Introduction

When a start-up is already established, the next step is to scale. This is when a priced round comes in: new venture capitalists replace previous angel investors and are in the position to negotiate significant economic and control rights over the company.

Therefore both aspects need to be mentioned in detail in the document agreement that is specific to this round of investment: the term sheet, which outlines the basic terms and conditions of the investment. The elements of this document will then be substantiated by a capitalization table (or « cap table ») and implemented in a suite of documents that include the shareholders’ agreement, the subscription form, the article of association and various other.

The term sheet preparation is a very delicate aspect of a venture deal, as the investors and the company need to devote full attention to the definition of their goals and objectives. Being aligned on the terms of investment from the beginning, will prevent future conflicts and help avoid unnecessary (and often costly) legal fees for avoidable amendments.

This article aims to clarify the main elements of economic and control rights of a term sheet, in order to give an overview of what to include in the document, but also to help anticipate some aspects of the negotiation that may come up at this stage.

 

Economic rights

The economic rights of the new shares include the following clauses:

 

1. Price

Just like before any round of financing, priced round requires a pre-money valuation of the company, that potential investors take into account to determine the investment amount. Venture financing usually begins when this amount is between 2M and 10M. The value of the company is used to set how much ownership the new investors can expect in return: in the case of venture capital, the ownership stake is usually between 20% and 30%. At this stage, the legal fees may vary from 30 to 50k and are generally covered by the company.

 

2. Option pool

The “employee share option pool” (ESOP) is a powerful way to attract, motivate and retain key talents, which is why investors strive to include it in the Term Sheet. This incentive plan consists of reserved shares of stock for those employees who contribute to the growth of the company. Investors generally require that option pool is set aside prior to the investment: as a result, the founder’s share is diluted.
While the size of the option pool may vary according to a great number of factors, in most cases it is recommended to agree on 10% of the company’s value. A 15% option pool is considered to be investors’ favourable, while 5% clearly tips the scale in the founder’s favour, as his or her shares are less diluted.
What if the company strategy requires employing a substantial number of highly qualified profiles? In this case, investors can insist on an option pool of 20%. However, they will have to adjust the pre-money valuation, to stay fair with the founder.

 

3. Liquidation preference

The liquidation preference is a clause that describes the payout order in the event of a liquidation, such as:

• the sale of the company
• the sale of an asset of the company
• sometimes, also the statutory merger

There are two types of liquidation preferences: non-participating preference and participating preference:

• Non-participating preference (also called OR) = {founder friendly}
• Participating preference (also called AND) = {investor friendly}

In both cases, preferred shareholders get paid their dividends before common shareholders. However, in the second case preferred shareholders receive their standard dividend first and, in addition to this, they benefit from a percentage of dividends that are paid to common shareholders (which is what makes this option more investor-favourable than the non-participating preference).

Another important aspect to consider with regards to the liquidation preference is seniority.
In case of equal seniority among preferred shareholders, the parties will have equal rights of payment and will be treated the same: this is called “pari-passu”, “equal footing” in Latin.
On the other hand, if there are senior (or stacked) preference shares, seniority will give priority to some shareholders who will, therefore, be paid before others, in reverse order from the latest round to the earliest round.

 

4. Vesting

This article can figure in the shareholders’ agreement as a retention mechanism for the founder and other executive employees of the company. It requires the shares to be held in an escrow account and given back after a specified period of time, instead of right after the capital is invested. A typical vesting period is four years with a 1-year cliff: this arrangement, particularly reserved to the founder of the company, means that he will receive 25% of his shares every year four years (generally, on a pro-rata monthly basis), starting only at the end of the first year. If, for example, the founder leaves the company after year three, he would be vested 50%, but not the remaining 50%.
However, some cases may require an acceleration of the vesting for senior executives, which can take place in two ways: the single trigger and the double trigger. In the first case, one single event triggers the acceleration: the founder’s replacement, for example, is sometimes highly encouraged to increase the company growth after the capital is raised. Therefore, investors may want to foresee a single trigger acceleration in the agreement. In case of a double trigger, the vesting acceleration requires two events to be triggered: the first event is the sale or merger of the company, and the second can be the termination of the employee without cause. This clause is recommended when investors aim to retain some valuable assets of the company, either because they can contribute to achieving good performance, or because they plan to position the company for acquisition after a certain period of time.

