Search Results for: term sheet

Who pays legal fees in a convertible note bridge financing and how much does it cost?

May 13, 2007 By Yokum 2 Comments

In deals where investors don’t have counsel, the term sheet usually says that each party will bear its own legal fees and expenses. It wouldn’t be unusual for investors to not engage counsel in an early stage convertible note financing with friends and family. If one of the investors wants to have the documents reviewed by counsel, those fees typically are paid by the company, which is customary in any VC financing. The amount of fees to investor counsel can be as low as $2500 for a quick look at documents and no due diligence in a seed stage deal, to over $15K, depending on the amount of diligence and the complexity of the documents. Investor’s counsel may conduct UCC searches and extensive due diligence, especially if the note is secured. In complex deals, investor’s counsel fees may exceed $50K to $100K. Investor counsel fees payable by the company are typically capped, with the investors responsible for any excess over the cap.

Company counsel fees could be under $10K if there is no negotiation on terms and a single investor to over $30K if there is extensive due diligence and complexity. Company counsel fees on convertible loans may exceed $100K for later stage companies or extremely complicated deals. Company counsel fees are higher than investor’s counsel fees because company counsel drafts documents (on the West Coast) and needs to solve diligence issues. In addition, there is typically some deferred corporate housekeeping that needs to be done by company counsel before the financing.

Should a startup company raise its seed round using a convertible note or Series A Preferred Stock?

April 27, 2007 By Yokum 13 Comments

I’ve noticed some interesting posts on the subject by Brad Feld, Josh Kopelman, Jeff Clavier, Dick Costolo, and Education Revolution, among others. In addition, there seemed to be a lot commentary (such as from Fred Wilson) about Charles River Ventures QuickStart Program that involves a seed financing with a convertible note with an increasing (but capped) discount over time.

Generally speaking, I think that the founders of a startup company are probably better off with a convertible note financing over a Series A financing in a seed round for a couple of reasons.

1. A convertible note avoids setting a valuation for the company. In a seed Series A, the valuation is probably going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrant coverage), the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. People good at excel should try to model the different scenarios. Venture Hacks has a good article about the math involved in this modeling exercise.

2. Convertible note documents are simpler than a Series A. This means that a convertible note financing should get closed quicker and cost less in legal fees than a Series A. However, this is not always the case.

That being said, I think that there are two principal reasons to dislike convertible debt from the founders’ perspective.

1. Convertible debt investors have a perverse incentive to want the valuation of the company in the eventual VC Series A to be low, so the investors and the VCs have a greater percentage ownership of the company compared to the founders after the VC Series A.

2. Investors may request aggressive terms. For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default (i.e. the equivalent of getting your arms broken if you don’t repay), etc. In a Series A financing, there seem to be some established norms on what is typical. In a convertible note bridge financing, creative investors may suggest some unusual terms.

I will run through the nuts and bolts of a sample convertible note bridge financing term sheet in the next series of posts.

What’s on this site?

April 26, 2007 By Yokum 10 Comments

Below is a comprehensive list of posts.

