A company will typically go through seed rounds, which may be accomplished with the Series Seed, SAFE, or convertible Note closings before they attempt a name, preferred round of equity. We generally call the first of this type of deal a company closes, a Series A. If it is a second, then we say a Series B and so on. We generally invest in seed rounds, Series A rounds, and sometimes Series B rounds if the terms are attractive or we have previously invested in the company and wish to take our prorata investment option (more on this later).For many LONG years startup companies were forced to create a Private Placement Memorandum. The PPM is the operative document for any Investment Bankers working under the Series 63 regulations, or private placements of stock. The PPM was a cover-your-backside document that really protected the entrepreneur and the investment banker, but provided little information or utility to the investors. So, by 2007, private equity investors of the VC community made public legal templates for companies and investors alike to use as a standard preferred equity closing vehicle (National Venture Capital Association, NVCA, templates). The documents are still VERY cumbersome and voluminous, but they are written for investors to protect their rights in closing a venture-style deal. They are the defacto standard in the industry for doing so. And, the advantages are clear:

  • Any SECURITIES lawyer that does not know and use them is not worth his salt.
  • Because they are template documents, they are easy and relatively cheap to execute (don’t let the lawyers charge you $20,000+ for this! You should be able to get them reviewed for $10,000.)
  • Use of and compliance with these documents will ensure a clean and easy transition to new rounds of capital.
  • They can be used simply by changing the names of the participants and the diligence information to use them for additional rounds of capital.

So, use them. Do not let an entrepreneur talk you into custom documents or clever terms. Those will only cause the company great pain at the next investment round. The next professional money in the deal will require these documents be used. So, anything you or the entrepreneur do to circumvent these terms will ultimately be undone or corrected before a new round of capital will be closed.

So, let’s dive into the terms of an NVCA Series A Preferred Term Sheet:

  • Closing date – date of the proposed closing, generally triggered by an amount of capital, not a give date (typically the minimum to break escrow of committed funds).
  • Investors – typically the lead investor in the round and others that may participate.
  • Amount to be raised – typically given as a minimum (to break escrow), maximum (target amount), and oversubscription (amount the company is willing to accept over the target).
  • Price per share – which is set from the capitalization table that describes the min, max, and oversubscription on a fully diluted basis.
  • Premoney valuation – the enterprise valuation of the company immediately before the investment, the post money valuation is equal to the premoney valuation plus the total amount raised in the round.
  • Dividends – common practice to include an 8% accrued annual dividend which serves to keep the venture’s leadership focused on creating a liquidity event. Essentially, your share price decreases by 8% each year that the company does not create an exit.
  • Liquidation preference – liquidation preference defines the waterfall of capital that is paid out when a liquidity event occurs. Preferred (that is what the terms means, preferred liquidation rights) shareholders are paid their original investment back first (typically 1x) and then participate prorata with the common holders shareholders on an as-converted basis. If there are multiple liquidity preferences, they stack up in order and are all paid before the holders of common.
  • Voting rights – establishes that preferred shareholders vote with the same authority as common shareholders typically with a 1:1 ratio.
  • Protective provisions – describes individual investor protections the company must observe as long as the investor holds stock in the company or until a change of control of the company
    • The company may not dissolve itself without a positive vote of the preferred holders.
    • The company may not amend its Certificate of Incorporation/Articles of Incorporation or ByLaws without the consent of the preferred holders.
    • The company nay not create new stock without the consent of the preferred holders.
    • The company may not repurchase its own stock or pay a dividend without the consent of the preferred holders.
    • The company may not create any debt in excess of a threshold without the consent of the preferred holders.
  • Conversion – established that the preferred holders may convert to common at any time they desire.
  • Anti-dilution – establishes the company may not issue preferred stock at a lower valuation than that paid by the existing preferred holders without retroactively correcting the share price/shares purchased by the investor, which is commonly done with an average weighted formula that allows for an appropriate accounting for time that has elapsed between rounds. In other words, if a company issues shares at one price and immediately issued them at a lower price, the investor is essentially brought on par with the new purchase price. Conversely, it time has elapsed, there is an allowance for a difference in share price. This is expressly to keep the company for trying to sell shares at a lower price in a short period of time after taking a round of capital.
  • Automatic conversion – establishes that the preferred shares will automatically be converted to common shares if an initial public offering of at least a given threshold is met.
  • Standard representations and warranties – both investors and the company agree that they have the authority to commit and accept an investment.
  • Conditions to closing establishes what diligence filed must be completed and documents must be filed before the investor will sign the closing documents and wire the capital.
  • Expenses – establishes that the invested company has the responsibility of paying for the investor’s legal costs, typically with a cap.
  • Registration rights – establishes the right of the shareholder to participate in future rounds of capital in the company.
  • Information rights – establishes that preferred holders of a given threshold have rights to certain financial and business confidential information on a regular, periodic basis.
  • Right of first offer – establishes the existing investors have the right to make a first offer of capital on a new round of capital proposed by the company.
  • Nondisclosure – establishes the documents that must be in place regarding nondisclosure and IP ownership rights between the founders and the company. All IP must be assigned to the company.
  • Stockholders Agreement – establishes the investor will sign a stockholder agreement as part of the closing. This agreement governs
  • Board matters – describes certain governance terms that must be in place by the leadership team, such as the frequency of Board of Director’s meetings.
  • Stock Options and Employee Stock Options – describes the stock option pool that must be in place to incentivize management and new hires BEFORE the investor invests. In other words, the founders are diluted to accommodate an option pool before the investors invest.
  • Equity vesting – describes how the leadership team’s stock incentive plan will be invested, typically 25% per year after one year and proceeding for four more.
  • Right of first refusal/co-sale – governs how shares must be offered to the company and investors before they may be offered to others.
  • Board of directors – describes the make-up of the Board of Directors immediately after signature of the closing documents.
  • Drag along – requires all holders to vote in favor of a valid liquidity event, which is typically defined by explicit thresholds of return and approved by the Board of Directors.
  • No Shop clause – restricts the company from shopping the deal to other investors once the term sheet is signed.
  • Expiration – defines the time window of which the Term Sheet is in full force and effect, typically 90 – 180 days.

There is a lot to understand in the Series A Term Sheet and it is clearly oriented towards protecting the investor and ensuring the company is following best management practices in its operations and governance. These terms are in there for a reason. Many investors have been burned for not properly protecting themselves and their investment.

In future posts, we will explore the important points of:

As you can see, this is a very complex set of documents working as one vehicle. The full document will typically range from 150 – 250 pages and completely supplants the Private Placement Memorandum for venture style investments. More importantly, it puts the investor in the driver’s seat, now an investment banker or lawyer.

For more information on term sheets:

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