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Should board members representing inside investors vote on the board resolutions authorizing the insider-led down round?

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As a theoretical matter, entrusting disinterested directors to approve a down round or dilutive financing is an excellent way to protect the insider-affiliated directors against claims from stockholders.  In this situation, the board may establish a special committee comprised only of disinterested directors to negotiate and approve the financing.  In a perfect world, the insider-affiliated directors would not participate in any of the board discussions to approve the transaction.

However, establishing an independent committee of disinterested directors to approve the terms of an insider-led down round financing is often impractical.  Oftentimes, there aren’t any disinterested directors to approve the transaction. All of the directors affiliated with investors participating in the financing will not be disinterested.  In addition, directors that are also employees may not be considered disinterested because they have a vested interest in completing a financing in order to keep their jobs.

In many scenarios, the inside directors will have to vote in order to have a valid board action.  However, the board will not have the benefit of the business judgment rule unless a majority of the disinterested directors or disinterested shareholders approve the transaction.  In this situation, courts will apply the entire fairness doctrine as the standard of review of director actions, which presumes that the directors acted unfairly and places the burden of proof on the directors to show fair dealing and fair value for the company.

Why do preferred stockholders have odd economic incentives upon a sale of company when they have non-participating preferred stock or particpating preferred stock with a cap?

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Even savvy investors often don’t understand the subtle nuances on economic incentives that result from non-participating preferred stock or participating preferred stock with a cap in the event of a sale of company.

Assume a simple cap table of:

10,000,000 shares of common stock

10,000,000 shares of Series A preferred stock

Also assume that the Series A preferred stock has a $1.00/share liquidation preference and is non-participating.

If the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

If the company is sold for $10M to $20M, the holders of Series A would still receive $1.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $15M, then the Series A would receive $1.00/share and the common would receive $0.50/share.  Thus, the holders of Series A are indifferent between sale prices from $10M to $20M, which may lead to odd economic incentives.  Hypothetically, a venture capital fund holder of Series A might not want a company to argue hard over merger valuation with an acquiror if there is no marginal benefit to the fund and there is a risk that the deal may fall apart.

If the company is sold for over $20M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $30M, then the common would receive $1.50/share (assuming all Series A converted).  Of course, if some holders of Series A did not act in their optimal economic interest and convert, then the merger proceeds available to the common would increase and the common would receive greater than $1.50/share.

Similarly, if the Series A is participating with a cap, there will be a range of merger consideration values where the holders of Series A will be indifferent because the cap has been met, but it still does not make economic sense for the Series A to convert.

In the same example, assume that the Series A has a $1.00/share liquidation preference and is participating with a 3X cap.

Like the non-participating preferred, if the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

For merger consideration greater than $10M but less than $50M, the Series A participates with the common on the amount over $10M.  For example, if the merger consideration is $20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which represents the $10M liquidation preference and $5M of participation with the common), and the holders of common would receive $0.50/share, or an aggregate of $5M.

If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an aggregate of $30M (which represents the $10M liquidation preference and $20M of participation with the common), and the holders of common would receive $2.00/share, or an aggregate of $20M.  At $50M, the Series A hits the 3x cap on participation by receiving $3.00/share.

If the company is sold for $50M to $60M, the holders of Series A would still receive $3.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $55M, then the Series A would receive $3.00/share and the common would receive $2.50/share.  Thus, the holders of Series A are indifferent between sale prices from $50M to $60M, which may lead to the same odd economic incentives as the non-participating preferred stock, albeit at higher transaction values.

If the company is sold for over $60M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $60M, then the common would receive $3.00/share (assuming all Series A converted).

Please see the liquidation preference spreadsheet and program some examples if you want to proof this yourself.

If a down round financing is led by a new outside investor, does the board need to be concerned about the business judgment rule?

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Having a new lead outside investor substantially improves the legal risk in a down round financing.  In most cases, the outside investor acting as lead will agree to invest the largest amount of money in the round, will perform the diligence necessary to set the valuation and pricing, and will dictate the terms of the transaction, including the amount of additional investment required or permitted of the inside investors.  In these circumstances, even where the new financing is at a reduced valuation, the conflict of interest issues are normally eliminated.  A rights offering is typically not considered necessary, although the company may still conduct one in order to solicit additional investor investor interest.  Disinterested board and disinterested stockholder approval procedures are typically not necessary, although following them will also decrease risk.

What are securities laws?