INCORPORATION

1. What do you need to do before you quit your job to form a startup company?

2. When do I need to incorporate a company?

3. What type of entity should I form?

4. What state should I incorporate in?

5. What is a certificate of incorporation?

6. What are bylaws?

7. Why should a company follow corporate formalities?

8. What does the board of directors do?

9. What liabilities do the board or officers face?

10. What do stockholders need to approve?

11. How many shares should be authorized in the certificate of incorporation?

12. What does fully-diluted capitalization mean?

13. What is par value?

14. What is an agent for service of process?

15. How do you calculate Delaware franchise taxes?

16. What trademark and other legal issues are involved in selecting a company name?

17. What inspection and information rights does a stockholder have?

FOUNDERS ISSUES

1. Should founders pay for their stock in cash or contribute intellectual property?

2. Should founders stock be subject to vesting before a venture financing?

3. What should the vesting terms of founder stock be before a venture financing?

4. What is an 83(b) election?

5. What is qualified small business stock?

6. Obama proposes no capital gains tax on qualified small business stock

7. What is Series FF stock?

8. What is Class F common stock?

9. What is TheFunded Founder Institute?

STOCK OPTIONS/COMPENSATION

1. What is Section 409A?

2. How do you set the exercise price of stock options to avoid Section 409A issues?

3. What’s the difference between an ISO and an NSO?

4. Should a company allow early exercise of stock options?

5. Should a company allow exercises of stock options with promissory notes?

6. How many shares should be reserved under a stock option plan?

7. How much should you pay an executive in a startup company?

GENERAL

1. What is important in a confidentiality agreement or non-disclosure agreement (NDA)?

2. What are securities laws?

3. What is an accredited investor?

4. Can a California company have unpaid interns?

5. Is crowdfunding legal?

CONVERTIBLE NOTE BRIDGE FINANCINGS

1. Should a startup company raise its seed round using a convertible note or Series A Preferred Stock?

2. What does a convertible note bridge financing term sheet look like?

3. What should the interest rate for a convertible bridge note be?

4. What should the conversion discount be for a bridge note into preferred stock?

5. What is a convertible bridge note with a price cap?

6. What type of financing forces an automatic conversion of the promissory note into Preferred Stock?

7. What happens to the convertible promissory note if the maturity date is reached and there hasn’t been a financing?

8. What happens if the Company is sold after the convertible bridge note is issued and before the maturity date or the next round of financing?

9. What should the maturity date of the convertible note be?

10. What should the terms of bridge loan warrant coverage be?

11. Can you have multiple closings in a convertible note bridge financing?

12. What does subordination mean in a convertible bridge note?

13. What is a security interest in connection with a convertible note?

14. What should the representation and warranties in the note purchase agreement be?

15. Why should a majority of investors be able to amend the convertible notes?

16. Who pays legal fees in a convertible note bridge financing and how much does it cost?

17. What is the economic difference between a conversion discount and warrant coverage for a convertible note?

18. What is the California Finance Lenders Law?

19. Is convertible debt with a price cap really the best financing structure?

20. What are the terms of Yuri Milner/SV Angel’s Start Fund $150K investment into Y Combinator companies?

21. What is convertible equity (or a convertible security)?

SERIES A FINANCINGS

1. What trends does WSGR see in venture financings?

2. What does a Series A term sheet look like?

3. What do definitive agreements for a Series A financing look like?

4. Are Series A term sheets binding?

5. What is preferred stock and why is it issued to investors?

6. How do you calculate Series A price per share?

7. Can you have multiple closings in a Series A financing?

8. What is a dividend preference?

9. What is a liquidation preference?

10. What is the amount of a typical liquidation preference?

11. What is the difference between non-participating preferred stock and participating preferred stock?

12. What is a cap on a participating preferred liquidation preference?

13. What is the priority of the liquidation preference when the Series B financing occurs?

14. 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?

15. What are redemption rights?

16. Why is preferred stock convertible into common stock?

17. When should preferred stock be automatically converted into common stock?

18. What is anti-dilution protection?

19. What is weighted average anti-dilution protection?

20. What is full ratchet anti-dilution protection?

21. What is a pay to play provision?

22. What are carveouts to anti-dilution protection?

23. What are protective provisions?

24. What stockholder approval is necessary to complete a venture financing?

25. What are information rights?

26. What are registration rights?

27. What are demand registration rights?

28. What are piggyback registration rights?

29. What are S-3 registration rights?

30. What is a market standoff or IPO lockup provision?

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

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

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

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

35. What are board observer rights?

36. What is a management rights letter?

37. What should legal fees for a Series A financing be?

38. What should the terms of the no shop be?

39. Why should a term sheet be confidential?

40. What are the conditions to closing of a Series A financing?

41. What does the legal opinion cover?

42. What is Form D and what information gets publicly disclosed to the SEC in a financing?

43. 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)?

