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The Handbook of Financing Growth: Equity Instruments and Term Sheet Provisions

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al.


The capital stock of a company is represented by shares of either common stock or preferred stock. A company can be capitalized with only common stock, but preferred stock is normally issued in addition to common stock and not as a stand-alone equity. Preferred stock and common stock are each entitled to receive dividends, but where a company has outstanding preferred and common stock, the holders of preferred stock are entitled to receive dividends in priority to the holders of common stock.

Common stock can be structured as voting or nonvoting shares. Common stock always represents an ownership interest in a company, and the holder of a voting common stock interest in a company is entitled to vote to elect directors, and to vote on fundamental corporate activities such as mergers and acquisitions. In the context of a sale of the stock of a company capitalized with only common shares, the holders of common stock are entitled to receive their pro rata share of the proceeds of the stock sale, based on the number of shares each shareholder owns over the aggregate number of shares owned by all shareholders. In the context of a corporate liquidation, the holders of common shares are entitled to receive the residual portion of the assets of the company only after all creditors have been paid in full.

Preferred stock can be structured as a traditional straight preferred, convertible preferred, or participating preferred. Traditional preferred stock represents an ownership interest in a company, but in most cases, the preferred has no voting rights. The characteristics of a traditional preferred stock included a fixed dividend and the right to receive the face value of the preferred stock and any dividends prior to the distribution of any assets to the holders of common stock. Straight preferred looks more like debt than equity in many respects because it is paid prior to common stock but after all debt, and it does not share in the capital appreciation of the company. Dividends could be structured as cumulative or noncumulative. That is, if a company were unable to pay a dividend on a noncumulative preferred stock, there would never be an obligation to pay the missed dividend. Conversely, if the company missed a cumulative dividend payment, the dividend would be owed to the preferred stockholders and must be paid in full prior to any distributions, including dividends, to the common stockholders.

Convertible preferred stock is an equity instrument that in many cases would include voting rights based on the number of shares of common stock into which the preferred stock could be converted. In contrast to straight preferred stock, convertible preferred is based on the premise that at any given moment, a greater return may be ascribed to either the face value of the preferred or the fair market value of the common stock into which the preferred may be converted. As a result, the holder of convertible preferred has the luxury of waiting until the time of an exit and then deciding whether to demand repayment of the face value of the preferred stock, plus any accrued or cumulative but unpaid dividends, or to convert the preferred into common shares. The election made by the holder will depend on which alternative results in a higher return or greater proceeds. For example, if a company is being sold for $1,000,000 and a preferred holder owns $100,000 of convertible preferred that can be converted into 20 percent of the company, the holder would elect to convert into common and receive $200,000 or 20 percent of the sale proceeds.

Participating preferred is perhaps the best of all worlds for an investor in that the holder takes priority over the common shareholders in terms of proceeds of a sale or liquidation, and in addition, after receiving the face value of the preferred plus any accrued or cumulative but unpaid dividends, the holder is entitled to receive a pro rata portion of any remaining assets or proceeds. The pro rata portion of proceeds that a participating preferred holder is entitled to receive is based on the number of shares of common stock into which the preferred could be converted divided by the aggregate number of common shares. Using the same company example as before, the holder of participating preferred would be paid $100,000 first and in priority over all common shares, plus 20 percent of the remaining $900,000 or $180,000. The total proceeds to the holder of participating preferred would be $280,000, making participating preferred the choice of sophisticated investors evaluating early stage or emerging growth companies that are candidates for institutional venture capital investment.

Securing the Equity Investment

In many respects, preparing the materials required to support a request for an equity investment is similar to the exercise performed by companies looking for debt. A company making the request for equity must be able to articulate a reasonable financial plan describing the use of proceeds of the investment. However, instead of preparing financials that are focused on generating cash flow to repay the money invested over a fixed period of time, the company will demonstrate the potential for capital appreciation in the investment through its financial forecasts. Most equity requests are coupled with an analysis of the potential for capital appreciation in connection with specified events. These events are typically known as exit strategies. Historically, companies seeking equity investments have described three general exit strategies as being available to equity investors. These strategies have a variety of combinations and permutations that may be attached to each category, but the basic alternatives include a merger or acquisition taking the form of a sale of the company's stock, an initial public offering of the company's equity securities, or a recapitalization in which the investor's equity position is purchased or redeemed by the company.

Preparing for an equity investment involves a significant amount of time and attention dedicated to generating a business, strategic, and financial plan for the company. The business plan will describe the company's financial plan for using the proceeds of the equity offering in a detailed budget showing inflows of capital and expected outflows. In connection with the financial plan, a company expecting to raise capital will expend a significant amount of time and energy in developing a business plan. The business plan generally is thought of as a road map for a potential investor to follow the thought process of the company as it determines its own rationale for securing the investment.