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The SEC publishes a guide titled: Q&A: Small Business and the SEC that provides a simple answer.

In the chaotic securities markets of the 1920s, companies often sold stocks and bonds on the basis of glittering promises of fantastic profits – without disclosing any meaningful information to investors. These conditions contributed to the disastrous Stock Market Crash of 1929. In response, the U.S. Congress enacted the federal securities laws and created the Securities and Exchange Commission (SEC) to administer them.

Companies selling common stock, preferred stock or issuing options or warrants are issuing “securities.”  The Securities Act of 1933 generally requires companies selling securities to give investors full disclosure of all material facts that investors would find important in making an investment decision. The Act also requires companies to file a registration statement (i.e. see the Google IPO registration statement) with the SEC that includes information for investors, unless the security or the type of transaction is exempt from registration.

However, registering a securities offering with the SEC is a very expensive (typically costing over $1,000,000) and time-consuming process.  Therefore, sales of securities by companies to private investors or venture capitalists are usually structured to be exempt from the registration requirements of the Act.  These exemptions (post to come) are fairly technical and companies need advice from competent securities attorneys to ensure compliance.

Even if a securities offering is exempt from federal registration requirements, the company must also comply with securities laws in each state where securities are offered.  States may impose their own registration or qualification requirements that must be complied with unless an exemption is available.

Failure to comply with securities laws allows a purchaser to rescind or undo the purchase of securities and get his or her money back or recover damages.  These rescission rights create potential exposure to the company if its stockholders demand their money back.

Generally, the federal statute of limitations for noncompliance with the requirement to register securities under the Securities Act is one year from the date of the violation upon which the action to enforce liability is based.  State remedies and statutes of limitations vary and depend upon the state in which the shares were purchased.  For example, the California statute of limitations for noncompliance with the requirement to register or qualify securities under the California Corporate Securities Law is the earlier of two years after the noncompliance occurred, or one year after discovery of the facts constituting such noncompliance.

In extreme cases, a company may make a rescission offer (i.e. offer to repurchase the securities plus interest) to stockholders that were sold securities in noncompliance with securities laws in an attempt to eliminate the exposure from rescission rights.  The rescission offer itself must comply with all relevant securities laws.  For example, Google’s noncompliance with securities laws in connection with option grants required it to file a registration statement with the SEC to make the rescission offer at the time of its IPO and resulted in a cease and desist order by the SEC.

How can a board decrease litigation risk in an insider-led down round or dilutive financing?

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The role of the participating inside investors in an insider-led down round financing, who have the ability both to set the investment terms and make the investment, creates tension between management and minority stockholders on one hand, and the participating inside investors on the other. In addition, former founders or early investors not participating in the financing may perceive that the participating inside investors are attempting to secure control of the company by diluting their equity position.

Furthermore, the directors affiliated with the participating inside investors are often regarded as having a conflict of interest with regard to their approval of the down round financing.  This conflict of interest creates a difficult legal environment surrounding the actions of the board members and the company.

The actions of the board of directors are governed under state law by the business judgment rule.  This rule creates a presumption that business decisions made by a board of directors will be given deference by the courts if the board’s judgment is exercised diligently and in good faith.  Where the board’s decision may be influenced by conflicting financial interests of the directors (a so-called interested transaction), as in a down round financing, the favorable presumption of the business judgment rule falls away.  In these situations, the transaction is voidable by the shareholders or the company. Under corporate statutes in both Delaware and California, the board may successfully avoid an attempt to void the transaction by showing that the transaction was approved by a vote of the disinterested board members or a special committee, or by a vote of the disinterested stockholders or by proving that the transaction was intrinsically fair and reasonable at the time it was authorized by the board.

If the members of the board were to be found to have breached their duties, state law provides that they may be personally liable for their actions.  Since most private companies don’t carry directors’ and officers’ liability insurance and may not have the cash resources to engage in sustained litigation, the threat of personal liability can be serious.

Other theories of liability have been advanced based on the controlling influence that a venture fund or its general partners may have over the actions taken by a portfolio company.  These theories are based on facts which can demonstrate that a controlling stockholder has breached its fiduciary duty to minority stockholders, or that venture funds or their general partners have conspired with each other to aid and abet a breach of fiduciary duty owing to the stockholders.

There are a number of steps that a board of directors and the company can consider to reduce the risk of litigation from disenchanted stockholders when faced with a dilutive financing driven by inside investors.

