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What should the composition of the board be like and how are the board seats allocated?

Investors in venture financings almost always demand representation on the board of directors. In a VC-led Series A financing, there are typically three or five directors immediately after the financing. As a practical matter, smaller size boards are easier to manage (i.e. scheduling board meetings for larger boards is extremely difficult; meetings seem to go faster when there are less people in the room whose opinions needs to be heard).

If there is one lead investor, then there are typically three directors, consisting of one Series A investor designee, one common designee (typically the founder/CEO) and one independent person (approved by the investor and the common stockholders or the common designee). The independent seat will oftentimes be left vacant at closing, with the intention of filling the seat sometime after closing.

If there are two lead investors, there there are typically five directors, consisting of two Series A investor designees (one from each investor), one common designee, the CEO (which will be a seat elected by the common stockholders) and one independent person.

In later rounds of financing, investors in the later rounds will also inevitably demand a board seat, which results in larger boards dominated by investor representatives. Investors in later rounds will sometimes request that investors in previous rounds relinquish their board seat to limit the size of the board. These early investors are typically given board observation rights, which allow them to attend and participate in board meetings, but not have an official vote in board decisions.

For the entrepreneur’s point of view on the subject, please read the Venture Hacks articles “Create a board that reflects the ownership of the company” and “Make a new board seat for a new CEO,” along with Dick Costolo’s post on “Early Stage Board of Directors.”

In some financings, especially non-VC led Series A financings, the board composition can simply be a closing condition to a financing with no other mechanism to guarantee a certain board composition. In such case, the composition of the board in future elections typically defaults to one vote per share (preferred converted to common basis) and may be favorable to the common stockholders as they typically control a majority of the outstanding shares.

In most venture financings, however, the board composition is set forth in the certificate of incorporation (i.e. common may elect one board member, Series A may elect one board member and the common and preferred voting together may elect all other board members). A voting agreement among the common and preferred stockholders forces the stockholders to vote in favor of director nominees selected in a certain manner (i.e. all of the Series A stockholders agree to vote in favor of the nominee from VC Fund X for the Series A seat).

In my experience, it seems like founders are overly concerned about board composition compared to other provisions in a term sheet. At the end of the day, most founders typically don’t control the board after a VC-led financing, as the investors won’t allow a situation where the common stockholders have significant control or veto power. As a practical matter, investors will typically end up with a significant amount of control due to the protective provisions and the drag-along provision, aside from board composition.

What is a drag-along or bring-along provision?

The drag-along or bring-along provision forces a stockholder to vote in favor of a sale of company if a certain threshold of stockholders and/or the board of directors approve the transaction. Below is a typical term sheet provision.

“Drag-along” right: Subject to customary exceptions, if holders of [50]% of the Preferred approve a proposed sale of the Company to a third party (whether structured as a merger, reorganization, asset sale or otherwise), [__________] will agree to approve the proposed sale. This right will terminate upon a Qualified Public Offering.

The items typically negotiated in the drag-along provision include:

• Parties subject to the drag-along.  Generally, investors want common stockholders with significant holdings to sign up to the drag-along. This is especially important for companies that may be subject to the California long-arm statute, which would require the holders of a majority of common stock to approve the transaction.  Major investors also typicaly want the other investors to be subject to the drag-along to ensure that minority investors also approve the transaction.  If significant stockholders exercise dissenters rights, which would allow them to receive cash in the transaction, they could interfere with the tax-free nature of certain mergers.

• Threshold to trigger the drag-along.  The trigger is typically a certain percentage of stockholders (such as 50% or 2/3 of the Preferred, or a specific series of Preferred) and sometimes board approval.  The percentage to trigger and the group of stockholders that control the trigger are typically negotiated.

• Minimum price.  Due to liquidation preferences, some stockholders (especially common and junior preferred) may not receive any proceeds in a merger.  Forcing these stockholders to vote in favor of a merger in which they receive no consideration may be objectionable to them.  Therefore, some stockholders may try to negotiate minimum price thresholds for the drag-along to apply.  For example, a common stockholder may try to argue that the drag-along should only apply if the common stockholder receives at least a certain price per share (such as the Series A purchase price) or the valuation of the company is greater than a certain amount in the transaction.  Investors will likely resist these modifications to the drag-along because the purpose of the drag-along is to force a vote in the event of a sale of company transaction that might not be entirely supported by the stockholders subject to the drag-along.

• Limitation to cash/freely tradeable securities.  Many stockholders would object to having to vote in favor of (and waive dissenters rights in) a taxable merger transaction in which they receive illiquid securities.  Therefore, some stockholders argue that the drag-along should only apply if the merger consideration is cash or freely tradable securities.

• Limitation on representations, warranties and covenants made by the dragged party. Some stockholders may argue that the drag-along should not force them to give representations, warranties and covenants in the transaction that go beyond ownership and authority to sell the shares.  This is typically agreed to by investors.