Business plans take many shapes and forms, but the best plans are those that are succinct yet demonstrate that management has a full understanding of its target market. The plan must also provide an investor with comfort that management has paid attention to the smallest of details.

Great business plans start with an executive summary that concisely states the premises underlying the request for investment. The executive summary is followed by what is commonly known as the setup - in other words, a description of either the problem that the company intends to solve or the market opportunity that the company intends to attack. Once the setup is stated, the business plan must contain a clear statement of the company's objective, which is the company's solution to the problem or unique value proposition that permits the company to attack the market more aggressively than its competitors. While a great solution or unique value proposition will generate interest in many investors, it is the strategy section that sophisticated investors will examine under a microscope. This section includes the company's strategy for accomplishing its objective or solving the problem articulated by the company.

Of significant interest to the potential investor is the financial section supporting the company's strategy. And while revenue forecasted by the company will be tested and examined, a significant investor focus will be on the company's cost structure. The cost structure must line up with the requested equity investment or the offering will inevitably fail.

There are a couple of strategies used by companies in connection with developing cost structures in support of equity requests. The first and perhaps most desirable alternative is known as a fully funded business plan. In this alternative, the company requests capital that will, under its assumed financial model, be the only capital required to achieve its objective. The capital may be a combination of debt and equity. Fully funded business plans are expected when the proposal relates to the acquisition of a target company.

In contrast, where a company's objective is long-term in nature, such as a biotechnology company, the business plan must be designed to match up with significant milestones, since fully funding a budget designed to discover, develop, and market a start-up company's proposed drug candidate is not feasible. In this respect, the company will identify specific milestones that have been recognized by the investment community as demonstrating acceptable progress in the drug discovery or development process. Upon achievement of the specified milestone, and assuming that the company correctly forecasted the costs to achieve the designated milestone, the company would normally expect to go back to the investment community to obtain financing sufficient to achieve its next series of milestones.

In either a fully funded case or a milestone case, the investor will conduct significant due diligence in an effort to confirm the reasonableness of the cost estimates. In addition, where the plan is not fully funded, the investor will carefully evaluate the company's assumptions relating to value created by achieving designated milestones. If the cost structure proposed by the company does not match an investor's analysis, in most cases the investor will pass and not make the investment. Where the analysis relates to value created by milestones, if there is a difference of opinion between the company and the investor as to whether the proposed budget permits the company to realistically claim value appreciation upon achieving certain milestones, the investor may remain engaged in discussions with the company, but only to the extent that the two parties come to an agreement on revised budgets or milestones.

If the investor and company agree on budgets and the ability of management to accomplish the objectives of the business plan, the investor and the company must agree on company valuation in order to determine the amount of equity that will be issued in exchange for the proposed investment. In setting valuation for start-up companies, the process is as much an art as it is a science. Investors look to comparably positioned companies in similar industries as a starting point. Exclusive control over products or potential products with large addressable markets will add value to an investor's initial valuation discussion. Early adoption of the start-up's technology or services by customers willing to pay premium prices for the products or services will also add value. But what is most important to the sophisticated investor is the quality of management involved with the business. Quality in this respect means seasoned, mature, and experienced managers with a track record of success in raising capital, commercializing products, and generating financially rewarding exits for prior investors. A business plan that is not supported by a management team with these characteristics has little probability of successfully raising equity capital in today's financial environment at any valuation for the company.

Where the equity investment is requested in connection with a proposed acquisition or by a company with existing revenue and earnings, the valuation process follows the traditional valuation metrics. These metrics include the discounted cash flow analysis valuation method, the comparable company valuation method focusing on earnings or EBITDA multiples, and the replacement cost method.

When negotiations between a company and an investor or group of investors begin to stabilize, the parties will initiate the documentation process. Because definitive documentation and final due diligence on the part of an investor is time-consuming and in many cases expensive, the company, but more frequently the investor, will propose a term sheet containing fundamental terms and conditions before definitive documentation is prepared. In the term sheet, the company and the investor will attempt to create an investment structure acceptable to each of the parties. The term sheet that is finally agreed upon will describe the securities that the investor will purchase, and the terms and conditions that must be satisfied prior to closing the transaction. While the actual closing of a transaction may include many documents, the term sheet normally describes the fundamental provisions of four main agreements - the stock purchase agreement, the certificate of incorporation, the investors' rights agreement, and the shareholder agreement.

Equity Investment Term Sheet

In many respects the term sheet is where the most action occurs in the investment process. As the parties negotiate the terms of the deal, valuation of the company and the role of existing management in the ongoing entity will be carefully documented. Several concepts relating to valuation of the company are important to understand in the negotiating process. The impact of slight nuances in the words used to finalize the term sheet can have dramatic impacts on the amount of equity retained by the owners.

