More Related Content Similar to Negotiating the Term Sheet in Today's Market (14) Negotiating the Term Sheet in Today's Market1. Negotiating the Preferred Stock Term Sheet
in Today’s Market Place
Presented by Bart Greenberg
Haynes and Boone, LLP
OCTANe Foundation for Innovation’s Building Blocks Series
July 21, 2011
© 2010 Haynes and Boone, LLP
3. Market Conditions Impact Terms
• Shortage of willing investors leads to
aggressive terms
• Desire by Investors to “correct” prior valuation
errors (i.e., overvaluations) and pull up returns
on whole portfolio may lead to more aggressive
terms
• Desire by Investors to avoid future errors may
lead to more aggressive terms, such as by
imposing self-adjusting valuations, guaranteed
returns, downside protection, more bridge
financings
© 2010 Haynes and Boone, LLP
4. Prior Rounds Impact Terms
• Severe down round/cramdown (leads
to most aggressive terms)
• Flat round (could be considered a “win”
in unfavorable market conditions)
• Up round (best chance to get
reasonable or favorable terms)
© 2010 Haynes and Boone, LLP
5. Valuation
• Means many different things
• $2.5 million pre-money with $2.5 million new money
could mean:
– Original investors get $2.5 million if sold for $5 million
– Original investors + optionees (current or all future) get $2.5
million if sold for $5 million
– Original investors + founders and optionees (current or all
future) will each have equivalent ownership percentages if
“go public” (and convert to common stock) – but not
necessarily under other liquidity scenarios
• Conversion concept vs. liquidation concept
© 2010 Haynes and Boone, LLP
7. Dividends
Considerations
• Priority of Payment
•Common
•Other Preferred
• Dividend/Coupon Rate
• Cumulative vs.
• Non-Cumulative
• Form of Payment
•Cash “coupon”
•Payment-in-Kind Securities
(PIKs)
© 2010 Haynes and Boone, LLP
8. Dividends
Pre- • Non-mandatory, non-cumulative
Bubble 8% per year
Post- • Mandatory, cumulative 8% per year
• More Extreme: Mandatory, cumulative,
Bubble payable in kind up to 15% per year
© 2010 Haynes and Boone, LLP
9. Dividends
Example
“Annual $_____ per share dividend on the Series ___
Preferred Stock, payable when and if declared by Board,
prior to any dividends paid to the Common Stock; dividends
are [not] cumulative. No dividends will be declared or paid
on the Common Stock unless and until a like dividend has
been declared and paid on the Series ___ Preferred
Stock.”
© 2010 Haynes and Boone, LLP
10. Liquidation Preference
Considerations
• Should the holder have a
“preferred” return before other
equity holders?
• When should the preference
apply (e.g., non-conversion
contexts such as a merger or
upon liquidation)?
