Shares, Protective Provisions, BoD. Guide to Terms Sheets, Part 2
This is the second post in a series of articles, which describe basic concepts and practical tips related to Term Sheets. For other posts please follow the links below:
- Valuation, ESOP, Liquidation Preference, Dilution. Guide to Term Sheets
- Shares, Protective Provisions, BoD. Guide to Terms Sheets, Part 2
- Investor Rights. Guide to Term Sheets. Part 3
In my first post, I touched upon the economics of an investment deal within startup financing process and implications of the Term Sheets. In my current post, I am going to describe details of a typical investor involvement in startup company operations both from day to day operations and legal perspective. The main goal of this post is to shed some light on what are the typical rights and duties of investors and how they can relate to the founders of the startup company and vice versa.
Common vs. Preferred Shares
Within a startup, equity shares are normally broken down into common and preferred stock. Common shares are sometimes split into Common A and Common B — varying in priority. Preferred shares are herewith divided into participating and non-participating stock — which determines whether preferred investors would get priority for additional funds distribution from the proceeds on top of their initial investment. Preferred equity shareholders have the right to negotiate specific terms, which are favourable to them when it comes to negative events such as bankruptcy, down round, dilution and more. For example, liquidation preference allows preferred investors to get their initial investment back before owners of common shares in the event of a liquidation. Another example is pro-rata rights, which helps existing preferred investors to maintain their percentage of equity ownership via subsequent investments in the following rounds, while common shareholders will be diluted. One more example can be anti-dilution rights, which protects preferred investors in case of future drop in value of their shares (down round). In this situation, preferred investors will be granted with newly issued additional shares in order to preserve the value of an initial investment.
Practical tip: founders and employees of a startup are typically granted with common stock, while investors get preferred stock (with sometimes aggressive rights), hence many features of preferred shares can significantly impact the allocation of proceeds to common shareholders in case of exit. As a result, founders and employees can be left with little or no returns after required payments are allocated to preferred investors, especially in case of participating preferred shares or multiple liquidation preferences.
Protective Provisions
Any Term Sheet represents a combination of provisions, each of which favour either investor (mainly) or startup founders. Protective provisions used in Term Sheets differ from one investor to the other, that is why startup founders are advised to carefully analyze and choose between different investment proposals, which include not just the price, but also a blend of investor’s provisions, incl. protective rights. Even though the terms of protective provisions can differ from case to case, there is a widely-used set of protective provisions, which most of VC investors use, including:
- Increase in the authorized number of common or preferred shares
- M&A event
- Adjustment of the size of the board
- Declaration of dividends
- Adjustment of ESOP pools
- Approval of annual budgets, business and financial plans
- others
Practical tip: preferred investors can get the right for veto-level control over certain company decisions based on protective provisions, however, this doesn’t mean, that the investors will impede on each of the decisions listed above, it simply requires obtaining approval from preferred shareholders. Also, it is recommended to founders to insist on the same set of provisions to all investors (at least at early stages of their business) in order to simplify the decision-making.
Board of Directors
One of the most important clauses within Term Sheets is the clause about Board of directors (BoD). The reason being is that BoD manages all of the major activities related to company top-level operations and strategy, incl. CEO & top management hiring and firing, veto for M&A and others. BoD is usually created at Series A stage and onwards upon maturity of a company and after the company raised significant amounts of funding. BoD acts as a means of investors’ influence, and usually includes 3–5 representatives at early stages: founder and/or CEO, investors’ representative(s) and independent board member (not a shareholder) who serves as a mediator between company founders or management and investors. When negotiating Term Sheet provisions, it is recommended to specify BoD composition, investors’ rights to board representation, voting rights for different types of shares among others.
Practical tip: when negotiating BoD terms, founders shall make sure that i) they get along well with selected investors, ii) they are on the same page with investors in regards to the vision and long-term goals of the company and iii) investors are competent enough to participate in the decision-making.
As a sum up, transparency in the Term Sheet structure and negotiations process should solve the issues of misunderstandings and mistrust between founders and investors: the founder won’t be afraid that the investor can seize the company, while an investor won’t fear that the entrepreneur will buy a Ferrari with his money.
Read other posts to understand all about Term Sheet:
- Valuation, ESOP, Liquidation Preference, Dilution. Guide to Term Sheets
- Guide to Term Sheets. Part 3 (coming soon)
We hope this article was helpful to you. We are super keen to hear your comments, feedback or any questions regarding startups financing mechanisms.
Do you run an innovative tech startup? We are investing in early-stage revenue-generating software startups across the world and would love to hear from you! You can reach us at leta.vc