Premoney and Postmoney Valuation

The first two concepts relate to understanding the significance of premoney and postmoney valuation, and the factors that impact ownership percentages retained by existing shareholders. While relatively straightforward in concept, understanding premoney valuation also requires an understanding of the terms that are superimposed on the concept. In its most understandable form, premoney valuation simply means the value of a company before an investment is made. When the premoney valuation of a company is added to the amount of investment, the two components are added together to obtain the postmoney valuation. For example:

Premoney valuation

$1,000,000

Investment amount

$1,000,000

Postmoney valuation

$2,000,000

Implicit in the example is an assumption that the owners of the company and the investors will each own 50 percent of the company immediately after the investment is consummated. The calculation of actual percentage will depend on the application of variables that are included in most investment term sheets. These variables include the size of the company's option pool and whether it is calculated on a premoney or postmoney valuation, the type of security being purchase - common stock, preferred stock, or participating preferred - the existence of any outstanding convertible securities, and whether the investor is requiring a multiple return prior to sharing proceeds of an exit event with the remaining common shareholders.

Not understanding the implications of any of these variables can result in severe surprises to management and to the owners of a business raising capital. In evaluating the impact of a term sheet condition requiring a 25 percent option pool, the difference to the current owners between the option pool percentage being applied to the premoney valuation as opposed to the postmoney valuation is dramatic. The difference can be illustrated as follows:

Twenty-Five Percent Option Pool Calculated on a Premoney Valuation Basis

Premoney valuation

$1,000,000

 

Premoney capitalization

   

Existing owners

 

750,000 shares

Option pool

 

250,000 shares

Investment amount

$1,000,000

 

Investor shares

 

1,000,000 shares

Postmoney valuation

$2,000,000

 

Fully diluted capitalization

 

2,000,000 shares

Understanding the impact of the option pool in this example becomes apparent when the shares owned by current shareholders is compared to the shares owned by investors immediately after the investment is consummated. While the example looks like a 50-50 split based on the investment amount, the investors own 1,000,000 shares and the owners own 750,000 at the time the money is invested. In order to understand this dynamic, management and the owners must understand the manner in which investors define the fully diluted capitalization of a company. In the example, the fully diluted capitalization is 2,000,000 shares even though only 1,750,000 shares are issued and outstanding. A sophisticated investor always counts the option pool as being outstanding whether or not the options have been granted and whether or not the options granted have been exercised or even have a reasonable chance of being exercised. So the unwary owner, agreeing to create an option pool without considering the consequences or impact on the company's fully diluted capitalization, will end up with a significant surprise at closing.

To contrast the impact of determining the size of the option pool based on a postmoney calculation, the following example is illustrative:

Twenty-Five Percent Option Pool Calculated on a Postmoney Valuation Basis

Premoney valuation

$1,000,000

 

Premoney capitalization

   

Existing owners

 

750,000 shares

Investment amount

$1,000,000

 

Investor shares

 

1,500,000 shares

Option pool

 

750,000 shares

Postmoney valuation

$2,000,000

 

Fully diluted capitalization

 

3,000,000 shares

The resulting equity ownership retained by the owners in these examples is dramatically different. In the case where no option pool is required, the amount of shares issued to the investor is equal to the amount held by the owners, and each group owns 50 percent of the company. Where the option pool size is determined on a premoney valuation basis, the owners hold approximately 42.85 percent of the company immediately after the investment is closed and the investors hold the remaining 57.15 percent of the outstanding shares. As options are granted and exercised, the owners and the investors will be diluted until the option pool is exhausted and the final capitalization will be owners 37.5 percent, option pool grantees 12.5 percent, and investors will end up with their bargained-for 50 percent. The most dramatic consequences are illustrated in the postmoney example where the owners start at 33.3 percent and the investors start at 66.7 percent. After the grant and exercise of the entire option pool, the final capitalization is dramatically different with the negotiated structure yielding 25 percent for the owners, 25 percent for the option pool grantees, and the investors ending up with the originally agreed-upon 50 percent ownership interest in the company.

In each of these examples, the basic valuation discussion is exactly the same. The company's premoney valuation is $1,000,000 and the investment amount is $1,000,000. The impact of superimposing an option pool on the premoney valuation changes the share dynamics significantly, but the most dramatic impact is when the option pool is discussed with the percentage being applied to the postmoney valuation.

Liquidation Preference

A liquidation preference is discussed in the context of a preferred stock offering of equity. The liquidation preferences can be stated in terms of what is known as straight preferred stock, convertible preferred stock, or participating preferred stock.

Straight preferred stock is essentially equivalent to debt. This type of preferred stock is not commonly used in today's private investment climate, but it still has significance in the public markets. Straight preferred is sold to investors for a face amount, normally coupled with a fixed stated dividend. The dividend may be cumulative or noncumulative, current cash pay, deferred, or payment in kind. Noncumulative dividends must be declared in order for the holder of the preferred to receive the dividend payment amount, while cumulative dividends accrue whether or not the board declares a dividend, and any accrued but unpaid dividends must be paid prior to payment of any dividends on a company's common stock.

