1. The Rule of 3
Once you have secured a term sheet, the Rule of 3 tells you to identify three issues that are most important to you and to negotiate those. In general, you do not want to accept your VC’s term sheet “as is,” as doing may risk you appearing as you are a novice, threatening your credibility with your VC. That said, the goal is to get a deal done, do not lose sight of that because you wanted to show the investor that you are not a pushover. Concentrate on what is important and do not create extra headache. Unlike some other legal matters, you are forming a long-term relationship with your financier. You will be working with them after this deal–as they hopefully will be participating in future financing rounds and will likely have a seat on your board. Remember to put the process of negotiation in the context of forming a positive long-term relationship.
2. What Should You Focus On?
i. Valuation and Price
How much of your company you will be selling and how much dilution you will take in the financing, will be set by the valuation of your company. Your company’s valuation will also determine the company’s price per share. There are two different lenses from which you can think about your company’s valuation: pre-money and post-money. Your company’s pre-money valuation is what the investor believes your company is worth before she invests. Following that logic, the company’s post-money valuation is the value the investor attaches to your company after she invests. Be sure to clarify with your investor whether her investment is based on her pre-money or post-money valuation of your company. Moreover, as stated above, remember that you are forming a long relationship with your VC. It can be easy to go with the financier who is offering the highest valuation, but at times it may be wise to choose the VC who is more align with your vision for your company, possesses a stronger reputation, has deeper network, or possesses superior industry expertise–even if she offered a lower valuation than others. In addition, in some instances an unreasonably high valuation may become a hindrance later. For instance, say your company has attracted the attention of a potential acquirer. The potential acquirer has given you an offer to purchase your business that you like. Everything is great right? Maybe not, as unfortunately, a VC that bought shares of your company at an unreasonable price may not want to approve the deal because it would mean she would not adequately recoup on her investment. Thus, you miss out on a viable exit opportunity.
ii. Employee Option Pool
It is important to understand dilution, and the effect of including the employee option pool in the fully diluted pre-money valuation. For context, fully diluted means that all outstanding stock of the company will be used when determining the price per share. That includes all company stock held by any party and any stock options or warrants held by other parties. VCs will value your company based partly on the size of the employee option pool. The pre-money valuation of your company can be lowered based on the size of your company’s option pool. Typically, early-stage startups will dedicate between 10-20% of the company’s stock to its employee option pool. If the VC believes that the pool needs to be increase, she will insist that it is done prior to financing so that she will not be affected by dilution herself (which means that your shares as a founder will be the ones diluted by the increase in the pool).
iii. Liquidation Preference
The liquidation preference defines the return on investment an investor will see in a liquidity event and can have a notable impact on your return on investment as a founder. It is made up of two components: the actual preference and participation. The actual preference refers to the instance certain investors receive preferential treatment after a liquidity event, meaning they are first in line to get paid. Regarding participation, if the stock is participating, then the investor will get their actual preference plus additional proceeds after the preference is returned. Participation has three flavors: 1) no participation; 2) full participation; 3) capped participation. Best sure to write or model out the exit values you expect to understand the actual dollar difference between the liquidation preference formulas. Be sure to remember that any terms are sticky. Terms that you agree to in early-stage deals may prove difficult to remove in subsequent financings. In fact, you can use that fact as firepower to pushback against certain terms.
iv. Board of Directors
Your board of directors is the most significant element of your company’s management structure, if only for the fact that they usually always can fire the CEO. For a seed or initial equity financing, the board usually is composed of three people: one founder representative, one investor representative, and one CEO representative, though this may vary. One note about the CEO board representative. Adding the CEO board representative can be a delicate subject because, for early-stage startups at least, the CEO is many times a founder. When the CEO is a founder, three board member structure allows you to retain control of the board for most matters. But if the founder stops being the CEO, then the founders lose control of the board. Think deeply about the proper makeup of your board as it is the nucleus of your business, having the power to green light or veto many of your strategic plans as a business. Generally, for early-stage companies, the board’s composition should reflect the relative share that each investor and common holder has under the cap table.
At times, in addition to a board seat, your VC may wish to add a board observer. A board observer can be a huge help, an extra person in the room sucking up oxygen, or a hindrance–being the one too many chef in the kitchen. Thus, be careful when considering adding them and be sure to talk and align with your VC to get on the same page regarding the company’s governance. That said, there may be instances, at least once your company and board mature, where you may not even want total control of your board, leaving it in the hands of outside/independent directors as they can act nonpartisan in instances where impartiality is paramount. Allowing independent directors to manage your board can also provide valuable different perspectives.