  • A compelling board record. Board minutes reflecting the board’s thinking and analysis are important. Board members typically should meet in person or by conference telephone as opposed to taking action by written consent, and should devote more than a single meeting to decide to proceed with a down round financing. The minutes should reflect the board’s rationale for considering a down round financing and its efforts to recruit potential third-party investors.
  • Diligent assessment of alternatives. The board should attempt to demonstrate that it has considered all reasonable alternatives to the insider-led round. Although actual contacts and presentations with possible new investors are not legally required, if the company has not attempted to engage with new investors, there should be a plausible reason in the record for the board’s decision.
  • Approval by independent directors. Approval of the financing terms by the independent directors, or by a special independent committee of the board empowered to authorize the financing, may allow the board to take advantage of the business judgment rule.  Independent director approval may not be practical, however, in many circumstances.
  • Disinterested stockholder approval. Down round financing structures typically require stockholder approval. Securing the approval of the stockholders who are disinterested helps the company defend against an attempt to void the transaction by disenchanted stockholders.
  • Full disclosure of terms. Complete disclosure of financing terms is essential in a down round, with particular consideration of the benefits of the financing terms to the inside investors, the likelihood of replenishment of equity incentives to management and employees following completion of the financing, and factors that would adversely impact non-participating stockholders.
  • Rights offering. Perhaps one of most important steps in an insider-led down round financing is a rights offering that accompanies or follows the financing. All stockholders of the company, and frequently including employees with vested options and warrant holders with “in the money” rights, should be permitted the right to participate in the financing on substantially the same terms as the inside investors. The disclosure or information statement provided to all stockholders of the company can serve to summarize the financing terms while soliciting the interest of potential investors. The rights offering should be structured in a manner to comply with applicable state and federal securities laws and should allow sufficient time to allow potential investors to respond to the offer.

Unfortunately, there is no single step or combination of steps that can completely remove the risk of legal exposure in a down round financing. Board members may be faced with the difficult decision of proceeding with a financing that may result in litigation or shutting down the company.

What does a liquidation preference spreadsheet look like?

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I’ve had some comments and emails asking if I would publish a liquidation preference spreadsheet.  Basically, when a company is thinking about an M&A deal, the first thing that everyone wants to know is how much money does everyone get from the merger proceeds.

Download Sample Liquidation Preference Spreadsheet

The spreadsheet is fairly straightforward.  You can plug in the deal value (merger proceeds) and spreadsheet automatically figures out exactly how much each founder gets and what the return per share is for each class/series of stock.  The spreadsheet determines if a series of preferred stock should convert based on whether the series would receive more merger proceeds as a holder of preferred stock or common stock.

The spreadsheet also takes into account whether options and warrants should be exercised or not.  For example, if the deal value is too low, the common stock merger consideration price per share may be lower than the exercise price for options.  Then the options will not be exercised.  Whether the options are exercised or not will affect the number of outstanding shares of common stock and therefore, the common stock price per share.

This spreadsheet assumes three rounds of financing with non-participating preferred stock, a couple of tranches of warrants (as a result of a bridge loan or two), and options with various exercise prices.  In my redacting of information in the spreadsheet, I’m sure that there is something broken.

I might post a spreadsheet in the future with more bells and whistles, such as the ability to easily manipulate the formulas for senior preferred and participating/non-participating preferred, as well as graphs to show the merger proceeds per share as aggregate merger proceeds increases. Please don’t expect any support or explanation on how the spreadsheet works. I already told someone who had emailed me that I might consider providing a tutorial if she brought my a decaf soy latte and a Sprinkles cupcake some afternoon.

Filed Under: M&A

What deal terms appear in down round and highly dilutive financings?

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[This is the first of a series of posts on down round and dilutive financings.]

I don’t want to add to the “sky is falling” in Silicon Valley theme that I’ve read on various blogs, but given recent economic conditions, a review of how venture financing deal terms may change seems warranted.

Existing investors generally want new investors to set valuations and deal terms in subsequent rounds of financing for a company. However, these deal terms typically become more investor favorable as raising money becomes more difficult. In many cases, existing investors are left to fund the company as new investors are unwilling to invest.

Unlike conventional, “up-round” financings which have a fairly predictable range of terms, the structures and terms of down round financings are variable.  A “down round” financing typically occurs when a company issues securities to investors at a purchase price less than that paid by prior investors.  Absent anti-dilution protection, a down round financing will dilute both the economic and voting interests of the prior stockholders.  A “washout” or highly dilutive financing, is an extreme form of down round financing that significantly reduces the percentage ownership of prior stockholders.

