How To Tell If Your Startup Ecosystem Is Sick

I had an interesting lunch with some fellow lawyers the other day. I know, “interesting” and “lawyers” shouldn’t be used together in a sentence, but bear with me. We were discussing venture capital deal terms we had encountered with various startup financings we had worked on. One of the other lawyers mentioned that in two deals he had worked on recently involving local Midwestern startups and investors, the investors had insisted on a 3X participating liquidation preference. I was really taken aback by this. In a Series A financing I had worked on a couple of months ago, involving a startup and VC firm that are both in the San Francisco bay area, there was a 1X non-participating liquidation preference. The VC didn’t even try to get something more.

To understand why this is important to startups and to the health of a startup ecosystem, let me explain what a liquidation preference is, and how it works. A liquidation preference is money that the investors take off the top, when a startup they have invested in goes through an exit. For example, suppose a startup is being acquired by Facebook. If a VC that has invested $3 million in the startup has a 1X participating liquidation preference, that means that the VC takes the first $3 million off the top, leaving less money for everyone else. Since the liquidation preference is participating, the VC then gets to share in the remaining proceeds with the common stockholders, pro rata. Essentially, the VC gets to double-dip. In a small transaction, this could be devastating to the founders. For example, look at what happens if Facebook is paying only $5 million for the startup. The VC gets $3 million off the top, leaving only $2 million for everyone else. Because the liquidation preference is participating, the VC may also get a share of that remaining $2 million. And that’s just with a 1X liquidation preference.

Typically, the VC may only use the 1X liquidation preference in a smaller exit transaction, as it protects his downside. In a larger exit transaction, the economics may favor converting the preferred stock to common stock and sharing in the proceeds that way. A liquidation preference greater than 1X, however, may skew those decisions.

Now let’s look at how a 3X participating liquidation preference would impact the deal. Suppose the sale price of the startup is $10 million, and the VC invested $3 million. Now the VC gets $9 million off the top, leaving $1 million for everyone else. Because the liquidation preference is participating, the VC will get a share of that $1 million, too. The founders and any employees holding stock and/or stock options get screwed, to put it politely.

What are the implications of this for startups and a startup ecosystem? When you have a vibrant ecosystem with lots of strong startups and many angel and VC investors, you have competition for deals. As a result, the deals tend to be fairer to the startups. A strong startup has some bargaining leverage when seeking financing, and investors are eager to invest in such companies. When the investors have to compete for deals, they offer more favorable terms to the startups, lest they miss out. FOMO is a powerful force.

You see this at work in Silicon Valley, which has a well-established startup ecosystem with many VC investors and some of the most promising startups. In the Fenwick & West Silicon Valley Venture Capital Survey for the first quarter of 2017, only 16% of the deals involved multiple liquidation preferences. This is actually a steady rise over the past year; in the first quarter of 2017, the number was about 7%. Of those multiple liquidation preferences during 2017Q1, two-thirds were in the 1X to 2X range, and one-third were in the 2X to 3X range. Also, for 2017Q1, only 22% of the financings provided for participation; the remaining 78% were non-participating.

In smaller and new startup ecosystems, you don’t have a lot of strong startups, and you may only have a handful of investors operating. This is frequently the case in some of the emerging Midwestern startup ecosystems, like Louisville, Indianapolis, Columbus, Pittsburgh, and Cincinnati, where I’m located. As a result, the investors feel more emboldened, or more risk-averse, so they demand terms that are way out of the norm for places like San Francisco and New York. I emphasize the word “demand,” because that’s what these investors do – they demand these terms, with a “take it or leave it” attitude. If you don’t like what Investor A is offering, good luck with Investor B – they probably are offering the same terms. There is no Investor C.

As long as this persists, these smaller ecosystems will be weak. In order to improve and strengthen the ecosystem, you need stronger startups to attract more investors who will offer fair terms. These weak ecosystems, however, risk losing the best startups to more favorable ecosystems. Also, startups have to be prepared to look outside their community for funding. If you are a startup in a place like Cincinnati, and you aren’t trying to raise funds from investors in Chicago, New York, Austin, San Francisco, and LA, you are putting yourself at the mercy of your local investors. You may say that you can’t afford to fly all over the country seeking out investors, but the truth is that you can’t afford not to. Your obligations are to the shareholders, to produce the highest returns. If you give away a 3X participating liquidation preference to a local investor because you didn’t seek out investors in stronger ecosystems, you are basically taking the money out of your pocket and putting it in your investors’ pockets.