A dividend with a current cash payment requirement is normally associated with either investments in public companies or investments made by private equity investors in leveraged acquisitions. In these cases, the company forecasts cash flow sufficient to satisfy the dividend obligation, with most of these investments being associated with larger companies enjoying relatively stable and existing cash flows.

Where the dividend is a current cash payment obligation of a company, in many cases, particularly in connection with leveraged buyouts, the company may under certain circumstances satisfy its dividend obligation by issuing a note for any dividend payment that the company is unable to make. This payment in kind may be required either for cash flow reasons or as the result of applying financial covenants to its balance sheet on a pro forma basis and determining that the dividend could not be paid without violating the financial covenants imposed on the company by a senior lender. In connection with mezzanine financings where the investment is structured as preferred stock, an investor may determine its overall return requirements are too high for the company to support out of cash flow, but the return that is required could be met by deferring a portion of the dividend, or interest payment when structured as subordinated debt, until the end of the investment period.

Convertible preferred stock is structured to permit an investor to hold its investment until a liquidity event or exit, and at the time of the exit, choose between a return of the face amount of the preferred stock plus accrued but unpaid dividends, or to convert the investment into common stock and take its pro rata shares of the proceeds of the liquidity event. The following example assumes that an investment of $1,000,000 was made for convertible preferred stock that equaled 50 percent of the company.

Proceeds of the sale of company stock

$10,000,000

Return of original investment plus accrued but unpaid dividends

$ 1,250,000

Pro rata percentage of sale proceeds

$ 5,000,000

In this example, the holder of convertible stock would elect to convert into common stock and receive $5,000,000 instead of $1,250,000 based on the original investment plus accrued but unpaid dividends.

Conversely, and using the same transaction assumptions, if the sale proceeds had only generated $1,500,000, the holder of the preferred stock would have elected to take $1,250,000 instead of the $750,000 amount calculated by reference to 50 percent of the sale proceeds. In making an election to take the face amount of the investment plus accrued but unpaid dividends, the investment looks more like debt than equity.

The liquidation preference associated with participating preferred stock can take many shapes and forms. The basic participating preferred stock investment returns an investor's original investment, plus accrued but unpaid dividends, and then permits the investor to receive a pro rata share of any remaining assets calculated on the assumption that the preferred stock holders had converted their shares into common stock. The following example assumes that an investment of $1,000,000 was made in exchange for participating preferred stock representing 50 percent of the equity of the company.

Proceeds of the sale of company stock

$10,000,000

Return of original investment plus accrued but unpaid dividends

$ 1,250,000

Net proceeds available for distribution to remaining shareholders

$ 8,750,000

Pro rata percentage of sale proceeds

$ 4,375,000

Total return to participating preferred

$ 5,600,000

In this example, even though the holders of participating preferred stock own 50 percent of the company, the overall percentage of proceeds received in connection with the transaction is 56 percent. Calculating the impact of the participation feature on various sale proceeds scenarios would show that as the total return increases, the percentage of the overall proceeds retained by the holders of participating preferred stock goes down, with the residual percentage approaching the nominal or stated 50 percent rate in the preceding example when the returns are significant.

In addition to the basic participation rights illustrated, in the current investment climate, there are two variations on the basic theme that are at least discussed in many term sheet negotiations. One of the variations is company friendly and one of the variations is favorable to investors.

A company favorable variation includes a preferred stock structure where the investor is subject to a cap on the negotiated participation rights. For example, the participating preferred stock might be structured such that an investor would receive the original investment and then a maximum of three times the amount of the original investment in participation rights. The effect of a cap on participation requires an investor to convert its shares of preferred stock to common stock in order to receive an amount in excess of the cap. By converting, the investor forgoes the participation right. The election to convert to common stock essentially makes the investment a convertible preferred where the returns exceed the cap. In other words, if the return to the holder of preferred stock is capped, the holder converts into the pro rata share of the company in order to receive a larger share of the proceeds. For lower return amounts, the participation feature is protected. Using the example previously assumed where a $1,000,000 investment is made in a company with a $1,000,000 premoney valuation, the alternatives can be illustrated as follows:

Proceeds of the sale of company stock

$10,000,000

Return of original investment plus accrued but unpaid dividends

$ 1,250,000

Net proceeds available for distribution to remaining shareholders

$ 8,750,000

Pro rata percentage of sale proceeds

$ 4,375,000

Total return to participating preferred

$ 5,600,000

Cap on participation (3x investment)

$ 3,000,000

Election to convert to pro rata percentage

$ 5,000,000

Amount to participating preferred

$ 5,000,000

In this example, the impact of the cap resulted in the investor not receiving the full benefit of the participation feature. Because the negotiation of a cap adversely impacts the return available to an investor, only the strongest of companies with the best bargaining positions will be able to achieve or to negotiate this limiting feature.

