Search Results for: term sheet

After the recent announcement of the Series Seed Financing documents by Marc Andreesen, Brad Feld points out that there are now four sets of “open source” equity seed financing documents:

• TechStars Model Seed Funding Documents (by Cooley)
• Y Combinator Series AA Equity Financing Documents (by WSGR)
• Founders Institute Plain Preferred Term Sheet (by WSGR – disclaimer, I represent the Founders Institute and was involved in drafting this document)
• Series Seed Financing Documents(by Fenwick & West)

My general opinion is that anything that makes the financing process faster and easier or otherwise educates entrepreneurs is a good thing.  (A reminder that anything I write on this site is only my personal opinion and does not represent the views of WSGR or anyone else from WSGR.)  In addition, I think that a “peace treaty” between early-stage investors and startup companies on standard terms (at least at a term sheet level) is a step in the right direction.

I previously wrote a post titled “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)?”  Much of the commentary on the Y Combinator documents is also applicable to the Series Seed documents.  (In fact, I recyled part of that post in writing this post.  I also reviewed the TechStars documents last year and they are similar in concept to the Y Combinator documents as the chart below indicates.)

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 seriesby Brad Feld/Jason Mendelson, among other places. If you really want to understand the nuances in venture capital financing documents, please review the NVCA model venture capital financing documents. 

What situations should the Series Seed documents be used in?

The Series Seed 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. under $500K).

I was actually somewhat surprised that the following investors have agreed to use the Series Seed documents in certain of the their deals:  Baseline, Charles River Ventures, SV Angel (Ron Conway), First Round Capital, Harrison Metal Capital, Mike Maples, Polaris Venture Partners, SoftTech VC and True Ventures. In contrast, Fred Wilson says while he is “hugely supportive of his intent here, I can’t and won’t get behind the Series Seed forms because they leave out some critical stuff that we simply won’t do a deal without.” 

I think that there are certain situations where the Series Seed and other stripped down equity financing documents might be appropriate, but I know that there are lots of situations where early-stage investors probably wouldn’t agree to the Series Seed terms.

Recently, I have seen a lot of seed stage financings being structured as convertible debt with a price cap, which is an alternative to the equity financing contemplated by the Series Seed documents. Certain angel investors refuse to do convertible debt deals, but will be okay if there is a price cap. In fact, I have seen convertible debt used to raise up to $1.0 million, but it seems like the sweet spot is around $500K.  Convertible debt documents are generally much more simpler to draft and read than equity financing documents, so I typically recommend convertible debt for companies raising below around $750K.

In my experience, if a company is raising, say $1.0 million, the investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors.  Therefore, the Series Seed documents may not be acceptable in these situations.  I think that the Series Seed documents are probably most appropriate in a friends and family equity seed financing, as opposed to a round led by a professional investor.

Why is it called Series Seed?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  There is no real rule to what a particular series of preferred stock is called.

What rights does the Series Seed have?

Ted Wang explains most of the highlights of the documents.  The primary rights in these documents, ranked in order of importance in my opinion are:

• Non-participating preferred liquidation preference.  The investor receives their money back and the remainder goes to the common. 

• Limited protective provisions.  Among other things, the company can’t be sold without consent of a majority of the Series Seed.

• Future rights.  If new investors get better rights in a future equity financings (such as registration rights, price-based anti-dilution, redemption rights, etc.), then the holders of the Series Seed get these better rights.

• Right of first offer on future financings.  Self-explanatory.

• Board seat.  The Certificate of Incorporation gives the Series Seed a board seat, while the common get two board seats. 

• Information rights.  The investor receives unaudited annual and quarterly financial statements.

• Drag along.  The Series Seed documents include a fairly harmless drag-along provision, which requires the investors and the key common stockholders to vote in favor of a “deemed liquidation event” (which basically means sale of company transaction) if a majority of the holders of common stock, a majority of the holders of the Series Seed and the board approve the transaction.  Given the general theme of the documents to eliminate unnecessary provisions, it strikes me as somewhat odd that there would be a drag-along. If I represent investors in a later Series A financing, I would probably use the existence of the drag-along as an excuse to implement a more aggressive drag-along provision — which does not require the approval of the holders of common stock to trigger.

• Legal fees.  The company is obligated to pay $10K for investors counsel.  I suspect that this seems reasonable if there is basically no due diligence due to the early stage of the companies.  (By the way, the TechStars documents and the Y Combinator documents do not have a provision to reimburse counsel for the investors, probably on the theory that the situation where the documents are used don’t require counsel to review the documents on behalf of the investors.)