44. How do the sample Series Seed financing documents differ from typical Series A financing documents?

45. What is upgradeable Series A preferred stock?

46. How do you find federal and state government funding opportunities for clean tech and other companies?

SERIES B FINANCINGS

1. What does pari passu mean?

2. Should the Series B liquidation preference be senior to the Series A?

3. Should the Series B have a separate protective provision?

DOWN ROUNDS

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

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

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

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

M&A

1. What stockholder approval is necessary to sell a company?

2. What are directors’ duties and what can they do to protect themselves in a sale of company?

3. What does a liquidation preference spreadsheet look like?

FAQs

Can I ask you a question?

Sure, but read the disclaimer. If you communicate with me in connection with a matter for which WSGR does not already represent you, you should not send me confidential or sensitive information via email because your communication will not be treated as privileged or confidential. If I answer a question on this site, it’s because I thought the question and answer would be helpful to other people and it doesn’t mean that I’m your lawyer. Neither WSGR or I are your lawyer unless you have signed an engagement letter with WSGR.

The likelihood that I will provide a thoughtful response to a question increases if the question is well thought out. Don’t contact me as a substitute for hiring your own lawyer. If you ask me a random question and actually expect me to reply, you should at least thank me in advance (and an offer to make a donation to an appropriate charity will increase the likelihood that I don’t treat the email like a 419 scam email). Sending over a box of Sprinkles or Kara’s cupcakes or Beard Papa cream puffs will get my attention. I think the most thoughtful gift I received was a copy of Madden 2009 the day after it was released. Read below to see what my hourly billing rate is. Also, please spell my name correctly.

Can I contact you to represent my company?

Yes. While I prefer to be introduced to people by someone that I know, I generally will at least chat over the phone with anyone who contacts me on a legitimate matter. My interest level will increase dramatically if I have some idea of your background (e.g. having a Ph.D in electrical engineering would automatically qualify you as someone that I would meet) and what the company does (e.g. an executive summary would be helpful). Like online dating (for which I have no personal experience by the way), I am worried about being contacted by potential axe-murderers and stalkers, so being able to quickly qualify a person is important to me. A LinkedIn bio where I can quickly review someone’s background is often helpful. I will invest the time to meet with someone or to grab lunch if I think it is worthwhile.

I generally prefer receiving emails as opposed to phone calls from people that I don’t know. This is partially because I don’t like the hassle of physically writing down sometimes garbled contact info (especially when I am listening to messages while driving). If you feel compelled to cold call me, then at least send me an email with contact info. If you’re going to contact me and you’re not being referred by someone I know, it would be helpful to understand your background and what you’re working on. An executive summary would be helpful.

Have you ever represented someone that has cold-contacted you?

Yes. A couple of companies have gone on to receive venture financing. Some of them would have likely gotten introduced to me anyway through one of several mutual connections.

What is your billing rate?

My current billing rate is $895/hour. I might provide startup companies with discounts off my billing rate, depending on factors such as whether I have worked with the entrepreneur before and whether WSGR has equity in the company. Every person at WSGR has an hourly billing rate ranging from $100/hour and upwards depending on their level of experience and expertise, among other things.

Will you defer legal fees?

Depending on the company, I will consider deferring legal fees (but not out of pocket costs) in connection with basic startup matters up to a specific dollar cap. In order to even consider deferring legal fees, the founders need to be working full-time on the project (i.e. why should I defer fees if it’s only a part-time hobby for you) and must have some likelihood of raising financing. Deferred legal fees are due upon a financing and will be reevaluated after a period of time (six months to one year) if the company has not raised financing. If a company continues in bootstrap mode and the founders are getting paid, then I think that the lawyers should be paid. If the company dissolves without raising financing, then I will write off the accrued legal fees, but with the expectation that the founders return to me for the next company.

In return for the risk in never getting paid, I expect my firm’s investment partnership to receive somewhere between 0% and 2% of the fully-diluted capitalization of the company at the same price as the founders. The exact percentage depends on the risk. For example, if you already have a term sheet from a legitimate venture fund, the risk is probably zero.

What does it cost to incorporate a company and what is the process?