Anatomy of a Term Sheet 6 — Protective Provisions

Welcome back to my series on the Anatomy of a Term Sheet. In this series, I am going through the model term sheet provided by the National Venture Capital Association, which you can find here.

In previous posts, I discussed provisions such as pre-money valuation, the option pool issue, dividend terms, the liquidation preference, and voting rights. Today we are going to look at protective provisions.

The protective provisions give the preferred stockholders a veto over certain actions. In order for the startup to take these actions, the preferred stockholders must take a vote to approve the action.

Here is the protective provisions term from our model Term Sheet:

[So long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding,] in addition to any other vote or approval required under the Company’s Charter or Bylaws, the Company will not, without the written consent of the holders of at least [__]% of the Company’s Series A Preferred, either directly or by amendment, merger, consolidation, or otherwise:

(i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any merger or consolidation or any other Deemed Liquidation Event;

(ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred];

(iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred;

(iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of [_____] Series A Director(s)]; or

 (v) create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit][unless such debt security has received the prior approval of the Board of Directors, including the approval of [________] Series A Director(s)]; 

(vi) create or hold capital stock in any subsidiary that is not a wholly-owned subsidiary or dispose of any subsidiary stock or all or substantially all of any subsidiary assets; [or

(vii) increase or decrease the size of the Board of Directors].

Founders should negotiate to have a minimum level of preferred shares outstanding for the protective provisions to be in place. If most of the preferred shares have been converted to common stock, you don’t want to have an investor holding a token number of preferred stock to have an effective veto over any major corporate action. You can see that option in the red bracketed language above. Also, the founders will want to negotiate over the percentage of preferred shares required to authorize an action, so that the approval threshold isn’t prohibitively high.

The above provisions are fairly standard. There are some variations in (iv) and (v), where Board approval is sufficient, provided that the Series A director(s) also vote in favor of the action.

There are other protective provisions, however, that might be included and that might be more troublesome. For example, there might be terms requiring the Series A investors’ approval of:

  • any hiring, firing, or change in compensation of executive officers
  • any transaction between the company and a director, officer or employee
  • any change in the principal line of business of the company, or the adoption of a new line of business
  • any purchase of a substantial amount of assets of another company 
  • incurring debt in excess of a specified amount

The company needs to be able to operate, and board oversight should be sufficient for those types of actions. During negotiations, the company should try to have the more intrusive provisions removed. It may be tempting to overlook the protective provisions during term sheet negotiations, because these don’t directly affect the monetary aspects of the financing. They do have a material impact on how the company will operate going forward, however, and it is important that the founders maintain sufficient freedom of action.

Next time, we will look at optional and mandatory conversion of preferred shares. Thank you for reading, and feel free to ask questions or comment.

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Anatomy of a Termsheet 5 — Voting Rights

Welcome back to the fifth installment of my series on the Anatomy of a Term Sheet. In this series, I am going through the model term sheet provided by the National Venture Capital Association, which you can find here.

In previous posts, I discussed provisions such as pre-money valuation, the option pool issue, dividend terms, and the liquidation preference. Today we are going to look at voting rights.    

Here is what the sample voting rights term looks like:

The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except 

(i) [so long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding,] the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the “Series A Directors”), and 

(ii) as required by law.  

The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock.

There are a few things going on with this term. First, it gives the Series A investors, which hold preferred stock, the ability to vote alongside common stockholders, as if their preferred shares had been converted to common stock. In addition, the Series A investors have the power to elect one or more directors, giving them an important voice in the management of the startup. Investors are naturally going to want control of the board, even if they don’t hold a majority of the stock on an as-converted basis, to protect their substantial investment. This is a negotiation point. It is still possible for the founders to maintain board control if other factors are at play, for example if the startup is particularly hot and there is more than one VC fund eager to invest. A possible fallback that might be acceptable for both sides is for the founders and investors to each select an equal number of board members, and for those existing board members to then choose an additional member. For example, if there is a five-person board, the founders and investors each choose two directors, and those four directors choose a fifth.