Below are some features of down round and highly dilutive financings.

  • Valuation.  Obviously, valuations may decrease as the financing environment becomes more difficult.
  • Liquidation preference.  Liquidation preferences are also typically more investor favorable than previous rounds.  These financings may involve the issuance of participating preferred stock with senior liquidation preferences at multiples of the purchase price.  Please keep in mind that the liquidation preference may be the most important right of the preferred stock, as the percentage ownership that the preferred stock represents upon conversion into common may become meaningless from a practical perspective if the common stock is worthless (see below).
  • Aggressive convertible debt terms.  Many investors in highly risky financings will prefer senior secured convertible debt over equity securities in the event the company has to file for bankruptcy. These financings may involve the issuance of secured convertible debt (sometimes coupled with warrants) senior to other debt with a payment of a multiple of the principal amount on a sale of company (or conversion into equity securities at a multiple of the principal amount). 5x multiples were not shocking during the post-dot com bust 2001 era. In these situations, voting control, as reflected by percentage ownership and affected by valuation, is a secondary concern to the return on a sale of company and protection in bankruptcy.
  • Milestone-based or tranched financings. Investors may be reluctant to invest large amounts of money in a risky financing.  Instead, they may provide enough money for a company to find someone willing to buy them or achieve a particular milestone that decreases investment risk.  These “IV drip” bridge financings may provide a couple to a few months of operating cash and are typically structured as secured convertible debt with a multiple X return upon a sale of company.
  • Conversion of preferred stock. Some financings involve a conversion of previous series of preferred stock into common stock in order to decrease the aggregate liquidation preference.  In some companies, previous financings may have resulted in an aggregate amount of liquidation preferences that may render the common stock worthless.  For example, due to multiple X liquidation preferences or raising multiple rounds of financing, a company that has raised $50M in financing may have $100M in liquidation preferences.  However, the company may realistically have a problem getting sold for greater than $100M in poor economic conditions where company valuations are low.
  • Pay to play.  Many dilutive financings implement a pay to play mechanism where stockholders not participating in the financing are penalized by being forced to convert into common stock. Absent a pay to play mechanism, stockholders may not have an incentive to risk additional investment into a company due to a free rider problem.
  • Enhanced rights for participating investors.  In some financings, existing stockholders that participate in the financing may receive additional benefits over non-participating stockholders.  This is similar to pay to play provisions that penalize existing stockholders for not participating in the financing. For example, existing stockholders that participate in a financing may have their preferred stock repriced via an adjustment to the conversion ratio, which would effectively give them the benefit of a lower valuation for their original investment. Alternatively, participating stockholders may have the opportunity to exchange their existing preferred stock for new preferred stock with more favorable rights, such as a senior liquidation preference.
  • Expanded investor protections.  Some investors may request more extensive representations and warranties, broader indemnification protection, D&O insurance, and other similar investor-favorable protections.
  • Drag-along rights.  Investors may require drag-along provisions that require existing investors to vote in favor of a future sale of company or an amendment of the certificate of incorporation to create a new series of preferred stock to facilitate a future financing (even before the terms of the preferred stock have been established).
  • Employee retention plans.  Some financings may involve large stock option grants to offset the dilutive effects of the financing to employees.  In some companies, aggregate liquidation preferences or multiple X returns on convertible debt may render the common stock worthless.  In these situations, stock options may not be adequate to hire and retain employees.  Instead, companies may implement retention plans where employees receive a certain percentage of sale proceeds upon a sale of company.

What is upgradeable Series A preferred stock?

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Occasionally, I see a new provision in a term sheet, which keeps things interesting for me. I’ve decided to call this type of Series A preferred stock “upgradeable” (after recently realizing that there are economy class plane tickets that aren’t upgradeable despite having system-wide upgrade certificates). The term sheet provides:

The Series A Preferred shall also be convertible into any future series of Preferred Stock (the “Future Preferred”) under either of the following circumstances: (a) if such conversion is approved by the Board or (b) if such conversion is in connection with a future Preferred Stock equity financing in which the Company’s fully diluted pre-money valuation is greater than the Company’s fully diluted post-money valuation immediately following the Series A Financing contemplated by this term sheet (a “Future Financing”), in either case, on a one-for-one basis (subject to anti-dilution adjustment) at the option of the holder; provided however, if such conversion is in connection with a Future Financing, that the holder may convert into shares of Future Preferred only in the event that all of such shares of Future Preferred received by the holder upon conversion are sold to an Approved Investor (as defined below) no later than 90 days following the first closing of the Future Financing at a price per share no lower than the price per share at which the Company sells shares of such Future Preferred in the Future Financing and, provided further, that such Approved Investor is not an affiliate, family member, or related party of the holder. For the purposes of the preceding sentence, “Approved Investor” means (1) a bona fide institutional investor, or (2) any investor who has invested at least $1 million in the Company. For the avoidance of doubt, any conversion into Future Preferred in connection with a Future Financing that does not result in a sale of such Future Preferred to an Approved Investor on the terms set forth above shall be void, and such Future Preferred shares shall be deemed re-converted into Series A Preferred Stock automatically and without further action on the part of the holder.

Basically, this is a variation on Series FF stock that I have previously written about.  Instead of the stock being issued to founders, the “upgradeable” Series A stock is issued to early investors.  If the early investors want to sell their stock to investors in a later financing round, the Series A stock is convertible into the later round of preferred stock.  This is helpful for early investors who may want liquidity prior to the sale of the company or an IPO.  Assuming the Series B is sold at $2 per share and the Series A was sold at $1 per share, the Series B investor typically would not want to pay $2 per share for a Series A stock with price-based rights (i.e. liquidation preference) at $1 per share.  Of course, allowing an exchange of stock with a lower liquidation preference to a stock with a higher (and potentially senior) liquidation preference is detrimental to the holders of common stock.

I have seen somewhat similar provisions in the past in a slightly different context. In early stage Series A financings, some investors have tried to eliminate certain provisions, such as registration rights, from the standard documents to decrease the complexity and length of typical financing documents. However, these investors want the benefit of rights given to future investors. For example, I have seen a term sheet provision that provides for “most favored nation” status.

When the company raises a Series B financing, the terms of the Series A shall be amended to be at least as favorable as those granted to the Series B.

The problem with this provision is that it is not precise enough.  For example, one might interpret this to mean that price-based provisions (such as liquidation preferences) would be upgraded.

As an alternative, I have used the following term sheet provision in seed stage Series A financings where the investors received a Series A preferred stock with a liquidation preference and no other rights.

If the Company grants registration rights, information rights, rights of first offer, price-based antidilution protection, protective voting provisions or other similar rights to new investors in a subsequent financing involving the sale of additional series of Preferred Stock, the Company will use reasonable efforts to extend such rights to the Purchasers on the same basis granted to new investors. The Company also agrees to use reasonable efforts to provide that holders of greater than 400,000 shares of Preferred Stock will receive any rights customarily having minimum stockholding requirements.

In any event, I wouldn’t be surprised if more sophisticated early-stage investors that want to sell their stock prior to a sale of company or IPO started started asking for “upgradeable” preferred stock.

How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?

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Y Combinator recently published forms of Series AA equity financing documents that YC portfolio companies have used when raising angel financing.  YC provides a three month startup program for entrepreneurs twice a year in Cambridge, MA and Mountain View, CA.  YC typically provides $5K plus $5K per founder of seed funding for usually 6% of the equity in common stock (which, as an aside, Sarah Lacy seems to question, but in my mind seems like something that I would jump at if I were a fledgling entrepreneur).

[Disclaimer/disclosures:  Please read the disclaimer on the documents and on my website.  I write this blog in my personal capacity and my opinions may differ from my colleagues.  WSGR represents Y Combinator and many of its portfolio companies.  I represent a YC portfolio company that provides the Chatterous application and have worked with Y Combinator founder Trevor Blackwell’s company Anybots.  I have also represented investors that have invested in a couple of YC portfolio companies.  I may update this post in the future.]

I was planning to write a post on the differences between angel financing terms and venture capital financing terms, and thought that the YC documents provided a good opportunity to explain the differences.  I’ve already noticed some commentary about the documents and decided to provide some more detailed explanations and the situations that they might be used.

If you want to review annotated Series A venture capital financing documents, please review the NVCA model venture capital financing documents.  (Please note that I think that the default provisions in the NVCA documents are generally fairly investor-favorable and reflect east coast practice rather than Silicon Valley practice.  I will probably write a post about these documents at some point in the future.)  This post assumes that you have a basic understanding of Series A financing terms.  If you don’t, please educate yourself on this site, Venture Hacks and the term sheet series by Brad Feld/Jason Mendelson, among other places.