In contrast to the company favorable variation, an investor favorable variation is negotiated where the company is financially weak or distressed, very early stage where the risk of failure is high, or where the company has raised several rounds of investment, but has yet to achieve significant milestones or revenue. In this variation, the participating preferred will negotiate a multiple return of the original investment, after which the holder of the preferred stock will participate to the extent of the negotiated pro rata percentage of the company. In this example, the preferred stock investment is $1,000,000 and the percentage ownership of the company is 50 percent. Instead of a traditional 1x - return of original investment, the investor has negotiated a 2x return.

Proceeds of the sale of company stock

$10,000,000

Return of 2x original investment plus accrued but unpaid dividends

$ 2,250,000

Net proceeds available for distribution to remaining shareholders

$ 7,750,000

Pro rata percentage of sale proceeds

$ 3,875,000

Total return to participating preferred

$ 6,125,000

In this example, which is based on an example of a very early stage company with no prior preferred investments, even though the holders of the participating preferred stock own 50 percent of the equity in the company, the multiple liquidation preference generates an absolute return of 61 percent of the sale proceeds.

Multiple liquidation preferences are common also in situations where a company has been successful in raising capital, but less successful in achieving milestones or significant revenue. In these types of cases, the company's fair market value may be significantly less than the sum of the liquidation preferences for prior investments made in the company. This type of financing structure is known as a restart or cram-down financing. For example, the company characteristics would include several series of preferred stock financings, such as series A, B, C, D, and E rounds where each round involved an investment of $1,000,000. The aggregate liquidation preferences would therefore be $5,000,000. In the absence of an agreement to the contrary, an investor considering a new series F round would either share proceeds pro rata with the prior rounds and then with all the shareholders, or the series F investor would receive its investment first, then the remaining series A through E investors would receive their investments, followed by all shareholders participating in any residual proceeds.

In this example, we will assume that the company has not achieved significant milestones as forecasted, that the fair market value of the company is $1,000,000, and that the series F investment amount is $1,000,000, with a 2x multiple. The investment results in a 50 percent ownership of the company for the series F investor.

Proceeds of the sale of company stock

$10,000,000

Return of 2x original investment plus accrued but unpaid dividends

$ 2,250,000

Net proceeds available for distribution to remaining preferred shareholders

$ 7,750,000

Return of series A through series E preferred stock preferences, exclusive of accrued

$ 5,000,000

Net proceeds available for distribution to remaining shareholders

$ 2,750,000

Pro rata percentage of sale proceeds

$ 1,375,000

Total return to series F preferred

$ 3,625,000

In this example, even with a 2x multiple applied to the series F investment, the holders of series F participating preferred stock would only receive 36.25 percent of the proceeds of the sale. As a result, in negotiating its up-front terms and conditions, the series F investor would need to negotiate a multiple greater than 4x - its original investment amount in order to receive a return equal to 50 percent of the proceeds in the example.

While the application of significant multiples to later stage cram-down investments is required in order to achieve desired financial return results, in some cases required returns can never be achieved under the company's assumed financial forecasts. In these cases, a later stage investor will require all prior preferred stockholders to convert their preferred stock to common stock immediately prior to the closing of the new series F investment. Under a forced conversion scenario, the series F investor in the preceding example would participate in the remaining proceeds of sale immediately after being repaid its original investment plus accrued but unpaid dividends. In this instance, the series F investor would not need to negotiate a multiple liquidation preference as the anticipated return would be equal to $5,600,000 in the example, with the results being the same as in the basic participating preferred example.

Voting Rights

In the privately held company context, almost all preferred stock investments include the right to vote shares based on the number of shares of common stock into which the investor may convert the preferred stock. These rights are typically manifested in a right to vote side by side or together with the common stock, on an as converted basis, and not as a separate class. In addition to the general right to vote, holders of preferred stock may be granted specific voting rights with respect to the election of directors and with respect to any negotiated negative covenants. For example, the holders of a designated class of preferred stock may be entitled to elect a specific number of directors for the board of directors and the company may not merge with or acquire another company without the approval of a specified percentage of the holders of the preferred stock. The specified percentage varies based on the actual negative covenant in question, but at a minimum would require a majority vote and in most cases would not exceed a requirement to obtain more than 80 percent of the vote of the holders of the preferred. The percentage is not 100 percent in most cases, because the requirement of a unanimous vote could give the holder of a small percentage of the preferred stock a block on fundamental or important actions of the company even where a majority of all other shareholders are in favor of the action.