Incorporating a company in Delaware, issuing restricted stock to founders, setting up an option plan and providing forms of NDAs, consulting agreements, etc. seems to cost around $5K or so. Actual mileage may vary. It could be higher or lower depending on the amount of back and forth and questions. For example, founders who are incorporating their third company with me probably already understand the nuances of vesting acceleration and know exactly what they want. Generally speaking, I have noticed that legal fees relating to incorporating a company with several founders will cost more because of increased explanation time, additional customization for standard forms and multiple revisions of documents due to the founders changing their mind on issues.

I send potential founders an incorporation questionnaire, which they fill in. Most founders have a handful of questions, which I answer over the phone or over coffee/lunch. Once the incorporation questionnaire is completely filled out, a paralegal and a junior associate typically create the documents, with me reviewing a couple of issues (e.g. vesting) for quality control purposes.

How much does a financing cost?

A simple seed stage convertible bridge note financing where the investors are not represented by counsel and don’t negotiate any terms typically seems to cost around $5K to $15K. A Series A preferred stock financing where the investors are not represented by counsel and don’t negotiate any terms typically seems to cost around $15K to $25K. Company counsel legal fees for a Series A financing with a venture fund typically seem to be greater than $50K or $60K, and can be much higher if there is neglected corporate housekeeping or mechanical hassles like bridge note conversions. In addition, the company needs to pay for investor counsel legal fees, which is often $25K to $35K. If investor counsel legal fees are $35K, it wouldn’t be unusual for company counsel fees to be around $70K. Actual mileage may vary.

What’s with the name Yokum?

My legal name is Yoichiro. In Japan, people are called last name-san. For young boys, it may be first name-kun. Yoichiro gets shortened to Yo-kun. Sometime when I was little, my parents probably told people to call me Yokum because Yoichiro was too hard to say. (Please note that this was before Ichiro Suzuki of the Seattle Mariners was a household name.)

Why are you blogging?

Two of my clients, Ballhype (which incidentally aggregates sports blogs) and EduFire started blogging about their experiences in starting up their companies. After reading their blogs, I realized that there was a lack of easily digestible legal information for entrepreneurs starting companies. I seem to answer the same questions over and over again, so I thought I would start blogging to disseminate what I know. (Oh, and I represented a company called Spotplex, which TechCrunch ponders as a potentially better Digg, so I figured I should join the blogging bandwagon.) Due to this blogging interest, I also started to represent Hatena, a Japanese blogging company.

What are you going to cover in this blog?

I’ll try to cover common startup company questions from my practice, including incorporation, founders stock, stock options, seed financings, convertible note bridge financings, Series A financings, M&A issues, IPO planning and other things that seem to come up over and over again.

How often are you going to post?

I’m not sure. Probably when I don’t have a client waiting for an immediate deliverable. I’ll aim for about once a week. Writing some of these answers takes a significant amount of thought and time.

Why are all of your posts in the form of responses to questions?

It seems like what I do most of the time is respond to questions.

Did you write all of these posts yourself?

Yes. However, I have recycled some WSGR client alerts and other memos at times. I have also had a couple of guest posts.

Is this an official WSGR publication?

No. Otherwise, there would be more WSGR logos and the color scheme would be different.

Can I use what you say here against you in a future negotiation?

Sure, but I could easily change one of the posts while I’m on the phone with you to whatever supports the position I’m advocating.

What if I think one of your answers is wrong or misleading?

Let me know. I’ll revise the answer accordingly.

Did you change the contents of one of your posts?

Probably. I write quickly and misspell things. If you read some of my emails, especially from my wireless email device, you’d realize this. I will change things as I notice errors or think of a better answer or if someone makes a comment. You may want to think about this site as a pseudo-wiki where I am the sole editor (until I get someone to volunteer to write more content).

Did you edit a comment?

Maybe. I reserve the right to do whatever I want, like fix typos and edit for clarity.

Why does your feed look funny?

See the previous two answers. I probably posted, then decided to change something.

Did you set up this blog by yourself?