What are the primary rights that are missing from the these documents that would be in a typical Series A financing?

In the Series Seed documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet.

• Dividend preference.  Almost all startup companies don’t declare dividends, so deletion of a dividend preference is irrelevant to an investor.  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 investors should really care about registration rights.

• Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series Seed 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 Seed is unlikely.

• Comprehensive protective provisions.  The Series Seed documents are fairly light on protective provisions compared to a typical Series A financing.

• Co-sale rights.  These rights are missing, which is probably okay since I have never heard of a co-sale right being used before.

• Voting agreement.  In a typical venture financing, there is 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 Seed 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.

Why will or why won’t people adopt the Series Seed documents?

• Investor pressure.  The only way that the Series Seed documents will be widely used is if investors demand use of the documents.

• Investors want additional protections. I suspect that things like lack of anti-dilution protection, a desire to have participating preferred stock and weak protective provisions will make it difficult for some investors to agree to use the documents without modification.  Once you start making substantial changes to the forms, then I think some of the value of standardization goes away.

• Law firm resistence.  As a reference point, WSGR generally does not use the NVCA documents in a Series A financing when it represents the company unless the investor specifically demands that the NVCA documents be used.  This represents approximately 20% of all venture financings in the U.S. I’ve read the WSGR form Series A documents hundreds of times (and probably have most of the provisions memorized).  I think I’ve only come across the NVCA forms a couple of times, and both times were on deals with Boston-based company counsel, where use of the NVCA documents is more widespread.  In addition, WSGR’s Series A documents can be created using the document automation software behind the WSGR term sheet generator. Therefore, using WSGR form documents when I represent a company is much more efficient than using the NVCA documents.

• Drafting issues in later rounds. One thing that I don’t like about stripped down documents is that adding provisions in the future is painful — especially if the documents are not written in a modular fashion.  For example, adding in the anti-dilution provisions into the Series Seed documents requires the insertion of a couple of pages of text into the Certificate of Incorporation.  It’s somewhat painful to ensure that all of the section references (including Microsoft Word auto-reference codes) and defined terms work properly.  Therefore, in my opinion, it’s actually more difficult to add the modular sections than it would be to start from a new robust template and tweak it to fit the term sheet.  I’d encourage the Series Seed project to have redlines of at least the Series Seed Ceritificate of Incorporaiton against the form of Series A Certificate of Incorporation that it was based on in order to show that the documents can easily be modified in a Series A financing to include anti-dilution and other provisions.  (It seems like the Series Seed Certificate of Incorporation is mostly based on the NVCA form of Certificate of Incorporation with various formatting and simplification-related changes.)

• Use of different forms for later Series A financing.  As a practical matter, in a typical Series B financing, the Series A documents will generally be tweaked slightly for the Series B, and company counsel will send redlines to investor counsel to show changes from the Series A (which are typically minimal).  When a company does a Series A financing and the Series Seed documents are in place, the Series Seed Stock Purchase Agreement and Investors Rights Agreement will probably not be re-used.  As discussed above, the Certificate of Incorporation will need to be amended and restated and various provisions will need to be plugged in.  (By the way, restated means that the entire document is redone in its entirely, as opposed to just an amendment, which might refer to discrete sections like: “Article IV shall be amended such that the number of shares of Common Stock shall be 15,000,000.”)  The Series Seed Stock Purchase Agreement has no lingering obligations, so Series A investors will want a more traditional stock purchase agreement with closing conditions and closing certificates — and it is much easier to use a typical Series A Stock Purchase Agreement than modify the Series Seed Stock Purchase Agreement.  In addition, there will be so many new provisions added to the Investor Rights Agreement (such as registration rights) that starting from a more robust form is easier than adding provisions to the Series Seed Investor Rights Agreement.

What’s the difference between the Series Seed documents, the TechStars documents, the Y Combinator documents and TheFunded Plain Preferred term sheet?

The Y Combinator documents were released in August 2008.  The TechStars documents were released in February 2009. TheFunded released their “Plain Preferred” term sheet in August 2009.  The Series Seed documents were released in March 2010.  Below are some of the material differences between the Series Seed, Y Combinator and TechStars documents.  (I won’t bother outlining the differences in TheFunded term sheet, as it was more intended for a typical Series A institutional venture capital financing, as opposed to the seed stage contemplated by the other documents.)

