Last week, we talked about some preliminary considerations when you’re looking to bring in funding for your company.  If your startup has piqued the interest of an investor and you are in negotiations, you will likely come out on the other end with a document called a Term Sheet.  A Term Sheet outlines the material terms and conditions of an investment agreement and is used as a guide by lawyers (because this is something you will want to get you lawyer involved in) in developing the final documents needed to paper the deal.  In this week’s post, we’ll outline some of the things you can expect to see in a Term Sheet so you can walk into negotiations with your investors with a better idea of what you need to be prepared to discuss.

One of the first topics of discussion will be the type of share that your investor will purchase (i.e. common or preferred) and the various rights to be attached to those shares.  In our last post, we discussed the difference between common and preferred shares.  In terms of the rights attached to preferred shares, as the name suggests, these shares have a “preference” or priority over a company’s common shares.  This preference is most often in relation to dividends and liquidation preference.

Dividends

Dividends are a distribution of profits by a company to its shareholders.  Dividends may be cumulative or non-cumulative.  Cumulative dividends must be paid. If they are not paid when due, they will accrue from year to year until they are paid in full.  In addition, any accrued dividends on preferred shares must be paid before dividends can be paid to the common shareholders.  In contrast, non-cumulative dividends are discretionary.  If the board of directors of a company does not declare dividends in a given year, the shareholders are not entitled to collect these dividends in the future. However, when declared, dividends are paid to holders of preferred shares before common shareholders.

Liquidation Preference

Liquidation preference determines how proceeds will be distributed in a liquidation event (for example, a sale, acquisition, or wind-up).  The two elements that determine liquidation preference are “preference” and “participation”.

“Preference” is related to the series of financing in which the shares were issued.  As discussed in last week’s post, tech startups will often go through multiple rounds of financing: Friends and Family, Seed round, Series A, B, C, etc., with investors in each series receiving a different class of shares.  The class or series of shares issued in a given round will normally rank in priority to all existing classes of shares.  For example, Series B preferred shares will have priority over Series A preferred shares, which will have priority over common shares.  Thus, a shareholder with a liquidation preference will receive a certain fixed amount as a return on their investment before proceeds are distributed to the shareholders ranking behind.

“Participation” refers to a shareholder’s right to receive a share in any proceeds distributed upon a liquidation event.  Most preferred shares have, at minimum, a right to participate in any distribution of proceeds in accordance with their preference right.  However, in some cases, once the investors have received those proceeds, they may have an additional right to receive their proportionate share of any remaining proceeds that would otherwise be distributed solely to the common shareholders.  So, a non-participating liquidation preference will give the investor a fixed return on liquidation (usually, an amount equal to the price the investor paid), while a participating liquidation preference will give the shareholder a fixed return on liquidation plus a share of any additional amounts distributed to common shareholders.

This effectively forces holders of non-participating preferred shares to convert their preferred shares into commons in order to get a piece of the pie that’s left over after the liquidation preferences have been paid out and, in doing so, forgo their liquidation preference.

Anti-Dilution Protection

Most investors will want some sort of anti-dilution protection provision to protect against the possibility that the company will issue shares in the future at a lower price per share.

Experienced institutional investors will typically receive convertible preferred shares in exchange for their investment in a startup.  This means their preferred shares can be converted into common shares, usually on a one-to-one basis.  Anti-dilution protection is implemented by adjusting this conversion ratio.

There are two common ways of formulating anti-dilution protection provisions: the “full-ratchet” and the “weighted average”.  Under a full-ratchet formula, if future shares are issued at a lower price than the price paid by the existing investors, the conversion ratio of the existing investors’ preferred shares is automatically adjusted to reflect the price per share paid for the new shares issued, regardless of the number of new shares being issued.  For example, if the existing investors paid $1.00 for each of their shares and the company later issues even one share at a price of $0.50, then the conversion ratio goes from 1 common share for each preferred share to 2 common shares for each preferred share.

The more common protection offered to investors, and one that is more fair to the existing investors and common shareholders, is anti-dilution calculated on a weighted average basis.  Under a weighted average formula, if future shares are issued at a lower price than the price paid by the existing investors, the conversion ratio of the existing preferred shares is adjusted according to a formula that incorporates the number of new shares being issued as well as their issue price.  In a sense, the weighted average formula provides a “do-over” since consideration is given to the relationship between the total number of shares outstanding and the number of shares held by earlier investors.

Final Thoughts

A Term Sheet will often be conditional on the completion of due diligence, legal review, and documentation that is satisfactory to both parties to the transaction.  This gives you an opportunity to call your lawyer and get some advice on the terms of the Term Sheet before going too far down the rabbit hole.  Your focus in a financing will often be… well, quite frankly, whatever the investor wants.  But before you get too caught up in the excitement of potential world domination, it is important to take a step back and evaluate your objectives—for yourself and for your company.  Your lawyer will play a key role in helping you bring in the financing you need to achieve those objectives while protecting your interests and ensuring the continued success of your business venture.

Author: Ava Aslani

This information is general in nature only. You should consult a lawyer before acting on any of this information. This information should not be considered as legal advice. To learn more about your real estate needs, please contact out office at (250) 448-2637 or any of our lawyers practicing in the areas of real estate at the following:

Una Gabie: una@touchstonelawgroup.com

Jennette Vopicka: jennette@touchstonelawgroup.com

Danielle (Dani) Brito: danielle@touchstonelawgroup.com