Part two in a series of seven articles overviewing founders’ rights on a term sheet.
Things move quickly in the startup world once a term sheet is signed with the lead investor. Attorneys get involved. The data room is opened. The next approximately 60 days of the financing tidal wave will build quickly through a sea of negotiations, deal document review, and preparing for the next stage of the company once the closing occurs. In any venture financing, from Series Seed and beyond, there are two main types of investor rights that the company will negotiate with its new preferred stockholders, control rights and economic rights. In my last article, I summarized the basics of the legal framework for a venture financing and the main control rights that are negotiated under one of the financing documents and arguably the most important, the corporation’s Certificate of Incorporation. This article focuses on the economic rights under the Certificate of Incorporation that are generally negotiated in a NVCA-style venture capital financing.
The liquidation preference is a preferential payment that is made to the preferred stockholders of the corporation in a “deemed liquidation event.” Generally speaking, the deemed liquidation event includes the sale of the company by way of merger or consolidation in which the company sells at least a majority of its capital stock, or a sale or exclusive license deal of substantially all of the company’s assets. In the most recent version of the NVCA Certificate of Incorporation template, the drafters added a provision for a merger or consolidation deal whereby a transfer of a majority of the capital stock “voting power” could trigger a deemed liquidation event. This permits a transaction in which a majority of the economic capital stock rights are transferred without triggering a deemed liquidation event. It is uncommon to see this term negotiated but a flag to watch out for and analyze for your company’s specific circumstances.
Lastly, in the deemed liquidation event definition, investors can ask for an “acquihire” event to be included in the definition of deemed liquidation event. This means that if a potential acquirer hires certain people (typically the company’s key employees or founding team) instead of purchasing the company’s stock or assets, it will trigger a deemed liquidation event. This has become more relevant in the Great Resignation era where talent is increasingly competitive, and some startup leaders have jumped ship to help build the next big thing.
A Deemed Liquidation Event Can Be
- The sale of the company by way of merger or consolidation in which the company sells at least a majority of its capital stock.
- An asset sale or exclusive license deal of substantially all of the company’s assets.
- A merger or consolidation deal whereby a transfer of a majority of the capital stock “voting power.”
- An “acquihire” event: a potential acquirer hires certain people (typically the company’s key employees or founding team) instead of purchasing the company’s stock or assets.
A deemed liquidation event occurring will in turn trigger the liquidation preference, which means that the holders of the shares of preferred stock will be entitled to receive the consideration (generally cash or stock) in connection with the deemed liquidation event before any payment is made to the holders of common stock. This liquidity preference is generally equal to the greater of a multiplier of the original purchase price of the preferred stock or the amount the preferred stockholders would receive if the preferred stock were converted to common stock immediately prior to the financing transaction. The multiplier of the purchase price is generally 1x the original purchase price of the preferred stock being purchased in the financing transaction.
If the company has multiple series of preferred stock, each series will maintain its original purchase price through each financing (i.e., not increase as the value of the company increases). Once a senior series of preferred stock is added to the company’s cap table (e.g., Series B and onward), the new investors may try to negotiate a seniority liquidation preference, however, the market standard is that each series of preferred stock participates on a pari passau basis.
Pari Passau Definition, in Case Your Latin Is a Little Rusty
Lastly, you may have heard the terms “participating preferred” and “non-participating preferred.” These terms relate to the consideration available for distribution to the stockholders after the liquidation preference is paid out. Participating preferred stock means that the preferred stockholders have the right to participate alongside the common stockholders on a pro rata basis. Non-participating preferred stock means that the preferred stockholders do not have the right to participate alongside the common stockholders. In today’s market, it is uncommon for venture-backed startups to agree to participating preferred stock.
Pro Rata, Defined
There are other economic rights tied to the liquidation preference to discuss with your legal team, including the treatment of additional consideration in a deemed liquidation event with earnouts and holdbacks, seniority of the liquidation preference, and limited redemption rights in the event of an asset acquisition.
The company-favorable approach to the liquidation preference is: 1x multiplier and non-participating preferred stock. Look out for these terms in your term sheet as they can easily be overlooked without legal counsel review.
Startups rarely issue dividends because any remaining capital is typically used to scale up the business. Even so, dividend rights are negotiated in a venture capital financing if the startup evolves into a lifestyle business (not pursuing an exit track) and is in a position to issue dividends to its stockholders.
In early-stage raises (Series Seed / Series A), it is common not to provide special dividend rights. This means the preferred stockholders would receive equal dividends alongside the common stockholders on an as-converted-to-common-stock basis.