Yes. I think I’m relatively technically proficient for an attorney. One of my clients called the WordPress interface slicker than any fantasy sports application he’d seen, which convinced me that I could do it myself. (Of course, it isn’t hard to have a better application than ESPN Fantasy Sports, which seems to have issues all the time.)

What does this blog run on?

This blog is powered by WordPress.

Why can’t you make this site look better?

I just did a complete overhaul in February 2016, so I’m not sure what more I can do. As Doctor McCoy might say, I’m a lawyer, not a web designer. It’s a work in progress. I will take suggestions and constructive criticism. If someone wants to offer to re-design the site, I’m sure we could work something out.

What is an employee retention or M&A carveout plan?

February 21, 2010 By Yokum Leave a Comment

I was speaking at an event last month to a group of CEOs and was surprised by the number of CEOs that were worried about the value of their common stock in a M&A transaction. Due to aggregate liquidation preferences that may exceed the acquisition price in an M&A deal, common stock may be rendered worthless. For example, if a company has raised $20M in venture financings by issuing non-participating preferred stock, the holders of common stock will not receive any proceeds from an M&A transaction unless the transaction value exceeds $20M. If you can’t figure this out yourself, you should probably build a liquidation preference spreadsheet to model how liquidation preferences work depending on M&A transaction value.

In response to the problem of worthless common stock, some companies have implemented employee retention plans, which are also referred to as M&A carveout plans. This was particularly common from 2001 to 2003, after the dot-com crash when companies had raised a large amount of venture financing at high valuations.

Below are some common structures for employee retention plans and issues related to each alternative. I have intentionally not covered all of the corporate law implications of designing and implementing a retention plan or provided a comprehensive analysis of any particular tax or accounting issues, as they are fairly complex and depend on specific facts. A company’s board of directors will need guidance from counsel on meeting their fiduciary duties when implementing a retention plan.

1. Change of Control Bonus Plans

Under a change of control bonus plan, eligible employees are entitled to certain benefits upon change of control transactions as specifically defined in the plan documents. This can be simple as an agreement with an individual employee that says “if you are still employed when the company is sold, you will receive $X.”

More complex plans set aside a pool of money for employees and a mechanism for dividing the pool. In addition, the plan could pay a fixed amount under the plan to the individuals, regardless of the value of the triggering event. Alternatively, the plan could pay a percentage of the proceeds from the triggering event (e.g. 10% of the size of the deal). In some cases, the payout may be a sliding scale (e.g. 10% of the first $5M in proceeds, 15% of the next $5M in proceeds, and 20% of the amount over $10M). In plans where the size of the payout is dependent on the size of the transaction, the definition of the transaction value needs to account for situations such as assumption of debt by the acquiror, earnouts, escrows, and illiquid stock as acquisition consideration, among other things. In addition, given that the plan is intended to solve for situations where common stock is worthless, they should terminate above certain transaction values, or payouts should take into consideration the value of the common stock.

2. Straight Retention Plans

Under straight retention plans, eligible employees are entitled to certain benefits or payments that are not contingent upon any triggering event, such as a change of control. These bonus payments may be paid as long as the employee is employed on a certain date (i.e. 50% of base salary if still employed 6 months later).

The following issues relate to both change of control bonus plans and straight retention plans:

• Currency. The company must determine the currency with which to pay the eligible employees. Typically, employees receive stock, cash or a combination thereof. A retention plan that pays employees in acquiror stock is less common than a cash payment plan as payment in acquiror stock will be ordinary income to the employee, and receiving illiquid acquiror stock in a taxable transaction is not desirable in most situations.

• Participation. The company must determine which employees are eligible to participate in the program. Executive management is typically the key participant, however, participation may be determined by time of service or benefits can be given to all employees.

• Allocation. Once the company has determined who is eligible, they must further determine how to allocate the units or stock to be issued to the employees. Alternatives include position, time of service, current equity holdings or other metrics as determined by the company’s board of directors. The board can set aside some of the “retention pool” for future issuances. However, it must determine when establishing the plan what will happen to the pool upon certain triggering events.