Protective Provisions

An owner of preferred stock holds shares issued in connection with the negotiation of a contract between the company and the investor. These contract rights include covenants that are generally referred to as protective provisions. Without a specified vote by the holders of preferred stock, the company is contractually prohibited from taking certain actions. These actions usually involve items fundamental to the ownership of the preferred shares, and the protective provisions are embodied in these contractual covenants, because the typical holder of preferred shares does not own a majority of the stock of the company. Included in the list of protective provisions are prohibitions on the following actions unless the specified percentage of preferred shareholders agree with the action: liquidation of the company, amendment of the charter or bylaws in a manner that would adversely affect the preferred stock, creation of a class of stock senior to the preferred stock, redemption of shares, payment of dividends, borrowing money in excess of an agreed-upon maximum, or changing the size of the board of directors.

Antidilution Provisions

Antidilution provisions focus on issuances of shares at a per share price less than the price paid by the investor for the investor's preferred stock. Issuances above the investor's per share price do in fact dilute the ownership interest of the investor, but only in rare cases do higher priced issuances trigger antidilution provisions included in a company's charter documents. Two types of antidilution protection form the basis for most investors. These protections are known as either weighted average-based or ratchet-based antidilution.

Weighted average-based antidilution is company friendly. In order to calculate the actual protection, an understanding of one of the fundamental provisions of preferred stock is required. The provision relates to the manner in which the number of shares of preferred stock is converted into common stock. For example, assuming an investment of $1,000,000 by a preferred stock investor, if the per share initial conversion price (ICP) is $1, the investor would be entitled to convert the investment into 1,000,000 shares of common stock. Applying weighted average antidilution protection to this assumed investment would generate the following calculation based on the associated assumptions of a dilutive investment to determine a new conversion price (NCP).

New investment

1,000,000 shares

New investment price

$.50 per share

Total shares outstanding

2,000,000 before new investment


NCP = ICP x (A + B)/(A + C)

= $1.00 x (2,000,000 + 500,000)/(2,000,000 + 1,000,000)

= $1.00 x 2,500,000/3,000,000

= $1.00 x 0.8333

= $.8333


where ICP = $1.00

A = number of shares outstanding before new issue

B = number of shares that new consideration would purchase at the conversion price in effect prior to the new issue

C = number of new shares issued

 

Predilutive investment 1,000,000 shares conversion shares

Postdilutive investment 1,000,000/.8333 = 1,200,048 shares conversion shares

In the weighted average-based antidilution calculation, the absolute percentage of shares held by the original investor goes down, but the investor's ownership in relation to the original owner's goes up because the investor is now entitled to 1,200,048 shares and the original owner's shares remain static at 1,000,000.

Full ratchet antidilution protection is dramatically different in its consequences to existing shareholders. Under full ratchet antidilution, an investor's conversion price moves down to the exact level of the new investment. Using the previous assumptions, the investor would be entitled to convert the preferred stock into 2,000,000 shares of common stock immediately after the issuance. The calculation is performed by changing the preferred holders' $1.00 conversion price to the new per share price of $.50 and dividing the investment amount of $1,000,000 by $.50 instead of $1.00.

Although the basic full ratchet calculation is unpleasant for existing common shareholders, when a new investor's percentage of ownership is stated as a percentage of the company assuming the investment has already been made, companies subject to full ratchet antidilution protection must perform multiple calculations to determine the new conversion price. For example, using the previous assumptions where the initial investment calculation would transfer one-third of the company to the new investors, if a full ratchet applies, the old investors would, by virtue of the new investment, increase the number of assumed existing shares from 2,000,000 to 3,000,000. By making this adjustment, the $.50 per share assumed conversion price no longer generates a number of shares equal to one-third of the company, but rather only one-fourth of the company or 1,000,000 out of 4,000,000. In order to place the investor in position to convert the preferred stock to one-third of the company the new investor must receive not 1,000,000 shares, but 1,500,000 in order for the assumed one-third ownership position to be accurate. By increasing the number of shares that the preferred stock investor must receive, and at the same time maintaining the assumed investment amount at $500,000, the per share conversion price must be reduced from $.50 per share to $.33 per share. However, issuing shares at $.33 per share again triggers the full ratchet antidilution protection, and the existing preferred stockholders now will be entitled to receive 3,000,000 shares instead of 2,000,000 shares. By making this adjustment the new investors must receive 2,000,000 shares instead of 1,500,000 shares resulting in a conversion price of $.25 instead of $.33. This adjustment now requires another round of calculations and the adjustments continue until the shares subject to the full ratchet antidilution protection stabilize at the new conversion price. This death spiral in conversion price forces many companies into a restart where early stage investors are crammed down into a nominal equity position. In order to retain management, new investors must provide for revised equity incentive compensation based on creative new series of equity that are permitted to participate in liquidity event proceeds after the new investors but before all existing investors.