Finally, there is a provision that the number of authorized shares can be changed only by a majority vote of the preferred stockholders and the common stockholders voting together as a class. It takes away the right of the common stockholders to vote separately as a class on changing the authorized number of shares. Note that if the company is incorporated in California, it cannot opt out of the statutory requirement that the common stockholders vote separately as a class to authorize shares of common stock. If the company is incorporated in Delaware, on the other hand, it can opt out from the separate class vote requirement under Delaware General Corporation Law Section 242(b)(2), and this clause in the Term Sheet exercises that opt-out right.

Thanks for reading, and I hope this has been informative. Next time, we look at protective provisions.

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Anatomy of a Term Sheet 4 – the Liquidation Preference

Welcome back to the fourth installment of my series on the Anatomy of a Term Sheet. I hope this series is helpful to startup founders, and helps break down some of the legalese in venture capital term sheets. In this series, I am going through the model term sheet provided by the National Venture Capital Association, which you can find here.

In previous posts, I discussed some basic provisions, including pre-money valuation, the option pool issue, and dividend terms. Today, I will delve into the liquidation preference, one of the signature features of preferred stock. Without further ado…

Series A investors are going to be getting preferred stock, not common stock, in exchange for their investment. Preferred stock gives its holders certain rights that are superior to the rights of the common stockholders (hence the name “preferred”). The liquidation preference is one of those terms that actually describes what it is pretty well. It gives preferred stockholders a priority position over common stockholders if the startup company goes through a liquidation, dissolution, or winding up. Here is what the liquidation preference term looks like in the model term sheet:

In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

Alternative 1 (non-participating Preferred Stock):  First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis).  The balance of any proceeds shall be distributed pro rata to holders of Common Stock.

Note the term “non-participating Preferred Stock.” This means that an investor that chooses to receive its liquidation preference will not get to participate pro rata with the other stockholders in any remaining sale proceeds after payment of the liquidation preference. Under this alternative, proceeds of any liquidation, dissolution or winding up are paid out first to preferred stockholders, and to the extent the proceeds are large enough, the preferred stockholders each get their original purchase price per share, and depending on the language, with accrued or declared and unpaid dividends. If the preferred stockholders would get more money by converting their preferred stock to common stock, then they get the higher amount. Essentially, the preferred stockholders are getting their money back, before any proceeds can be distributed to holders of common stock. If there are any proceeds left over after paying the liquidation preference, then the remaining proceeds are paid pro rata to common stockholders.

Also note that the liquidation preference could be a multiple of that original purchase price. For example, in the term sheet it could be a 2X liquidation preference, in which case the preferred stockholders get two times the original purchase price. This will be fairly important in the case of a merger, consolidation, or asset sale, as I will discuss below.

Alternative 2 (full participating Preferred Stock):  First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred.  Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

The second alternative is for the preferred stockholders to get their liquidation preference, and also participate in the distribution of any remaining proceeds. They participate alongside the common stockholders, receiving any remaining proceeds pro rata on an as-converted basis. As you can see, this form of liquidation preference is more attractive to the Series A investor. They are getting a double dip into the proceeds.

Alternative 3 (cap on Preferred Stock participation rights):  First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred.  Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).

The third variation on liquidation preference is where the preferred stockholders receive their liquidation preference, then participate alongside the common stockholders in a pro rata distribution of any remaining proceeds (on an as-converted basis), but their total participation is capped at some multiple of the original purchase price per share.

Finally, we have this language:

A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise].  [The Investors’ entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow in connection with a Deemed Liquidation Event.]

This crucial aspect of the liquidation preference term is the application of the preference to two other situations – a merger or consolidation (where the startup does not end up as the controlling entity), or an asset sale. If we had just been looking at a liquidation, dissolution, or winding up, there might not be any proceeds to distribute to preferred stockholders or common stockholders, as a practical matter. In the case of a merger or asset sale, however, the proceeds might be substantial indeed.