• Key Characteristics:
• Priority of Distribution
• Amount of Preference
• Participation Rights
© 2010 Haynes and Boone, LLP
11. Liquidation Preference
A B C D E F G H
Return cost Cost + Cost + AROI Cost + AROI Cost + Cost + Cost + AROI Multiple of
only, or else annual to PS; same to PS; AROI to PS; AROI to PS; to PS; then cost to PS;
convert ROI amount per negotiated cost + AROI then pro pro rata then pro
(“AROI”) share to CS; amount to to CS; then rata up to participation rata
or else then pro rata CS; then pro pro rata multiple of participation
convert participation rata participation PS cost; or
participation else convert
More favorable to More favorable to
common holders preferred holders
© 2010 Haynes and Boone, LLP
12. Liquidation Preference
Pre- •• 1X purchase price, plus participation
Bubble rights up to 3X
• 1X to 3X with some participation rights
Post- (the lower the X, the greater the
Bubble participation rights)
• Participation Rights are sometimes
subject to a management carve out
• More extreme: 3X purchase price, plus
participation rights with no cap
© 2010 Haynes and Boone, LLP
13. The “Waterfall”
First: Creditors Satisfied
Second: Distribution to holders
of preferred stock
Third: Distribution to holders of common
stock (with possible participation by holders
of preferred stock)
© 2010 Haynes and Boone, LLP
14. The “Waterfall” (an illustration)
Amount Available for Distribution: $15,000,000
Term Sheet: 1x preference for Series A, 1x
participation) First Second Third Total
Creditors 0 0 0 $0.00
Series A* 0 $4,100,000 $4,100,000 $8,200,000
Common Stock 0 0 $6,800,000 $6,800,000
(including option
pool) $15,000,000
Term Sheet: 3x preference for Series A, full participation
First Second Third Total
Creditors 0 0 0 $0.00
Series A* 0 $12,300,000 $1,350,000 $13,650,000
Common Stock 0 0 $1,350,000 $1,350,000
(including option
pool) $15,000,000
* Original investment of $4,100,000
© 2010 Haynes and Boone, LLP
15. Liquidation Preference
Example 1: Full Participation
“First pay the original purchase price [plus premium] plus
accrued dividends (if any) on each share of Series ___
Preferred Stock. Thereafter, Series ___ Preferred Stock
participates with Common Stock on an as-converted
basis.”
© 2010 Haynes and Boone, LLP
16. Liquidation Preference
Example 2: Cap on Participation Rights
“First pay the original purchase price plus accrued
dividends (if any) on each share of Series ___
Preferred Stock. Thereafter, Series ___ Preferred
Stock participates with Common Stock on an as-
converted basis until the holders of Series ___
Preferred Stock receive an aggregate of [ _ ]X
original purchase price.”
© 2010 Haynes and Boone, LLP
17. Liquidation Preference
Example 3: Non-Participating
“First pay the original purchase price [plus
premium?] plus accrued dividends on each
share of Series ___ Preferred Stock. The
balance to holders of Common Stock.”
© 2010 Haynes and Boone, LLP
18. Redemption
Considerations
• Who can trigger?
• Percentage of preferred
holders/individually
• Company (rare)
• Priority among other holders
• Staging of Redemption
• Device to force conversion
• Form of Payment
• Legal Restrictions
© 2010 Haynes and Boone, LLP
19. Redemption
Pre- • Not Common
Bubble
Post- • At option of holders after 5 years at
Bubble purchase price plus accrued dividends
© 2010 Haynes and Boone, LLP
20. Redemption
Example 1: Lump Sum
“Series ___ Preferred Stock redeemable at the
election of holders [of 66-2/3rds] of the outstanding
Series ___ Preferred Stock] on or after
____________ at a price equal to the original
purchase price [plus accrued dividends] [plus ___%
per year] or as soon thereafter as legally
permissible.”
© 2010 Haynes and Boone, LLP
21. Redemption
Example 2: Three Tranches
“[See Example 1], to the extent of 1/3 of the shares
of Series ___ Preferred Stock on the [____], [____]
and [____] anniversary dates of the Closing or as
soon thereafter as legally permissible[, but in no
event will more than 1/3 of the outstanding shares of
Series ___ Preferred Stock (plus 1/3 of the
aggregate accrued dividends) be redeemed in any
12 month period.]”
