no longer applies.
Jason and I are feeling the need for closure on our term sheet series as we’ve started gearing up on our next series (M&A). So – we’re going to knock out the balance of the standard term sheet terms this week. We’re still in the “terms that don’t matter much zone” so we’re including Voting Rights and Employee Pool for completeness.
“Voting Rights: The Series A Preferred will vote together with the Common Stock and not as a separate class except as specifically provided herein or as otherwise required by law. The Common Stock may be increased or decreased by the vote of holders of a majority of the Common Stock and Series A Preferred voting together on an as if converted basis, and without a separate class vote. Each share of Series A Preferred shall have a number of votes equal to the number of shares of Common Stock then issuable upon conversion of such share of Series A Preferred.”
Most of the time voting rights are simply an “FYI” section as all the heavy rights are contained in other sections such as the protective provisions.
“Employee Pool: Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants. The term “Employee Pool” shall include both shares reserved for issuance as stated above, as well as current options outstanding, which aggregate amount is approximately __% of the Company’s fully diluted capital stock following the issuance of its Series A Preferred.”
The employee pool section is a separate section in order to clarify the capital structure and specifically call out the percentage of the company that will be allocated to the option pool associated with the financing. Since a cap table is almost always included with the term sheet, this section is redundant, but exists so there is no confusion about the size of the option pool.
Today’s “term that doesn’t matter much” from our term sheet series is the Right of First Refusal. When we say “it doesn’t matter much”, we really mean “don’t bother trying to negotiate it away – the VCs will insist on it.” Following is the standard language:
“Right of First Refusal: Investors who purchase at least (____) shares of Series A Preferred (a “Major Investor”) shall have the right in the event the Company proposes to offer equity securities to any person (other than the shares (i) reserved as employee shares described under “Employee Pool” below, (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their right of first refusal) to purchase [X times] their pro rata portion of such shares. Any securities not subscribed for by an eligible Investor may be reallocated among the other eligible Investors. Such right of first refusal will terminate upon a Qualified IPO. For purposes of this right of first refusal, an Investor’s pro rata right shall be equal to the ratio of (a) the number of shares of common stock (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) held by such Investor immediately prior to the issuance of such equity securities to (b) the total number of share of common stock outstanding (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) immediately prior to the issuance of such equity securities.”
There are two things to pay attention to in this term that can be negotiated. First, the share threshold that defines a “Major Investor” can be defined. It’s often convenient – especially if you have a large number of small investors – not to have to give this right to them. However, since in future rounds, you are typically interested in getting as much participation as you can, it’s not worth struggling with this too much.
A more important thing to look for is to see if there is a a multiple on the purchase rights (e.g. the “X times” listed above). This is an excessive ask – especially early in the financing life cycle of a company – and can almost always be negotiated to 1x.
As with “other terms that don’t matter much”, you shouldn’t let your lawyer over engineer these. If you feel the need to negotiate, focus on the share threshold and the multiple on the purchase rights.
When Jason and I last wrote about term sheets, Jack was still trying to save the world (surprise – he did) and we dealt with a meaty and important issue – vesting. For completeness (and because all good “series” deserve to be finished off), we’re tackling the terms that rarely matter in the next couple of posts. Today we’re starting with Information Rights and Registration Rights.
You might ask, “If these terms rarely matter, why bother?” Well – you’ll end up having to deal with them in a VC term sheet, so you might as well (a) be exposed to them and (b) hear that they don’t matter much. Of course, from a VC perspective, “doesn’t matter much” means “Mr. Entrepreneur, please don’t pay much attention to these terms – just accept them as is.” Specifically, if one of these terms is being hotly negotiated by an investor or company, that time (and lawyer money) is most likely being wasted.