• Vesting. The company must determine whether the stock or cash distributed will be fully vested at the time of grant or will vest over time. The company must further determine which, if any triggers, will accelerate vesting and to what degree.

• Last Man Standing. Related to vesting issues, the company must also determine whether benefits will be forfeited if employees are terminated within a certain period of time of the change of control and whether the forfeited benefits will be redistributed to remaining employees. If the employee needs to be employed at the time of the change of control transaction, this may lead to a perverse incentive for company management to terminate employees, especially if the forfeited benefits are redistributed to remaining company management.

3. Junior Preferred Stock

Some companies have implemented junior preferred stock, which often receives a certain percentage liquidation preference on the sale of the company. The junior preferred can be created as an option plan or sold directly, with or without vesting. The junior preferred is often junior to existing preferred stock, but senior to common stock, in order to provide liquidation preference for certain classes of employees, senior to common stock. Participation, allocation and vesting issues are similar to those described above.

What is Series FF stock?

December 22, 2007 By Yokum 17 Comments

[Note: this post will likely get updated in the near future.]

I’ve been asked by a few people about the Series FF stock that has been advocated by the Founders Fund. Matt Marshall of Venture Beat reported on this invention in December 2006. See here for an Inc.com report in March 2007. Michael Martin blogs about economic incentives associated with the Series FF and founders receiving some liquidity in connection with a venture financing. Series FF stock has also recently received some attention due to the announcement of the Founders Fund raising a $220 million fund in December 2007. See additional coverage from Venture Beat, TechCrunch and the Mercury News.

I’ve reviewed the Certificate of Incorporation of a couple of WSGR clients that have implemented Series FF stock. (Please note that anyone can obtain the Certificate of Incorporation of a Delaware company from the Secretary of State of Delaware.)

The Series FF is an interesting mechanism for founders to obtain liquidity in connection with a venture financing. Below are the main features of the Series FF stock:

The Series FF is basically identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer of the Series FF purchases it in connection with the equity financing.
The conversion into preferred stock can only occur if the buyer of the Series FF pays the same price per share as the shares of preferred stock sold in the equity financing.
The conversion into preferred stock can only occur if the board approves the conversion.
The Series FF is convertible into common stock at any time at the option of the holder.
The Series FF automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of Series FF.

By the way, the Series FF preferred stock doesn’t need to be called Series FF. It can be called Series A, Series Q, Series Z, Series X, etc. The Founders Fund has managed to do some branding by referring to it as Series FF.

Below are some things to keep in mind about Series FF stock:

Pricing of the stock is complicated. Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the Series FF is not issued at initial incorporation, then issuing the Series FF stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares. As I will describe in a later post, founders stock is typically issued at a very nominal price per share, such as $0.001, so that the company may initially issue 10,000,000 shares for $1000.
If the Series FF is issued immediately prior to the Series A financing, then the price per share of the Series FF probably should be at least the same as the Series A. In some respects, the Series FF may be more valuable than the Series A in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because the board might not allow a conversion to occur (or investors may not be willing to purchase).
Legal fees incurred in issuing Series FF may be higher. This is because the Series FF receives some amount of custom drafting and tweaking compared to a typical incorporation. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting everyone comfortable. The additional costs involved in setting up the Series FF may be wasted if the future board does not allow the founders to obtain liquidity.
It is unclear whether venture funds are willing to allow founders to sell a portion of their stock in connection with a venture financing. Implementing the Series FF before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be a good thing to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in the following situations:
- The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
- The company is doing well (i.e. valuations above $100M and nearing an IPO) and the founders would rather sell the company that wait longer for liquidity.
Investors prefer to purchase newly issued shares supported by a legal opinion, representations and warranties and various contractual rights. I’m not sure what benefit the company receives by facilitating the sale by the founders as the company does not receive the funds from the investors.
Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies can repurchase founders common stock for cash, subject to various limitations. The main issue that the Series FF solves is the price difference between preferred stock and common stock. If common stock is repurchased by the company at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes probably should be the preferred stock price. However, in a company nearing an IPO, the common stock FMV will likely be very close to the preferred stock price anyway. Therefore the Series FF stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early stage venture financing. (I’ll write a future post about option pricing and 409A in the near future.)
Because the Series FF will likely only be issued to founders due to timing and pricing issues associated with issuing the Series FF, other employees may be upset that founders are receiving some liquidity.
There is some risk of claims against the founders that sell (and the board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.
Despite carefully drafted releases, venture funds may reluctant to purchase the shares due to potential claims by disgruntled founders that they were forced to sell their stake at a low price compared to the price in an eventual liquidity event.