	Series Seed	Y Combinator	TechStars
Name of security	Series Seed	Series AA	Series AA
Principal documents	COI, SPA, IRA	COI, SPA, IRA	COI, Subscription Agt.
Dividend preference	Pro rata with common	Silent	Pro rata with common
Liquidation preference	1x non-participating	1x non-participating	1x non-participating
Redemption rights	None	None	None
Anti-dilution	None	None	Broad-based weighted average
Board composition	2 common; 1 preferred	2 common, 1 preferred	2 common, 1 preferred (if Series AA is at least 5% of fully-diluted)
Protective provisions	Typical list for company-friendly VC financing	Changes in preferred and merger/sale of assets only	Changes in preferred only
Information rights	Unaudited annual and quarterly	Unaudited annual and quarterly	Unaudited annual
Registration rights	None	None	None
Right of first offer on new financings	Yes	Yes	Yes
Right of first refusal and co-sale agreement	Assignment of company right of first refusal to investors	Silent	Silent
Drag-along	Yes for Series Seed holders and founders. Triggered upon (i) majority of common, (ii) majority of Series Sees, and (iii) board approval.	No	No
Future rights	Yes	No	Yes
Legal opinion	None	None	None
Legal fees	$10K to investor counsel	None	None

 

What would you change about the documents?

I’m still pondering and will update this post later after I speak to some early-stage investors.

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.

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.

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.

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.

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.

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.

Protective provisions give the preferred stock or a series of preferred stock the ability to block certain company actions.

Typical preferred stock protective provisions

Typical preferred stock protective provisions from a term sheet may include:

So long as [any] of the Preferred is outstanding, consent of the holders of at least [50]% of the Preferred will be required for any action that (i) alters any provision of the certificate of incorporation [or the bylaws] if it would [adversely] alter the rights, preferences, privileges or powers of or restrictions on the preferred stock or any series of preferred; (ii) changes the authorized number of shares of preferred stock or any series of preferred; (iii) authorizes or creates any new class or series of shares having rights, preferences or privileges with respect to dividends or liquidation senior to or on a parity with the Preferred or having voting rights other than those granted to the preferred stock generally; (iv) approves any merger, sale of assets or other corporate reorganization or acquisition; (v) approves the purchase, redemption or other acquisition of any common stock of the Company, other than repurchases pursuant to stock restriction agreements approved by the board upon termination of a consultant, director or employee; (vi) declares or pays any dividend or distribution with respect to the [preferred stock (except as otherwise provided in the certificate of incorporation) or] common stock; [or] (vii) approves the liquidation or dissolution of the Company[; (viii)increases the size of the board;] [(ix) encumbers or grants a security interest in all or substantially all of the assets of the Company in connection with an indebtedness of the Company;] [(x) acquires a material amount of assets through a merger or purchase of all or substantially all of the assets or capital stock of another entity;] [or (xi) increases the number of shares authorized for issuance under any existing stock or option plan or creates any new stock or option plan].

These protective provisions are typically contained in the certificate of incorporation of a Delaware company.  I think provisions (i) through (vii) are fairly standard (although I think some of the provisions in brackets are not necessarily standard).  I think that provisions (viii) to (xi), along with anything not listed above, are investor favorable and not as typical in West Coast venture financings.  However, all of these provisions are subject to discussion depending on the negotiation strength of the parties.

Minimum threshold to maintain protective provisions

The company should argue for a minimum number of outstanding shares of preferred stock to maintain protective provision.  For example, if only one share of preferred stock remains outstanding as a result of redemptions or optional conversions to common stock, the holder of the one share should not have the ability to block certain company actions.  However, many protective provisions say that they are effective as long as “any” shares are outstanding.

Voting threshold for protective provisions

The necessary vote to bypass the protective provision is typically set at 50%.  In many cases, the percentage is set higher, such as 66 2/3%, because the investor group consists of multiple investors, and a fund or group of funds that holds a significant amount of the preferred want to ensure that a sufficient percentage of preferred shareholders favor the action.

“Series” protective provisions

Upon a Series B or later financing, the later round may request a separate protective provision.  The company generally would prefer that the preferred stock have a single protective provision as a group, rather than each series of preferred stock having its own protective provision.  A separate protective provision may make sense in a later round of financing where the investor is also receiving a senior (as opposed to pari passu) liquidation preference.  However, the company and investors will want to ensure that a series of preferred stock that represents a small percentage interest of the company or represents a small dollar amount of investment does not receive a separate protective provision.