© 2010 Haynes and Boone, LLP
22. Conversion Rights
Considerations
• The number of shares of common
stock, if any, into which preferred
stock converts:
preferred stock share price (fixed)
Conversion Price
• Typically Based on Certain
Triggering Events
• Election by percentage of
holders of preferred stock
• IPO
© 2010 Haynes and Boone, LLP
23. Antidilution Adjustments
Considerations
• Way to “fix” earlier valuation
errors on conversion (i.e. allocate
most or all of risk of down round
to common stock)
• Three Types of Adjustments
• “Full Ratchet”
• “Narrow-Based” Weighted
Average
• “Broad-Based” Weighted
Average
• Specified Exceptions
© 2010 Haynes and Boone, LLP
24. Antidilution Adjustments
Pre- • Standard broad-based weighted
Bubble average adjustment
Post- • Narrow-based weighted average
Bubble adjustment
• More extreme: Full ratchet adjustment
for a period; then narrow or broad-
based weighted average adjustment
© 2010 Haynes and Boone, LLP
25. Antidilution Adjustments (an illustration)
Scenario:
Common Stock Outstanding 1,000,000 shares
Series A Preferred 1,000,000 shares at $1.00
(or $1,000,000)
Series B Preferred 1,000,000 shares at 75¢
(or $750,000)
Adjustments (Upon Series B)
• Series A Conversion Ratio Prior to Series B = 1:1
• Upon Series B, Series A Conversion Ratio adjusted as follows:
Type of Adjustment Conversion Ratio
Full Ratchet 1:1.333
Narrow-Based 1:1.143
Broad-Based 1:1.091
© 2010 Haynes and Boone, LLP
26. Antidilution Adjustments - Pay to Play
• If stockholder does not purchase pro rata
share in subsequent offering, stockholder
loses benefit of antidilution provisions.
• In extreme cases, non-participating
stockholders must convert to common stock
(sometimes at less than 1:1), thereby losing
protective provisions of preferred stock.
• “Pay to Play” minimizes fears of major
investors that small investors will benefit by
having major investors continue providing
needed equity, particularly in troubled
economic times.
© 2010 Haynes and Boone, LLP
27. Antidilution Adjustments
Example 1: With Pay to Play
“Conversion ratio for Series ___
Preferred Stock adjusted on [ratchet/
[broad or narrow] weighted average]
basis in the event of a dilutive issuance
[so long as investor purchases full pro
rata share of dilutive issuance (“pay to
play”).]”
© 2010 Haynes and Boone, LLP
28. Antidilution Adjustments
Example 2: Pay to Play with Cram Down
“Any Existing Holder that does not fund its Pro
Rata Amount by the Initial Closing shall have its
Equity Securities automatically converted at a ratio
of 10 to 1 to a new series of Common Stock that
retains no voting rights; provided however, that to
the extent an Existing Holder partially meets its
Pro Rata Amount, such holder shall retain a
corresponding portion of its Equity Securities, and
may choose the respective portion to retain.”
© 2010 Haynes and Boone, LLP
29. Antidilution Adjustments
Example 3: Specified Exceptions
“Dilutive issuance” shall not include: (i) up to
______ shares of Common Stock issued pursuant
to a stock option plan approved [unanimously/by a
majority] of the Board of Directors; (ii) Common
Stock issued upon conversion of the Preferred
Stock; (iii) stock issued in any IPO in which the
Preferred Stock is converted into Common Stock;
or (iv) stock issued in connection with mergers or
acquisitions approved [unanimously/by a majority]
of the Board of Directors.”
© 2010 Haynes and Boone, LLP
30. Protective Provisions
Considerations
• Control Provisions
• Board Seats
• Voting Agreements
• Other Protections
© 2010 Haynes and Boone, LLP
31. Protective Provisions
• Investor approval of: senior securities,
Pre-
sale of company, payment of dividends,
Bubble
liquidation, change of rights
• Investor approval of senior or pari
passu
securities, sale of company, payment of
Post- dividends, change of rights, change of
business, incurrence of debt over
Bubble specified limit, annual budgets and
variances, acquisitions of other
businesses, grant of exclusive rights in
technology, appointment or termination
of CEO
© 2010 Haynes and Boone, LLP
32. Protective Provisions
Example
“Votes on an as-converted basis, but also has
[class/series] vote as provided by law and on (i) the
creation of any senior [or pari passu] security, [(ii) payment
of dividends on [Common Stock/on any class of Stock]],[(iii)
any redemptions or repurchases of Common Stock or
Preferred Stock [except for purchases at cost upon
termination of employment], (iv) any liquidation, dissolution
or winding up of the Company; (v) any merger, acquisition,
recapitalization, reorganization or sale of all or substantially
all of the assets of the Company, (vi) an
© 2010 Haynes and Boone, LLP
33. Protective Provisions
Example (cont.)