Redemption

As part of the planning for an exit strategy, investors negotiate provisions relating to a liquidity event as part of the term sheet. In addition to the traditional exit strategies of initial public offerings, mergers and acquisitions, and recapitalizations, investors will also negotiate the right to require the company to purchase or redeem their shares after a negotiated period of time if no liquidity event has occurred. A typical time period of five years is established, and at any time after the passage of five years, the investor may require the company to purchase the investor's preferred stock for a price equal to the greater of the fair market value of the underlying common stock into which the preferred may be converted or the original purchase price plus accrued but unpaid dividends. The redemption may be triggered by the vote of a majority of the holders of preferred shares. In order to permit the orderly liquidation of the shares, most redemption features contain provisions that permit the company to make installment payments over three years.

The redemption feature is subject to statutory limitations imposed on companies that preclude redemptions unless the company is able to make the purchase out of its capital surplus. Capital surplus is generally an amount equal to the equity invested in a company less cumulative operating losses. If the statute precludes redemption, investors may negotiate for board control in order to manage the ability of the company to effect the redemption or to cause the company to enter into serious negotiations for additional equity investments or the sale of the company. An investor will elect the redemption feature where the company is not making progress towards a liquidity event. The feature in many cases is of little real benefit to the investor due to the fact that if the company is not performing, there will be few if any funds to satisfy the redemption obligation.

Registration Rights

With most investments in privately held companies, and in connection with private placements in publicly traded entities, investors negotiate registration rights to facilitate liquidity events. The standard registration rights granted to an investor in a privately held company include demand registration rights, short-form registration rights, and piggyback or incidental registration rights.

Demand registration rights are triggered by the passage of time following the initial investment date, or by the passage of time following the initial public offering of securities by the company. The initial passage of time is normally not less than five years. At the five-year time frame, if the company has not registered its securities, the investors are granted the right to demand that their shares be registered. The registration process is time-consuming and expensive, and normally not an effective right of the investor unless the company is able to at- tract an investment banker to underwrite the offering. Nevertheless, the negotiation of a demand registration right is a fundamental right obtained by investors.

A more effective right is the right of investors to demand registration after the initial public offering of securities by the company. Investors negotiate one or two demand registration opportunities for the holders of preferred stock. In this case, the company has gone through a significant amount of due diligence with investment bankers and successfully offered securities to the public. With an established public market, investors have a realistic chance of liquidity. While the investors have, at this time, normally met minimum holding requirements to sell securities to the public in Rule 144 transactions, the aggregate amount of securities held by investors typically serves as an obstacle to selling all of their shares. Under Rule 144, the amount of unregistered stock that investors can sell in any given 90-day period in a private placement is limited to 1 percent of the issued and outstanding shares of the company. In contrast, if the investor is selling shares registered with the SEC by the company, the investors can liquidate their entire holdings in one sale. It is in the interests of the company and its shareholders in many cases to facilitate a registered sale, because a prolonged sale of blocks of investor shares every 90 days has a depressing effect on a company's share price. Once the company is public, its filings with the SEC will chronicle all shareholders with registration rights. With access to this knowledge, the market may depress the share price simply by virtue of the shares that can come to market at any given time. This effect is called overhang.

In addition to demand registration rights, investors negotiate shortform registration rights. After a company has been public for a year, and if the company is current with all of its required filings, companies meeting certain minimum valuation levels may take advantage of Form S-3. This form provides a mechanism for companies to register shares using an abbreviated SEC filing that is not as expensive or as time-consuming as Form S-1, the form companies use in connection with initial public offerings. Investors negotiate an unlimited number of short-form registration opportunities; however, the company is not normally required to effect more than two such registrations in any given year, and the amount of securities to be registered must meet minimum size requirements. The minimum size of a short form offering ranges from $1 million to $5 million in aggregate value of securities offered.

Piggyback or incidental registration rights permit investors to add their securities to any offering that is being registered by the company. Piggyback rights are unlimited in number, but subject to restrictions that may be imposed by the company's investment bankers. For example, in connection with a traditional initial public offering of securities by a company, investment bankers would normally restrict the investors from selling shares under the assumption that most initial public offerings are intended to provide the company and not investors with liquidity to accomplish the company's business plan. Recent offerings, however, have turned this traditional mentality upside down, with private equity investors, but not venture capital investors, having the opportunity to sell significant company stakes in the initial public offering. These offerings typically involve mature companies, with stable and significant cash flows, where the offering is used to refinance existing debt and in effect replace the private equity investors with public investors.

In connection with an initial public offering of securities, investors who have received registration rights are required to enter into lockup agreements. These agreements preclude investors from selling shares of the company's stock for a period of 180 days following the effective date of a company's public offering. Lockup agreements are required by a company's investment bankers in order to manage the offering process and avoid shareholders selling blocks of shares in the 180-day period. This restriction is designed to permit the company and its investment bankers to stabilize the company's share price immediately following the offering by avoiding significant price swings that may be caused by sales of shares into a thinly traded market for company shares.