Many acquirors will require a certain percentage stockholder vote in favor of a merger in order to minimize the risk of stockholders exercising dissenters rights.  If the thresholds for the drag-along are set at a level where various stockholder constituencies are protected against transactions that are not economically beneficial to them, the drag-along provision serves a good housekeeping function to make sure that minority shareholders vote in favor of the transaction.

Occasionally, some savvy investors will also require the drag-along provision to be included in the company’s option agreement so that any optionholder that exercises and holds common stock will be subject to a drag-along.

What is a right of first refusal and co-sale agreement?

The right of first refusal and co-sale (”ROFR/Co-sale”) work together to prevent a founder or major common shareholder for selling shares without the company and the investors being allowed to purchase the shares or participate in the sale of the shares. Below is a typical term sheet provision.

In the event [__________] proposes to transfer any Company shares, the Company will have a right of first refusal to purchase the shares on the same terms as the proposed transfer. If the Company does not exercise its right of first refusal, holders of Preferred will have a right of first refusal (on a pro rata basis among holders of Preferred) with respect to the proposed transfer. [Rights to purchase any unsubscribed shares will be reallocated pro rata among the other eligible holders of Preferred.] To the extent the rights of first refusal are not exercised, the holders of Preferred will have the right to participate in the proposed transfer on a pro rata basis (as among the transferee and the holders of Preferred). The rights of first refusal and co-sale rights will be subject to customary exceptions and will terminate on an initial public offering.

The items typically negotiated in the ROFR/Co-sale include:

• Common holders subject to the ROFR/Co-sale. Generally, investors will want holders of large amounts of common stock to be parties to the ROFR/Co-sale. The company (and founders) will want to minimize the number of holders of common stock that need to be subject to the ROFR/Co-sale. The hassle associated with a large number of parties becomes evident in subsequent rounds of financing when the ROFR/Co-sale agreement needs to be amended.

• Exceptions to the ROFR/Co-sale. Founders will want various share transfers to be exempt from the ROFR/Co-sale such as transfers to family members or for estate planning purposes. In some cases, a founder may want to transfer up to a certain number of shares each year without being subject to the ROFR/Co-sale.

• Minimum investor shareholding to have ROFR/Co-sale rights. The company may want to limit the rights to investors that hold a minimum number of shares.

The ROFR/Co-sale forces a founder to provide written notice to the board and the investors of any potential transfers, which allows the company and the investors time to evaluate if they want to purchase (or participate in the “co-sale” of) the shares. I have never heard of a co-sale right actually being used, although I know that lots of companies remind former founders about their ROFR obligations.

The ROFR/Co-sale agreement rarely receives more than cursory comments in a typical venture financing.

What is a right of first offer or right to maintain proportionate ownership in future financings?

A right of first offer allows an investor to purchase its pro rata percentage of issuance of new securities until an IPO. Below is a typical term sheet provision.

Each holder of Series A Preferred will have a right to purchase its pro rata share of any offering of new securities by the Company, subject to customary exceptions. The pro rata share will equal the ratio of (x) the number of Series A Preferred shares held by such holder (on an as-converted basis) to (y) the Company’s fully-diluted capitalization (on an as-converted and as-exercised basis). This right will terminate on an IPO.

The items typically negotiated in the right of first offer provision include:

• Major investor. Like information rights, the concept of “major investor” is often used to limit the investors that receive preemptive rights. The number of shares that an investor needs to hold to have these rights is typically set low enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives the rights and high enough to avoid giving rights to numerous small investors.

• Accredited investors. Sometimes, the right of first offer will be limited to accredited investors (to be covered in a future post). Federal and state securities laws limit offers and sales of securities to a limited number and certain types of investors.

• Percentage calculation. The pro rata calculation may be tweaked by aggressive investors so that the denominator in the formula is the aggregate number of preferred shares, which would result in existing investors having the opportunity to purchase 100% of the securities offering in the financing.

• Carveouts. The right of first offer typically not apply to certain issuances of securities. This list is generally the same as the types of issuances that do not trigger anti-dilution.

• Super pro rata rights. Investors sometimes ask to have a right to purchase more that their pro rata percentage ownership. This is not a common term in a typical venture financing. However, it may be requested in an early stage financing where the investor did not obtain a large percentage ownership because the company wanted to limit dilution, but investor expects to invest in additional rounds and wishes to increase their percentage ownership. Please read the commentary from AsktheVC and Venture Hacks for more thoughts on this provision.

• Over-allotment. If some investors with pro rata rights do not fully participate, then the participating investors may want the right to purchase the shares that the non-participating investors did not purchase. This potentially adds additional delay to completing the financing due to the need to comply with various notice periods for the initial offer and the over-allotment.

