Negotiating the Term Sheet

Springboard: New England

Bootcamp
October 13, 2004
Common Vs. Preferred Stock
• Management tends to hold common stock
– Founders stock
– Options
• Professional investors, both angels and venture
capitalists, want preferred stock
– More control over decisions
– Better economic terms
• Interests of common and preferred differ and
management will be negotiating against venture
investors during financing or sale of company
– Every new round of financing dilutes founder
shares
Objectives
• The purpose of the presentation is to
– Provide an understanding of the
common methods used by preferred
investors to protect their investment
– Look at the impact of the terms on
common shareholders
– Make you an educated negotiator
Preferred Stock Provisions
Liquidation Preference
– In the event of liquidation or sale, preferred stockholders are entitled to
amount of original purchase price (or some multiple) before common
shareholders
– Participating preferred continues to participate with common on “as
converted” basis
– If not enough cash to pay all preferred at original price, share pro rata with
other preferred stockholders (though priority issues among different series
of preferred)

Concerns of Common Stockholders

– If payout to preferred stockholders is very high before any payments to
common stockholders, will management continue to be motivated?
Preferred Stock Provisions (cont.)
Anti-dilution Protection
– If the company issues new shares at a price below the
conversion price of the preferred stock, the conversion price
is adjusted to eliminate the dilutive effects of the new stock,
although “pay-to-play” requires investors to keep investing to
maintain this provision
– This gives more shares on conversion: full ratchet (adjust at
last round price) vs. weighted average

Concerns of Common Stockholders

– Market conditions may require a “down round”, but unless
“pay-to-play” clause, preferred shareholders get more
shares without contributing more cash
Anti-Dilution Example
Full Ratchet Weighted Average Ratchet
First Round: $2 million First Round: $2 million
Conversion price: $2/share Conversion price: $2/share
Common shares on Common shares on
conversion: 1,000,000 conversion: 1,000,000

Second Round: $1 million Second Round: $1 million

Conversion price: $1/share Conversion price: $1/share
Common shares on Common shares on
conversion: 1,000,000 conversion: 1,000,000

New conversion price First Round: $1.00 New conversion price First Round: $1.50
Additional shares 1,000,000 Additional shares 333,333
Total shares on Total shares on
conversion: 3,000,000 conversion: 2,333,333
 Preferred Stock Provisions (cont.)
Participation in Future Rounds of Financing
– Preemptive Right - the preferred stockholders have the right
to maintain their pro rata interest in the company
– Right of First Offer - the preferred stockholders as a whole
can take the entire amount of the financing

Concerns of Common Stockholders

– This provision limits the flexibility to bring in new
stockholders that might add more value than existing
preferred stockholders
Preferred Stock Provisions (cont.)
Right of First Refusal
– In the event of sale of new equity, the company
must first offer the shares to preferred
stockholders to allow them to maintain their pro
rata interest
– This is the opposite of Liquidation Preference
Concerns of Common Shareholders
– This provision limits the flexibility to bring in new
shareholders that might add more value than
existing preferred stockholders
Preferred Stock Provisions (cont.)
Dividends
– Cumulative - dividends may accrue at some fixed rate until paid
(typically upon liquidation or redemption, sometimes conversion)
– When and If Declared - dividends may be paid at a specific rate
only when and if declared by the Board
– Parri Passu with Common - no cash dividends paid to common
stockholders unless the preferred stockholders receive comparable
dividend on an “as converted” basis