increase or decrease in the number of authorized shares
of Series [ _ ] Preferred Stock or Common Stock, (vii) any
[adverse] change to the rights, preferences and privileges
of the Series [ _ ] Preferred, [(viii) an increase or decrease
in the size of the Board], [(ix) [material] amendments or
repeal of any provision of the Company’s Charter or
Bylaws]; [(x) the issuance of any additional shares of
capital stock (or options) to the Company’s founders,] and
[(xi)] authorization of any amount of indebtedness in
excess of $____.]”
© 2010 Haynes and Boone, LLP
35. Representation and Warranties
Considerations
• Scope/Coverage
• By the Company
• By the Founders
(e.g., technology)
© 2010 Haynes and Boone, LLP
36. Closings
Considerations
• When will the Investors
go “at-risk”?
• Lump Sum at Closing
• Staging of Investment
• Passage of Time
• Milestones
© 2010 Haynes and Boone, LLP
37. Closings
Pre-
• Single Tranche Investment
Bubble
Post- • Single Tranche Investment
Bubble • More Extreme: Milestone-Based
Tranches
© 2010 Haynes and Boone, LLP
38. Conditions to Closing
Considerations
• Satisfactory Completion of
Due Diligence
• Exemption or Qualification
of Shares under Applicable
Securities Laws
• Filing of Amendment to
Charter to Establish Rights
and Preferences of the
Preferred Stock
• Opinion of Counsel to the
Company
© 2010 Haynes and Boone, LLP
39. Employee Matters
Considerations
• Employment
Agreements with
Founders
• Obligation for All
Employees/Consultants
to Enter into Company’s
Standard Inventions
and Proprietary
Information Agreement
© 2010 Haynes and Boone, LLP
40. Expenses
Considerations
• Company Typically
Pays Reasonable Fees
and Expenses of
Investors’ Counsel
• Consider Cap on
Obligation
© 2010 Haynes and Boone, LLP
42. Registration Rights
Considerations
• Types of Registration Rights
• Demand Rights
• Piggyback Rights
• S3 Rights
• Termination of Rights
• Limitation on Subsequent
Rights
• Absolute prohibition
• Permitted if Subordinate
• Allocation of Expenses
© 2010 Haynes and Boone, LLP
43. Registration Rights
Example 1: Demand Rights
“Beginning on the earlier of [3-5] years from
Closing, or [three/six] months after the Company’s
IPO, [1-2] demand registrations [for underwritten
public offerings] upon initiation by holders of at
least [30]% of outstanding Series ___ Preferred
Stock (or Common Stock issuable upon
conversion of the Series ___ Preferred Stock or
any combination thereof) for aggregate proceeds
in excess of $_______.”
© 2010 Haynes and Boone, LLP
44. Registration Rights
Example 2: Piggyback Rights
“Investors in Series __ Preferred Stock will have
[unlimited] piggyback registration rights subject to
pro rata cutback at the underwriter’s discretion.
Full cutback upon the IPO; [30% minimum
inclusion thereafter]. Investors will not be subject
to cutback unless all other selling shareholders are
excluded from registration.”
© 2010 Haynes and Boone, LLP
45. Registration Rights
Example 3: S3 Rights
“[Unlimited] S-3 Registrations of at least $500,000
each [upon initiation by holders of at least [20%] of
the outstanding Series ___ Preferred Stock (or
Common Stock issuable upon conversion of the
Series ___ Preferred Stock or any combination
thereof)]. [No more than two S-3 Registrations in
any 12 month period.]”