What is a market standoff or IPO lockup provision?

In connection with the initial public offering of a company, the underwriters will generally require the company to prevent their existing stockholders from selling their shares for a certain period after the offering (with 180 days being standard). The purpose of this “market standoff” or “lock up” is to delay the trading of these existing securities until the market can absorb the additional sales after the IPO. To avoid potential disagreements with shareholders immediately prior to the offering, the lock-up provision is typically contained in agreements in connection with every issuance of company stock.

Below is a typical form of lockup provision from an Investor Rights Agreement.

[If requested by the Company and an underwriter of Common Stock (or other securities) of the Company, each Holder shall not] [Each Holder hereby agrees that such Holder shall not] sell or otherwise transfer, make any short sale of, grant any option for the purchase of, or enter into any hedging or similar transaction with the same economic effect as a sale, of any Common Stock (or other securities) of the Company held by such Holder (other than those included in the registration) during the one hundred eighty (180) day period following the effective date [of a registration statement of the Company] [of the registration statement for the Company's Initial Public Offering] filed under the Securities Act [(or such other period as may be requested by the Company or an underwriter to accommodate regulatory restrictions on (i) the publication or other distribution of research reports and (ii) analyst recommendations and opinions, including, but not limited to, the restrictions contained in NASD Rule 2711(f)(4) or NYSE Rule 472(f)(4), or any successor provisions or amendments thereto)] [, provided that: all officers and directors of the Company and holders of at least one percent (1%) of the Company's voting securities are bound by and have entered into similar agreements]. The obligations described in this Section 2.10 shall not apply to a registration relating solely to employee benefit plans on Form S-l or Form S-8 or similar forms that may be promulgated in the future, or a registration relating solely to a transaction on Form S-4 or similar forms that may be promulgated in the future. The Company may impose stop-transfer instructions and may stamp each such certificate with the second legend set forth in Section 2.8(c) hereof with respect to the shares of Common Stock (or other securities) subject to the foregoing restriction until the end of such one hundred eighty (180) day (or other) period. [Each Holder agrees to execute a market standoff agreement with said underwriters in customary form consistent with the provisions of this Section 2.10.]

In more recent forms of lockup provisions, the lockup period may be extended due to rules that prevent underwriters in an IPO from issuing a research report or recommendation on the company within 15 days prior to or after the expiration of a lockup agreement. If the company experts to issue an earnings release within 15 days of the expected release of the lock-up, then extending the lockup period to allow the investment bank to issue an analyst report may be beneficial.

What are S-3 registration rights?

An S-3 registration entitles investors to demand that a company register their shares on a Form S-3 registration statement. Form S-3 is a shorter form of registration statement than a Form S-1 (used in an IPO) and may be used by a company one year after an IPO. Form S-3 requires less effort by a company than a Form S-1 because the company is allowed to refer to certain items contained in its other SEC filings.

The items typically negotiated in the S-3 registration rights provision include:

• The number of S-3 registrations. Typically, the company may want to limit the number to a one or two in any twelve month period and the investors will want unlimited S-3 registrations. There are legal and accounting expenses associated with an S-3 registration, which the company will want to limit.

• The minimum size of an S-3 registration. The company will want the amount of securities to be registered to be greater than a certain dollar amount, such as $1 million, in order to avoid frivolous registration requests.

What are piggyback registration rights?

Piggyback registration rights entitle investors to register their shares of common stock whenever the company conducts a public offering, subject to certain exceptions. Unlike demand rights, piggyback rights do not entitle investors to require a company to conduct a public offering but simply allow them to include shares in a registration that is initiated by the company. Piggyback registration rights typically are not particularly disruptive (other than the effort involved in contact investors with piggyback right to solicit their participation in a registration) and do not require the special effort of demand registrations. Companies usually bear the cost of investors exercising piggyback rights.

The items typically negotiated in the piggyback registration rights provision include:

• The ability of underwriters to cutback investor shares in an offering. Typically, the piggyback registration rights provisions allows underwriters to completely eliminate investors as selling shareholders in an IPO. In subsequent offerings, the investors will typically negotiate that they cannot be cutback to less than 25% or 30% of the offering.

• The priority of investor shares to be included in an offering. Some venture funds aggressively negotiate the priority of any shares that the underwriters allow to be registered in a company-initiated registration. An aggressive later investor may request that their shares be included in a registration before any other non-company shares are included in the registration.

• Whether founders and management can also have piggyback registration rights. Savvy founders will argue to obtain piggyback registration rights for the same reason that venture funds want the rights.  Absent registration, founders that are affiliates will need to comply with volume restrictions under Rule 144. A registered public offering may be one of the few orderly ways that a founder can sell a large number of shares.

What are demand registration rights?