It is important to understand at which date your stock will vest. When founders are issued company stock, it is not all available to founders at once. It is typically locked up for four years with a one-year cliff, meaning that a founder will need to be with the company for at least year before she has access to any shares. After one year, the founder typically will receive 25% of their company stock, with the rest of the stock vesting over equal installments at a specified time intervals. Thus, if the founder leaves the company before the stock vests, she will only receive whatever stock has vested. As a founder, you may be able to argue for a different vesting structure that accounts for the work you have done for your company prior to any VC investment. For instance, where you receive one year of vesting credit once financing closes and then the remaining balance of your stock vests over the remaining thirty-six months.
Also important, is negotiating to have your shares vest if you are terminated without cause. This is a part of the return on investment you receive for locking up your shares in a vesting schedule. Having your shares accelerate in the instance you are terminated without cause gives you downside protection. Your value add to the company will be greatest in its early years, even before your stock fully vests. As such, it would be shame if you were to be fired before your stock fully vests , even though your services rendered justify you being granted the full amount of company stock. Ensure that this acceleration is available regardless of if your termination is due to a change in control. However, if you are a part of a team of founders, also think about what may happen if one of your partners is granted a termination without cause acceleration provision, decides they are no longer happy working at the company, and provokes you to terminate them without cause–resulting in the founder leaving the company with a plethora of shares.
Lastly, are your shares single or double triggered? Single trigger acceleration refers to automatic accelerated vesting in the event of a merger. While double trigger acceleration, much more common, refers to when stock vests in the instance of two differing events taking place (e.g., an acquisition of the company alongside termination). Whether stock will accelerate in the event of a change of control can be a controversial point of negotiation because though you will want to get all your stock in the said change of control, your VC and the potential acquirer of your company will want to keep the incentive that unvested stock provides to founders.
vi. Protection Provisions
Rather than exert control over your company through the board of directors, VCs many times will establish control over your company via protective provisions (aka “veto rights”) in the financing documents. Generally, VCs will look to have veto power over any matter that:
· Modifies their preferred stock rights;
· Increases or decreases the number of authorized company stock;
· Creates or reclassifies any new class of stock with senior rights to the VC’s;
· Results in redemption of repurchase of any shares of the company’s common stock;
· Amounts to a change of control or similar liquidation of the company;
· Amends/waives any provision in the company’s charter or bylaws;
· Changes the size of the board of directors;
· Results in a dividend payment on any company shares;
· Results in the company or its subsidiary issuing debt of a certain amount;
· Declaring bankruptcy;
· Licensing away your IP;
· Issuing any digital tokens.
The less controversial provisions are those concerning declaration of dividends and modifying the rights of stock issued to investors. More significant are veto rights on future financings and the sale of the company. You can usually push back on the amount of debt you may issue without your VC’s consent. In addition, your VC will usually need to hold a minimum threshold of preferred shares to invoke their veto rights. In subsequent financing rounds, new investors will fight for their own protective provisions, as a class separate from early investors, arguing that their interests may differ from early investors due to different pricing, different risk profiles, and a need to have control. Push back on this to avoid future headaches.
VCs will want some form of antidilution protection to protect themselves against subsequent sales of preferred stock at a lower valuation. In addition to dictating the economics of a financing, antidilution can impact how much control your VC will have over your company as their presence will provide an incentive for you to issue subsequent rounds of stock at higher valuations due to the impact of antidilution protection on the common stockholders.
Protection is determined by the variation of the antidilution protection. There are two varieties: weighted-average and ratchet based. Full ratchet refers to if the company issues shares at a lower price in a subsequent financing, then the price of the shares in the previous round will be adjusted, reduced to the price of the subsequent issuance. As a founder, it is generally not in your best interest to agree to full ratchet. Rather, the more commonly found antidilution protection is weighted average, which accounts for the extent of the lower-priced issuance rather than simply the new valuation. Weighted average antidilution protection can be either broad or narrow based. Broad based antidilution provision account for both the company’s outstanding common stock as well as any options, rights, and securities other parties may have. In contrast, narrow based antidilution does not include these other options, limiting the calculation to purely outstanding securities. Make sure you and your VC are in alignment as to which definition you are using. Concentrate on reducing the impact of antidilution provisions by creating value in your company so you do not need to worry about antidilution.