Board Composition

Although most venture capital preferred stock investors take a minority investment percentage in their portfolio companies, control of the board, or at least assurance that the board will act independently, is a significant negotiating term. Composition of a venture backed company's board may be negotiated to reflect this independence by naming an equal number of existing owners and investors to the board with one independent board member being selected by the consent of the investors and the existing owners. In this respect, fundamental operation of the company is placed to a large extent in the hands of the independent board member, whose vote will break any deadlocks between the investors and the existing owners. The strategy behind this negotiation includes a recognition on the part of the investors that they must gain the confidence of existing owners in the decision making process. By taking less than a majority on the board, management obtains comfort that the investors cannot force the company to take a specific action without the vote of the independent director. Conversely, if management and the existing owners can convince the independent director that an action is proper, they can take the action, subject only to any contractual negative covenants that the company concedes in the negotiation process. The negative covenants are, therefore, known by all parties prior to consummation of the preferred stock investment.

Employee Stock Options

As previously illustrated, an important negotiation term is the size of the employee stock option pool. By negotiating the size up front, existing owners and investors know the boundaries of dilution that will be imposed on shareholders, and the dilution cannot be changed in the absence of an agreement by existing owners and investors. It should be noted from the examples dealing with antidilution protection that the percentage of a company that an investor bargains for is based on the assumption that all options have been granted. The effect of this assumption is that in the early stages of an investment, investors own a higher percentage of the company than their investment would purchase, but as options are granted, the percentage decreases until the option pool is exhausted and the investors reach their agreed-upon residual company equity percentage.

Most employee option pools are designed as qualified option pools, which means that options up to the aggregate size of the pool can be granted, but the options must be granted at the then current fair market value of the company's shares as determined by the board of directors. Options normally vest over time, with vesting schedules generally extending over three or four years following the date of the option grant.

Founder Share Vesting

A term sheet feature that is perhaps the most contested term, other than valuation, is the requirement by investors that the equity held by founders of an early stage company vest over time. This feature is based on the premise that much of the valuation attributed to early stage companies will only be realized to the extent that the founders stay with the company and fulfill the objectives of their business plan. If a founder determines not to continue with the company, investors or the company will be granted the right to repurchase some or all of the founders' shares. The purchase price for vested shares is normally fair market value, determined by an independent third party if the founder and the company are unable to agree on price. In contrast, the purchase price for unvested shares is generally a nominal amount or an amount equal to the price paid by the founders where an actual cash investment has been made. In negotiating this purchase right, investors are attempting to ensure that the value anticipated at the time of investment will be achieved by the ongoing efforts of the founders, and if not, that controlling the shares will permit the company to recruit replacement management without diluting the remaining shareholders.

In determining vesting periods, the maturity of the company is taken into account. In this respect, companies with customers and revenues may permit founders to retain an initial percentage of their shares that are subject to no vesting. The residual shares will then vest over a three-to-four year period. Vesting schedules vary from pro rata vesting on a monthly basis over the full vesting term to a combination of cliff vesting at the end of one year with the balance of the shares vesting ratably on a monthly basis over the balance of the vesting period.

Miscellaneous Term Sheet Provisions

It is rare that an investor will have completed its due diligence investigation of a target company at the time of negotiation of a term sheet. As a result, term sheets are nonbinding indications of interest, with the opportunity for either party to terminate negotiations. Termination provisions are crafted to provide investors with a defined period of time to complete their due diligence, and it is customary for the company to provide investors with a period of exclusivity during which the company will not negotiate with any other investors. At the end of the exclusivity period, either party is free to terminate the negotiations or seek alternative investors.

The term sheet will also include a list of negative and affirmative covenants that the company must observe as long as the investors maintain a significant investment in the company. Affirmative covenants include obligations on the part of the company to provide investors with monthly and quarterly unaudited financial statements, an annual audited statement, and a proposed annual budget thirty days before the start of each fiscal year.

Investors will also jealously guard the right to purchase ongoing sales of securities by the company. Most companies have eliminated preemptive rights to purchase shares that otherwise are available under some state corporate law statutes. As a result, without a contractual right to purchase shares, an investor could fund the important start-up phase of a company and then be excluded from participating in company offerings as the company matures. Although the right to participate in future offerings negotiated in the term sheet is most often used in connection with additional purchases at higher valuations, the right also protects investors by giving them the right to maintain their percentage ownership in the event of subsequent issuances at lower or nominal valuations.

Where the target company value is based on intangibles or intellectual property, investors will negotiate term sheet provisions requiring all employees, contractors, and consultants to enter into nondisclosure and development agreements. The development agreement portion of the requirement is designed to insure that the covered parties agree that any proprietary rights developed during employment or as a consultant belong to the company. Where key individuals have the ability to replicate the business plan of the company, and therefore the value of the investors' investment, designated individuals will be required to execute noncompetition and nonsolicitation agreements.