I am curious to see whether the Founders Fund has managed to invent something that will be broadly accepted or just a novel feature that is occasionally used by companies that have a connection to the Founders Fund.

I will likely update this post (without warning) with more thoughts as I hear feedback from various people.

What is full ratchet anti-dilution protection?

August 4, 2007 By Yokum 3 Comments

Full ratchet anti-dilution protection is conceptually much simpler than the weighted average approach, and its effect on the company is considerably more severe in the event of a dilutive financing. Under the full ratchet formula, the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share paid in the dilutive financing.

For example, if the outstanding preferred stock was previously sold at a price of $1.00 per share, and the new preferred stock in the dilutive financing is sold at a price of $0.50 per share, the effective price of the previously outstanding preferred stock would be reduced to $0.50 per share with the result that each share of such preferred stock previously convertible into one share of common stock would now be convertible into two shares of common stock.

Under the full ratchet formula, this same result is obtained whether the company raises $100,000 at a price of $0.50 per share or raises $10,000,000 at a price of $0.50 per share. In contrast, the amount of money raised in the dilutive financing is an important factor in determining the new conversion price in the weighted average formula.

Below is an example of how full-ratchet anti-dilution protection works.

Assume that the pre-financing capitalization of the company is (same as example for weighted average anti-dilution protection):

1,500,000 Common Stock

2,500,000 Series A Preferred Stock (issued at $1/share)

2,000,000 Series B Preferred Stock (issued at $2/share)

1,000,000 Options

7,000,000 Total

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

Series A adjustment

The Conversion Price of Series A Preferred Stock becomes $0.50.

Thus, the number of shares of common stock issuable upon conversion of Series A Preferred Stock =

(2,500,000) * ($1.00/$0.50) = 5,000,000

This results in a Series A Conversion Rate of 2:1

Series B adjustment

The Conversion Price of the Series B becomes $0.50.

Thus, the number of shares of common stock issuable upon conversion of Series B Preferred Stock =

(2,000,000) * ($2.00/$0.50) = 8,000,000

This results in a Series B Conversion Rate of 4:1

Problems with the full ratchet

At first glance, the full ratchet formula seems very attractive for investors as it completely protects their investment from any subsequent price erosion until the occurrence of a liquidity event (at which time the preferred stock would normally be converted to common stock). The company should argue that it is unfair to have the company bear all the downside price risk where there is no limit on the upside potential for the investors.

However, a full ratchet formula can also be problematic for the investors in a syndicate. Because the prior money invested is fully protected with regard to price decreases, if the company’s prospects deteriorate and the company is forced to undertake a dilutive financing, there is no incentive for all of the investors to participate in the new dilutive round. Therefore, the lead investor(s) may have difficultly inducing the smaller investors in the syndicate to continue to participate, and the burden of continuing to fund the company can fall heavily on the lead investor(s). In addition, the application of the full ratchet will be disclosed to the incoming invstors in the new round upon review of the company’s charter documents in the due diligence process. This will make the company appear significantly less attractive to invest in and will exacerbate the problems of an otherwise already difficult financing. Because the number of pre-financing shares outstanding increases due to the anti-dilution adjustment, the price per share of the new series of preferred stock will decrease. This results in a circular formula, that requires strong spreadsheet skills to solve.

In addition, as a result of the anti-dilution protection for the preferred stock, the percentage ownership of the common stock will decrease, which decreases the incentive of management and employees.

[Note: this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike O’Donnell and Anton Commissaris.]