Let’s look at how this works in practice. First, we assume that our startup is being sold for $60 million, and the Series A investor has $10 million invested for one third of the company, with a 2X participating preferred. The investor gets $20 million off the top (assuming no accrued dividends) because it is a 2X preference, and an additional $13.3 million (one-third of the remaining $40 million sale proceeds). The investor’s total take is $33.3 million, which is more than half the sale proceeds, even though the investor only owned one third of the startup company.

It is for this reason that founders should push for a non-participating liquidation preference, and fall back to participating preference with a cap when negotiating the term sheet. In addition, whatever terms founders agree to in the initial round will influence the terms they get in later rounds, so it is important to push for non-participating liquidation preference at the start.

Thank you for reading, feel free to comment, and next time, I will discuss voting rights and protective provisions.

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Anatomy of a Term Sheet 3 – Dividends

Welcome to Part 3 of my series, Anatomy of a Term Sheet. If you are new to this series, I am analyzing in detail a Series A investment term sheet, using the model term sheet from the National Venture Capital Association.

Part 1 of the series, which addressed some basic introductory terms, can be found here. Part 2 dealt with pre-money valuation, and in particular, the dilutive effect of the option pool. It can be found here.

The next group of terms from the model Term Sheet deals with charter terms, or terms that will affect the startup company’s certificate of incorporation. The certificate of incorporation, or charter, will need to be amended to create a new class of stock, the preferred stock, which is what the Series A investors will purchase. There are quite a few terms relating to the rights of the Series A Preferred stockholders, and many of them are complex, so I will spread out the discussion over several installments of this series.

The first of the charter terms deals with dividends. Take the jump with me for a discussion of the three alternative dividend terms in the Term Sheet…

Alternative 1:  Dividends will be paid on the Series A Preferred on an as‑converted basis when, as, and if paid on the Common Stock 

The purpose of this first alternative is to ensure that the startup cannot pay out dividends to the common stockholders without also paying dividends to the Series A Preferred holders, treating them as if they have converted their stock to common stock. It is a fairly favorable term for the startup, because it doesn’t impose any specific requirement to pay dividends. It merely puts the preferred stockholders on an even footing with the common stockholders with respect to any dividends the business decides to pay.

Alternative 2The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption].  For any other dividends or distributions, participation with Common Stock on an as-converted basis.

This alternative does several things. First, it specifies that the dividends for the Series A Preferred will be annual and cumulative, rather than at the pure discretion of the board of directors. That is, there will be a specific dividend amount each year, and the holders of the preferred stock have the right to receive accrued (previously unpaid) dividends in full before dividends are paid to any other class of stock. Second, these cumulative dividends must be paid upon a liquidation or redemption of the preferred stock. This alternative can be viewed as a means of providing a specified annual rate of return to the investors. Founders should push back and require that any such dividends only be payable upon a liquidity event (like the sale of the company), and that the dividends be forfeited in the case of an IPO or conversion of the preferred stock into common stock; the investors don’t need the protection of an annual cumulative dividend in those cases.

Alternative 3:  Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.

This alternative specifies a dividend amount for the preferred stock, but the dividends are neither annual nor cumulative. The board can decide whether or not to pay dividends to the preferred stockholders, but the amount is set in advance.

In general, dividends are not going to be a big issue for startups. The main goal of these companies is to find a way to generate revenue and profits, and it may be years before the company is in a financial position to pay dividends. When startups do begin to generate cash, a higher priority is reinvesting in the company. Indeed, tech companies often delay years before paying dividends. Microsoft paid its first dividend in 2003, almost 30 years after its founding. Intel paid its first dividend in 1992, 24 years after it was founded. Google was founded in 1998 and has never paid a cash dividend.

Even though the payment of dividends is most likely going to be deferred for years, it is still important to understand how the dividend terms work, in particular the second alternative, which gives the board of directors the least amount of discretion with regard to paying dividends. None of the above alternatives provide for stock dividends, but that is something else that founders need to watch out for. Stock dividends have the effect of further diluting the founders’ holdings.

Next time: the liquidation preference terms.

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