Board level protective provisions

In some cases, investors request additional board level protective provisions.  The board level protective provisions from the sample investor-favorable NVCA term sheet are:

[So long as [__]% of the originally issued Series A Preferred remains outstanding] the Company will not, without Board approval, which approval must include the affirmative vote of [____] of the Series A Director(s):  (i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of [two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors]; (vii) hire, fire, or change the compensation of the executive officers, including approving any option plans; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or encumber technology or intellectual property, other than licenses granted in the ordinary course of business.

These provisions are not common in West Coast venture financings, but are more common in East Coast venture financings, and standard in venture financings for Cayman incorporated Chinese companies.  As a practical matter, almost all of these provisions will require board approval anyway for good corporate governance.  The issue is whether the Series A director(s) should have the ability to veto these actions despite majority board approval.  This type of control might be reasonable in the context of a joint venture, but may not be reasonable when the Series A director only represents a small fraction of the outstanding shares.

Board level protective provisions are usually placed in the investor rights agreement or document other than the certificate of incorporation.  If these provisions were placed in the articles of incorporation of a California company, the California Secretary of State would reject the articles on the theory that this gives the Series A director more power than other directors.

Drafting issues

Investors wanting protection through protective provisions must make sure that the provisions are drafted carefully and clearly.  In the WatchMark (2004) and Benchmark (2002) cases in Delaware, the certificates of incorporation clearly required the consent of the opposing stockholders to amend their terms as contemplated by a proposed financing. However, the same approval was not necessary for an amendment effected through a merger (with a subsidiary).  Thus, the companies were allowed to achieve a result indirectly that was otherwise prohibited under the protective provisions.  To avoid this result, the certificates of incorporation should have specifically prohibited changes to preferred stock terms “whether effected, directly or indirectly, by means of an amendment, merger, consolidation or otherwise.”

All rights in preferred stock provisions, even if considered standard or customary, must be “expressly and clearly stated.” Courts in Delaware will not imply or presume meaning or language from other provisions of the charter.

In addition, most certificates of incorporation contain a “no impairment” clause. These clauses are provisions that generally prohibit a company from seeking to avoid or impair the rights of the preferred stock. The WatchMark court held that no impairment clauses, like other preferred stock provisions, will be interpreted very strictly. A generic “no-impairment” clause will not provide the preferred stock with any particular protection beyond what is specifically provided in the certificate of incorporation.

A company will want to ensure that certain types of stock issuances do not trigger anti-dilution protection.  This is especially true with full-ratchet anti-dilution protection because the issuance of even 1 share at a price lower than a series of preferred stock will result in an adjustment of the conversion price of all shares of that series of preferred stock.

A list of company-favorable carveouts to anti-dilution protection from a term sheet may include:

There will be no adjustment to the conversion price for issuances of (i) shares issued upon conversion of the Preferred; (ii) shares or options, warrants or other rights issued to employees, consultants or directors in accordance with plans, agreements or similar arrangements, but not to exceed a total of [__________] shares issued after the closing date [or such greater number as unanimously approved by the board]; (iii) shares issued upon exercise of options, warrants or convertible securities existing on the closing date; (iv) shares issued as a dividend or distribution on Preferred or for which adjustment is otherwise made pursuant to the certificate of incorporation (e.g., stock splits); (v) shares issued in connection with a registered public offering; (vi) shares issued or issuable pursuant to an acquisition of another corporation or a joint venture agreement approved by the board; (vii) shares issued or issuable to banks, equipment lessors or other financial institutions pursuant to debt financing or commercial transactions approved by the board; (viii) shares issued or issuable in connection with any settlement approved by the board; (ix) shares issued or issuable in connection with sponsored research, collaboration, technology license, development, OEM, marketing or other similar arrangements or strategic partnerships approved by the board; (x) shares issued to suppliers of goods or services in connection with the provision of goods or services pursuant to transactions approved by the board; or (xi) shares that are otherwise excluded by consent of holders of a majority of the Preferred.

Investors and the company will argue about the scope of the carveouts and potentially the number of shares in any given careveout.  In order for some of the carveouts to apply, the investors may require that the issuance of stock be unanimously approved by the board or approved by the directors nominated by the preferred stock.

A company generally wants flexibility in the carveouts to avoid anti-dilution protection being triggered and bothersome amendments to the certificate of incorporation to waive anti-dilution adjustments.  Although an anti-dilution adjustment may be waived by a specific shareholder, I’m not sure the waiver would be valid against a subsequent holder of the shares that did not know about the waiver.  Therefore, a properly drafted certificate of incorporation should allow for the waiver of an anti-dilution adjustment upon a certain vote of the preferred stock or applicable series of preferred stock, without the need to amend the certificate of incorporation.