© 2010 Haynes and Boone, LLP
46. Registration Rights
Example 4: Termination
“Registration rights terminate [(i) [3-7] years after
the IPO;] or (ii) when [the Company is publicly
traded and] all shares can be sold [in any 90-day
period] under Rule 144, whichever occurs first.][,
provided that this clause (ii) shall not apply to any
5% holder deemed to be an affiliate of the
Company.]”
© 2010 Haynes and Boone, LLP
47. Market Stand-Off
Considerations
• Time of Lock-Up
• Who Controls Decision
• Investors
• Underwriter
• Equal Application
• Obligation to Execute
Underwriter’s Form of
Lock-Up Agreement
© 2010 Haynes and Boone, LLP
48. Market Stand-Off
Example
“Prior to the Closing, all shareholders shall agree that in
connection with the IPO not to sell any shares of Preferred
Stock or Common Stock issuable upon conversion thereof
for a period of up to [180] days following the IPO
[(provided directors and officers of the Company and [5]%
shareholders agree to the same lock-up. Such
shareholders also shall agree to sign the underwriter’s
standard lock-up agreement reflecting the foregoing.”
© 2010 Haynes and Boone, LLP
49. Right of First Offer
Considerations
• Who Owns the Right?
• All holders of preferred stock
• Holders of at least [____]
percentage of preferred stock
• Determination of
Percentage
© 2010 Haynes and Boone, LLP
50. Right of First Offer
Pre- • Right to maintain pro-rata ownership in
Bubble later financings
Post- • Right to maintain pro-rata ownership in
Bubble later financings
• More Extreme: right to invest 2X pro-
rata ownership in later financings
© 2010 Haynes and Boone, LLP
51. Right of First Offer
Example
“The Investors shall have a pro rata right, based on
their percentage equity ownership of [Preferred
Stock] [Common Stock, on a fully diluted basis], to
participate in subsequent financings of the
Company (excluding [See List of Specified
Exceptions to Antidilution Adjustments]. Such right
will terminate immediately prior to a Qualified
Public Offering.”
© 2010 Haynes and Boone, LLP
52. Financial Information
Considerations
• Financial Statements
• [Audited] annual statements
• Unaudited monthly/quarterly
statements
• [1-5] Year Projections
• Other Material
Information
© 2010 Haynes and Boone, LLP
53. Board of Directors
Considerations
• Determination of Authorized
Number of Directors
• Voting Agreement Among
Shareholders
• Class Votes
• Specific Identification
• Independent Members of
Board
• Use of an Advisory Board
• Board Observation Rights
© 2010 Haynes and Boone, LLP
54. Board of Directors
Example
“[The Company’s Articles of Incorporation shall provide that
the] Board shall consist of ____ members, with the holders
of a majority of Series ___ Preferred Stock entitled to elect
____ member(s) [and the holders of a majority of the
Common Stock entitled to elect ____ member(s)]. [The
Company and the Investors intend to select ____ outside
director(s) with relevant industry experience as soon as
possible after Closing.] Board composition at Closing shall
be _______, [with vacancy].”
© 2010 Haynes and Boone, LLP
57. Rights of First Refusal
Pre- • Right to purchase any shares proposed
Bubble to be sold by employees
• Right to purchase any shares proposed
Post- to be sold by employees
Bubble • More extreme: right to purchase any
shares proposed to be sold by any
shareholder
© 2010 Haynes and Boone, LLP
58. Rights of First Refusal
Example
“Any [vested] Common Stock acquired
by [employees] [founders]
[shareholders] shall be subject to a
right of first refusal of [the Company]
[the Investors] to repurchase any stock,
at the bona fide offer price.”
© 2010 Haynes and Boone, LLP
59. Co-Sale Rights
Pre- • Right to sell alongside any founder that
Bubble sells shares
• Right to sell alongside any founder
Post- that sells shares
Bubble • More extreme: Right to sell alongside
any shareholder that sells shares
© 2010 Haynes and Boone, LLP
60. Co-Sale Rights
Example
“Until the IPO, the Investors also shall have the right
to participate on a pro rata basis in transfers of any
shares of [Preferred Stock or] Common Stock [held
by the Founders or any [major] shareholder], [and a
right of first refusal on such transfers, [subordinate
to] [prior to] the Company’s right of first refusal.