What situations should these documents be used in?

The YC documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. a couple hundred thousand dollars or less).

In my experience, sophisticated angel investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors, so the Series AA documents may not be acceptable in these situations.  I think these documents are most appropriate in a friends and family equity seed financing.  However, I believe that companies are generally better off with convertible debt rather than an equity financing at a low valuation.

Why is it called Series AA?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  I’ve had clients rename their Series A, B and C to Series A-1, Series A-2 and Series A-3, so that their first institutional venture capital financing was called the Series B.  There is no real rule to what a particular series of preferred stock is called (i.e. Series FF for the Founders Fund invention).  I suppose that YC could have named it Series YC, instead of Series AA, for better branding.

What rights does the Series AA have in the sample YC documents?

Obviously, please read the term sheet. The primary rights in these documents, ranked in order of importance in my opinion are:

  • Right of first offer on future financings.  Please note that these documents provide that the right of first offer expires five years after the financing, which I believe is not standard (but happens to be the company-friendly default in the WSGR form of documents that the Series AA documents were based on).
  • Information rights.  The investor receives unaudited annual and quarterly financial statements.

There are situations where an investor might receive stock with even less rights.  For example, if a founder contributes a significant amount of cash (i.e. enough to buy a car) to fund the company, then I might suggest that the company issue preferred stock with a liquidation preference and no other rights to the founder, as opposed to issuing common stock.  The reason for issuing preferred stock instead of common stock is to preserve a low common stock value for option grants as explained in this post, and providing the stock with a liquidation preference.

What are the primary rights that are missing from the these documents that a VC or sophisticated angel would expect?

Some people have suggested that various terms are unnecessary in early stage Series A financings.  See the VentureBeat article titled “Reinventing the Series A.”  In the sample YC documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet (i.e. one from Sequoia Capital).

  • Dividend preference.  Deleting the dividend preference is not a big deal, as almost all startup companies don’t declare dividends.  The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.
  • Registration rights.  As a practical matter, I don’t think that most investors should really care about registration rights, especially in light of the shortening of the Rule 144 holding period to 6 months.  (I suppose I will write a boring post about Rule 144 at some point.)
  • Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series AA is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series AA is unlikely.
  • Comprehensive protective provisions.  The YC documents are fairly light on protective provisions compared to a typical Series A financing.
  • Right of first refusal and co-sale.  These rights are missing.  This is probably okay assuming that the founders restricted stock purchase agreement has a right of first refusal on transfers until a liquidity event.  The right of first refusal on founder stock transfers in a typical restricted stock purchase agreement is in favor of the company.  (Please note that when I say typical, I mean an agreement drafted by attorneys experienced in venture financings, not the boilerplate you might get from an online incorporation service.)  The typical RFR/co-sale agreement in a venture financing gives the investors a right to purchase the shares if the company does not exercise its right.
  • Voting agreement.  An optional bracketed provision in the Certificate of Incorporation provides for a Series AA board seat.  In a typical venture financing, there would also be a voting agreement that governs how specific board seats will be filled.  In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.
  • Comprehensive representations and warranties.  The Series AA Preferred Stock Purchase Agreement has fairly limited reps and warranties.  As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues.  In an early stage company, extensive reps and warranties are probably unnecessary.
  • Legal opinion.  A company counsel legal opinion is missing in these documents.  A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.
  • Legal fees.  Each side pays its own legal fees in these documents.  Venture funds expect the company to pay investor counsel fees.

Do I need an attorney to help me complete a financing if I have these documents?

Yes.  Absolutely.  These documents are not intended to be “fill in the company name,” sign the docs and collect checks/wire transfers.  The fact that certain rights were intentionally omitted from the documents compared to typical VC financing documents is a judgment call that requires the guidance of an experienced attorney. There are always various corporate housekeeping matters that need to be cleaned up in connection with a financing.  Please don’t try to use the YC documents without working with a competent attorney.

What does fully-diluted capitalization mean?

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“Fully-diluted” capitalization typically includes (1) all outstanding common stock, (2) all outstanding preferred stock (on a converted to common basis), (3) outstanding warrants (on an as exercised and as converted to common basis), (4) outstanding options, (5) options reserved for future grant, and (6) any other convertible securities on an as converted to common basis.

The concept is what number of shares is already “spoken for.”

Authorized, but unissued stock, is not counted in the fully-diluted capitalization number.