Demand registration rights entitle an investor to force a company to register shares of common stock so that the investor can sell them to the public. This effectively causes the company to undertake an IPO if the company is not yet public. Registrations are time-consuming and expensive, particularly if they involve underwritten public offerings of securities. These offerings require significant efforts from management, diverting them from the business of running the company. These offerings can even depress the market price of the company’s stock if the offering is poorly timed.

As a practical matter, I have never heard of a demand registration right being exercised by an investor. Completing an offering without company and management cooperation is impossible.

The items typically negotiated in the demand registration rights provision include:

• The number of demand registrations the investor can require. Because registrations are expensive, the company typically tries to limit it to one, while the investors typically want two.

• When the investor can make a demand. In an early state financing, a demand registration cannot be exercised until five years from the closing of the financing. In a later stage financing, the time period may be much shorter, depending on the expected potential IPO-readiness date. In addition, a demand registration right typically cannot be exercised for a certain time period after an IPO, such as 180 days.

• Who pays for the demand registration and up to what amount. Typically, the company pays for registration expenses and the expenses on a single counsel to the investors (which is subject to a cap).

• The minimum dollar size of a demand registration. Given the expense involved in a registration, companies want to set some minimum requirements on a demand registration so that it is a legitimate offering. The minimum price per share to exercise a demand registration and the minimum dollar amount of the offering are typically similar to the definition of a Qualified Public Offering that causes the preferred stock to convert to common stock. This is typically set at around 3x to 5x the purchase price of the preferred stock (5x in earlier stage financings and 3x or lower in later stage financings) and an aggregate of $20M or higher to be raised in the offering.

• Rights to delay a demand registration. Companies routinely request the right to delay a demand offering for a fixed maximum period of time if the company has commenced preparations for a public offering or believe a delay would beneficial because of market or other conditions or to avoid disclosing material company developments, such as pending merger negotiations.

• Whether the company needs to use “best” efforts or “commercially reasonable” efforts to effect a registration. Investors ask for “best” efforts, which may require registration irrespective of costs or effort disproportionate to benefit. However, some commentators suggest that there is no real difference between any of these standards.

What are registration rights?

Registration rights entitle investors to force a company to register shares of common stock issuable upon conversion of preferred stock with the Securities and Exchange Commission.

Federal and state securities laws place certain limitations on the transfer of shares that have not been registered. Rule 144 of the Securities Act of 1933 requires that securities be held for at least one year before being sold.  Among other things, Rule 144 also requires that certain current public information about the company be available and limits the volume of shares that can be sold, unless the seller has held the securities for at least two years and is not an affiliate of the company.  Registration allows venture funds to freely sell the shares without complying with these restrictions even if they are deemed affiliates due to significant shareholdings or a director on the board.

Registration involves filing a registration statement with the SEC, which is a expensive and time consuming process. Please see the initial filing of Google’s registration statement for its IPO as an example of the complexity of the document. Legal, accounting and other fees in connection with an IPO can easily exceed $2M.

As a practical matter, registration rights are rarely used and have little practical effect on a company until after an IPO. However, some venture funds and attorneys seem to spend a long time negotiating these provisions, when they have little practical impact.  Registration rights are negotiated between the company and the investors, well before underwriters are involved.  At the time of an IPO and subsequent underwritten public offerings, underwriters will have the ability to dictate whether investors are allowed to sell, which makes the registration rights negotiated at the time of the venture financing a mere starting point for discussions with the company and the underwriters.

What are information rights?

Information rights force a company to provide investors with financial statements and other company information.  These rights are typically contained in an Investor Rights Agreement.

A typical information rights provision from a term sheet provides:

The Company will deliver to each holder of at least [500,000] shares of Preferred, (i) [un]audited annual financial statements within [90] days following year-end, (ii) unaudited quarterly financial statements within [45] days following quarter-end, (iii) unaudited monthly financial statements within [30] days of month-end, and (iv) annual business plans. The information rights will terminate upon an initial public offering.

Most information rights also include the opportunity to visit the company’s facilities, inspect the company’s books and records and discuss matters with company officers.  As a practical matter, I don’t think that most venture backed companies are in 100% compliance with information rights provisions, especially the time periods for delivery of the information.  For example, audited financial statements for private companies never seem to be completed within the specified time period.

One issue that gets negotiated in the information rights provision are the number of shares that an investor needs to hold to receive information rights.  This concept of “major investor” is often used to limit the investors that receive preemptive rights and rights of first refusal and co-sale (to be covered in future posts).  The number of shares is typically set low enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives information rights and high enough to avoid giving rights to numerous small investors.  In addition, companies may wish to avoid commiting to delivering annual business plans or monthly financial statements

Information rights provisions also contain provisions that ensure that investors keep the information confidential. This is important because directors have a fiduciary duty to keep company information confidential, but investors do not have a similar obligation absent a contractual confidentiality provision.

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