[Any shares not subscribed for by an Investor may
be reallocated among the other eligible Investors.]”
© 2010 Haynes and Boone, LLP
61. Drag-Along Rights
Pre- • None
Bubble
• None
Post- • More extreme: Right to force
Bubble • shareholders to sell company upon
board and majority shareholder vote
© 2010 Haynes and Boone, LLP
62. Drag-Along Rights
Example
“So long as the Investors own shares of Series ___
Preferred Stock representing at least [25]% of the
Company’s Common Stock on a fully-diluted basis
(as determined by ]), the Investors shall have
drag-along rights with respect to securities of any of
the Founders or principal Common Stock holders in
the event of a proposed sale of the Company to a
third party (whether structured as a merger,
reorganization, asset sale or otherwise).”
© 2010 Haynes and Boone, LLP
63. Founder Vesting
Pre- • 3- or 4-year vesting with some up-front
Bubble vesting
• 4-year vesting with no-up front vesting
Post-
• More extreme: 5-year vesting and/or
Bubble
performance standards
© 2010 Haynes and Boone, LLP
64. Founder Vesting
Example 1: Single Trigger
“If a Founder voluntarily terminates his or her
employment with the Company or is terminated for
cause, then the [Company/the Investors] will have
the right to repurchase 100% of the Founders’
shares less [1/48]th of those shares for each
complete month of service the employee served with
the Company.”
© 2010 Haynes and Boone, LLP
65. Founder Vesting
Example 2: Double Trigger
“Upon termination of the employment of the
shareholder, with or without cause, the Company
may repurchase at cost any shares subject to the
repurchase option. The Company’s repurchase
option shall lapse by [___ percent (__%)] of the
unvested portion in the event such Founder is
terminated without Cause or Constructively
Terminated as a result of and within six (6) months
prior to or twelve (12) months following a Change in
Control.”
© 2010 Haynes and Boone, LLP
67. Capitalization
Example
“The Company’s capital structure before and after the Closing
is set forth below [including founder’s shares to be issued prior
to the Closing]:”
Pre-Financing Post-Financing
Security # of Shares % # of Shares %
Common – Founders 4,077,670 73.7 4,077,670 40.5
Common – Employee Stock Pool
Issued -- -- -- --
Unissued 1,456,311 26.3 1,456,311 14.5
Common – Warrants to Debt Holders -- -- 75,000 0.7
Series A Preferred -- -- 4,466,019 44.3
Total 5,533,981 100.0 10,075,000 100.0
© 2010 Haynes and Boone, LLP
68. Publicity
Example
• “The Company will not discuss the terms of this Term
Sheet with any person other than key officers,
members of the Board of Directors of the Company or
the Company’s accountants or attorneys without the
written consent of Investor, except as required by law.
In addition, the Company shall not use the Investor’s
name in any manner, context or format (including,
reference on or links to websites, press releases, etc.)
without the prior review and approval of Investor.”
© 2010 Haynes and Boone, LLP
69. No Shop
Example
• “From the signing date hereof until 5:00 P.M. Pacific
Standard Time on __________, the Company and the
Founders agree that they shall not solicit, encourage others
to solicit, encourage or accept any offers for the purchase
or acquisition of any capital stock of the Company, of all or
any substantial part of the assets of the Company, or
proposals for any merger or consolidation involving the
Company, and they shall not negotiate with or enter into
any agreement or understanding with any other person with
respect to any such transaction.”
© 2010 Haynes and Boone, LLP
70. Questions?
Bart Greenberg
Partner
18100 Von Karman Avenue, Suite 750
Irvine, California 92612
bart.greenberg@haynesboone.com
949.202.3037
70
© 2010 Haynes and Boone, LLP