 

5. Pay-to-play

New investors may also want to include “pay-to-play” provisions in the Term Sheet. Such incentive requires existing shareholders to invest on a pro-rata basis in future financing rounds, otherwise their preferred stock is converted into common stock, which means that they will lose some or all of their preferential rights, such as liquidation preferences, anti-dilution or certain voting rights.
Pay-to-play provisions are particularly current in case of a “down round”, which may happen when the company needs to raise more capital and decides to sell additional shares at a lower price than had been sold for in the previous financing round.

 

6. Anti-dilution clause

This clause is a way to secure existing shareholders against the possibility for their shares to be diluted over time. This can occur when a company that had previously raised capital requires additional investments, and the second valuation turns out to be lower than the first one. This results in lower-priced, later-issued stocks, compared to those initially paid by early investors, and this is when anti-dilution comes to play. The two common types of anti-dilution clauses are known as “full ratchet” and “weighted average.”

• With a full ratchet provision, the conversion price of the existing preferred shares is adjusted to the lowest the price at which new shares are issued in later rounds

→ founder favourable option

• In case of a “weighted average” anti-dilution clause, the price of shares is adjusted by taking into account the lower-price issuance and making an average

→ investor favourable option

 

7. Pre-emptive rights

Pre-emptive rights are also called Pro Rata Right or Right of First Refusal. They state that each time a company issues additional shares, the existing shareholders have the right to buy them first. Only if they refuse, potential buyers can buy them. Pre-emptive rights are often connected to pay-to-play, because they require existing shareholders to invest more in order to protect their ownership of the company. Although it is usually limited to “major investors”, according to the Swiss Law this is a given right for each shareholder. However, pre-emptive rights can be waived in the shareholders’ agreement, particularly in the case of small companies.

 

Control rights

The second component of every shareholders’ agreement is control: who is involved in the decisions and to what extent.

 

1. Board of Directors

The board of directors should be a representation of both management and shareholder interests, therefore usually includes both internal and external members. The shareholders elect the board, who then appoints officers to whom they delegate the day-to-day management of the company.
On a five-member board of directors, the founder favourable composition will include two seats for the co-founders, two for the venture capitalists and one for an outsider. However, the new investors may judge more suitable for the business to replace one of the founders’ seats with a CEO.

 

2. Protective provisions

Although the Board of Directors approves a particular action, preferred stockholders may be granted the right to veto certain corporate decisions. This is mentioned in the term sheet as “protective provisions”. A non-exhaustive list of these rights include:

• Change terms of preferred shares
• Create more shares
• Sell the company
• Amend charter or bylaws
• Change board size
• Pay/declare dividends
• Borrow money in excess of a predetermined amount

 

3. Drag-along and tag-along rights

Last but not least, there are two types of provisions that considerably influence the control over a company, especially in case of a takeover offer.
A drag-along provision is a clause that allows majority shareholders to force the minority shareholders to join in on a sale of their shares. It is a way to eliminate minority owners and sell 100% of a company’s securities to a potential buyer.
On the other hand, a tag-along provision also called ‘co-sale right’ is a clause that allows minor shareholders to ‘tag along’ with a larger shareholder or group of shareholders if they find a buyer of their shares.

 

Conclusion

The purpose of this article was to give a general overview of the main aspects to include in a term sheet and their implications for the parties involved. The degree of complexity varies according to the situation and may seem quite overwhelming to people with little or no experience in investment agreements.
We hope this article will help the reader anticipate some aspects of the negotiation in a VC round. To dive deeper into the topic, I highly recommend the book « Venture deals », written by Brad Feld and Jason Mendelson: an enlightening reading that covers every aspect of capital deals in today’s dynamic economic environment, with a clear and practical approach.