First up is Information Rights – the typical clause follows:
“Information Rights: So long as an Investor continues to hold shares of Series A Preferred or Common Stock issued upon conversion of the Series A Preferred, the Company shall deliver to the Investor the Company’s annual budget, as well as audited annual and unaudited quarterly financial statements. Furthermore, as soon as reasonably possible, the Company shall furnish a report to each Investor comparing each annual budget to such financial statements. Each Investor shall also be entitled to standard inspection and visitation rights. These provisions shall terminate upon a Qualified IPO.”
Information rights are generally something companies are stuck with in order to get investment capital. The only variation one sees is putting a threshold on the number of shares held (some finite number vs. “any”) for investors to continue to enjoy these rights.
Registration Rights are more tedious and tend to take up a page or more of the term sheet. The typical clause(s) follows:
“Registration Rights: Demand Rights: If Investors holding more than 50% of the outstanding shares of Series A Preferred, including Common Stock issued on conversion of Series A Preferred (“Registrable Securities”), or a lesser percentage if the anticipated aggregate offering price to the public is not less than $5,000,000, request that the Company file a Registration Statement, the Company will use its best efforts to cause such shares to be registered; provided, however, that the Company shall not be obligated to effect any such registration prior to the [third] anniversary of the Closing. The Company shall have the right to delay such registration under certain circumstances for one period not in excess of ninety (90) days in any twelve (12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand right provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty (180) day period commencing with the date of the Company’s initial public offering, or (ii) if it delivers notice to the holders of the Registrable Securities within thirty (30) days of any registration request of its intent to file a registration statement for such initial public offering within ninety (90) days.
Company Registration: The Investors shall be entitled to “piggy-back” registration rights on all registrations of the Company or on any demand registrations of any other investor subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered pro rata in view of market conditions. If the Investors are so limited, however, no party shall sell shares in such registration other than the Company or the Investor, if any, invoking the demand registration. Unless the registration is with respect to the Company’s initial public offering, in no event shall the shares to be sold by the Investors be reduced below 30% of the total amount of securities included in the registration. No shareholder of the Company shall be granted piggyback registration rights which would reduce the number of shares includable by the holders of the Registrable Securities in such registration without the consent of the holders of at least a majority of the Registrable Securities.
S-3 Rights: Investors shall be entitled to unlimited demand registrations on Form S-3 (if available to the Company) so long as such registered offerings are not less than $1,000,000.
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one special counsel of the selling shareholders not to exceed $25,000).
Transfer of Rights: The registration rights may be transferred to (i) any partner, member or retired partner or member or affiliated fund of any holder which is a partnership, (ii) any member or former member of any holder which is a limited liability company, (iii) any family member or trust for the benefit of any individual holder, or (iv) any transferee satisfies the criteria to be a Major Investor (as defined below); provided the Company is given written notice thereof.
Lock-Up Provision: Each Investor agrees that it will not sell its shares for a period to be specified by the managing underwriter (but not to exceed 180 days) following the effective date of the Company’s initial public offering; provided that all officers, directors, and other 1% shareholders are similarly bound. Such lock-up agreement shall provide that any discretionary waiver or termination of the restrictions of such agreements by the Company or representatives of underwriters shall apply to Major Investors, pro rata, based on the number of shares held.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to registration rights as are reasonable, including cross-indemnification, the period of time in which the Registration Statement shall be kept effective, and underwriting arrangements. The Company shall not require the opinion of Investor’s counsel before authorizing the transfer of stock or the removal of Rule 144 legends for routine sales under Rule 144 or for distribution to partners or members of Investors.”
Registration rights are also something the company will have to offer to investors. What is most interesting about this section is that lawyers seem genetically incapable of leaving this section untouched and always end up “negotiating something.” Perhaps because this provision is so long in length, they feel the need to keep their pens warm while reading. We find it humorous (so long as we aren’t the ones paying the legal fees), because in the end, the modifications are generally innocuous and besides, if you ever get to the point where registration rights come into play (e.g. an IPO), the investment bankers of the company are going to have a major hand in deciding how the deal is going to be structured, regardless of the contract the company entered into years before when it did an early private financing.