Concerns of Common Stockholders

– Common stockholders stand behind preferred stockholders when
sharing profits. If dividends accrue, may be difficult for common to
get any return.
Preferred Stock Provisions (cont.)
Protective Provisions
– Long list of items must be approved by 51- 67%(or more) of
preferred stockholders, including: sale, merger or liquidation
of company; sale of shares with equal or more rights;
issuance of debt over some $ amount; increase in board
size; amendment to charter; payment of dividends on
common, etc.
– Preferred stockholders may elect majority of board seats
Concerns of Common Stockholders
– Takes some control away from management and puts
preferred stockholders in position to block certain
transactions, including the sale of the company
Preferred Stock Provisions (cont.)
Voting Rights
– Preferred stockholders have right to vote shares
on an “as converted” basis
– Except for election of directors and Protective
Provisions, vote with common as single class
Concerns of Common Stockholders
– Preferred stockholders have rights of ownership
as well as benefits of priority over common
Preferred Stock Provisions (cont.)
Redemption - May be Optional or Mandatory
– Company must repurchase preferred stock (generally in
annual installments) at election of preferred after some
period of time (typically 3-6 years), or upon a date certain, at
the redemption price (e.g., original purchase price plus
dividends or some stated fixed return)
– Penalties for failure to redeem (reduction in conversion
price, control of the Board)
Concerns of Common Stockholders
– This provision treats preferred stock like debt, which needs
to be paid back with interest
Preferred Stock Provisions (cont.)
Automatic Conversion
– Preferred stock always has right to convert to common stock
at any time, and will automatically convert into common
stock upon IPO above certain dollar amount and share price.
However, if dollar thresholds not met, IPO must be approved
by preferred stockholders
Concerns of Common Stockholders
– Unless company can meet required dollar amount and share
price of IPO, preferred can hold up offering and demand
special rights
 Preferred Stock Provisions (cont.)
Rights of First Refusal/Co-Sale on Founder Sales
– Right of First Refusal - if Founder receives bona fide 3rd
party offer for his or her shares, the preferred stockholders
have the right to purchase shares on the same terms as the
3rd party
– Co-Sale Rights - the preferred stockholders can sell on a pro
rata basis some of their shares to the 3rd party
Concerns of Common stockholders
– This may limit the ability of Founders to attract willing buyer
for their stock
 Preferred Stock Provisions (cont.)
Drag-Along Right
– Typically requires all stockholders to vote for and participate
in any sale transaction approved by a specified percentage
of the preferred stock
Concerns of Common stockholders
– Allows preferred stockholders to force a sale of the company
which may be on terms that do not provide any return to the
common stockholders
 Preferred Stock Provisions (cont.)
Vesting of Founders’ Stock
– Preferred stockholders may impose vesting restrictions on
Founders’ stock such that if the Founder leaves the
company before her stock has fully vested, the company
may repurchase the unvested shares at their original cost
Concerns of Common Stockholders
– Founders want to be rewarded for their sweat equity and
prefer that at least a portion of their stock be vested
immediately. What happens in the event of termination
without cause or death or disability? What is the right
vesting period? Timely 83(b) tax filings are critical.
Preferred Stock Provisions (cont.)
Registration Rights
– Even after conversion to common in an IPO,
preferred stockholders may have rights requiring
the company to register their common shares for
sale and pay their expenses
Concerns of Common Stockholders
– The sale of these shares can depress stock price
and compete with company in raising funds
Impact of Options
• Venture rounds can reduce management equity
and often compensate with large option packages
• Must balance management ownership/dilution
• Investors consider stock options when looking at
shares outstanding
• Investors focus on “overhang” or options granted
but not exercised as percentage of total shares
• If overhang is too high, it may be difficult for
company to sell new shares
Other Agreements
• Repurchase Agreement:
– Management/employees agree to sell shares back
to company if leave before certain date
– Concern: may lose benefit of sale or IPO
• Tag-Along Agreement:
– Management agrees will not sell stock without
giving other investors right to pro rata participation
in sale
– Concern: Need to find buyer for more stock
Other Agreements (cont.)
• Warrant Agreement:
– Investors get the right to buy stock at a set
price. Can be contingent on certain
conditions such as company not meeting
numbers.
– Concern: Additional dilution with no up-
front cash put into company
Negotiating Term Sheet
• Some terms are entirely non-negotiable
• Others depend on competitive situation
• Best case: receive several term sheets
and see who is offering best deal
• Need good venture lawyer
• Make the term sheet as complete as
possible
• Do not want any surprises in documents