As the company progresses in its venture financings (Series B and beyond), it is more common to provide the preferred stockholders with special dividend rights that are paid at a specific dividend rate and payable only when the board of directors decides to do so, in addition to pro rata shared dividends with the common stock. These sets of dividend rights are non-cumulative and non-accruing. The dividend rate generally ranges between five and ten percent of the original purchase price of preferred stock per each share.
The least common special dividend rights are cumulative and accruing dividends. This means that dividends will accrue at an annual rate per annum whether or not declared by the board of directors. Once the board of directors issues dividends, the company will be obligated to pay all accrued dividends to the preferred stockholders plus the pro rata dividends on an as-converted-to-common-stock basis.
Dividend rights in the term sheet will typically fall under the first or second scenarios mentioned above — on par with common stock or non-cumulative and non-accruing. Look out for “cumulative” and “accruing” dividend rights at the term sheet phase.
Dividend Rights Rundown: 3 Possibilities
- Preferred stockholders would receive dividends on par with common stockholders.
- Non-cumulative and non-accruing: Preferred stockholders are provided with special dividend rights, paid at a specific rate (usually between five and ten percent) and at the board of directors’ discretion. This is in addition to the pro rata dividends shared with common stockholders.
- Cumulative and accruing: Dividends will accrue at an annual rate per annum whether or not declared by the board of directors. Once the BOD issues dividends, the company will have to pay these special dividends as well as the pro rata dividends.
The preferred stock is typically convertible into common stock on a 1:1 ratio. Sometimes you will see an investor present a 2:1 conversion ratio (two shares of common stock for one share of preferred stock) at the term sheet phase but it is rare for a company to accept greater than a 1:1 conversion basis. Conversion rights are important because they affect the company capitalization calculations and impact other stockholders. Under the Certificate of Incorporation, the conversion may occur in one of the following trigger events: an optional conversion or a mandatory conversion.
An optional conversion occurs at the election of the stockholder. The conversion ratio is calculated by dividing the original purchase price of the preferred stock by a defined conversion price. For a 1:1 ratio, the conversion price equals the original purchase price. The Certificate of Incorporation includes the mechanics of an optional conversion, requires the corporation to always reserve enough shares of common stock to allow for a conversion of the preferred stock in whole, and stipulates special adjustments to account for specific dilution scenarios. The most common adjustment calculation for the conversion price is done through a mechanism called “broad-based weighted average anti-dilution.” This anti-dilution calculation is more founder-friendly than the other less common alternatives (“narrow-based weighted average” and “full ratchet”) and has continued to be the market standard for venture deals of all sizes.
A standard mandatory conversion occurs upon the closing of a public offering where the company sells the shares at a minimum price resulting in a minimum amount of gross proceeds as stipulated in the Certificate of Incorporation. The price per share and the amount of gross proceeds will increase during each round of financing to account for the company’s increase in valuation. The per-share amount of the qualified public offering will usually be a multiple of the original purchase price of the preferred stock. The multiple is typically higher in the early stages of the company (up to 5x) and lower in the later stages of financing (up to 3x).
Preferred Stock Is Typically Converted to Common Stock in 1 of 2 Ways:
- An optional conversion occurs at the election of the stockholder.
- A standard mandatory conversion occurs upon the closing of a public offering where the company sells the shares at a minimum price resulting in a minimum amount of gross proceeds as stipulated in the Certificate of Incorporation.
The recent updates to the NVCA Certificate of Incorporation also include a special mandatory conversion tied to a pay-to-play provision. These pay-to-play rights are a rare but company-favorable gem, which provide that if the company has a future qualified financing of preferred stock and the preferred stockholder does not invest their entire pro rata portion of such offering, then a portion of that investor’s preferred stock will automatically convert to common stock upon the closing of the qualified financing. If the company negotiates a special mandatory conversion of such nature, it should carefully consult with legal counsel to determine whether the converted shares should lose the contractual rights provided to such an investor under the company’s various stockholder agreements.
The most important conversion terms for the company to watch for at the term sheet phase include: (1) the conversion ratio – the market standard is 1:1; (2) the type of anti-dilution protection as “broad-based weighted average”; and (3) the mandatory conversion triggers and associated value thresholds as well as decide whether to pursue pay-to-play protections.
Redemption provisions are extremely uncommon but may show up in a term sheet from time to time. Redemption rights provide the investors with the ability to demand a redemption of the preferred stock at the greater of the original purchase price and the fair market value as of the date a redemption request is received by the company. If the company proceeds with redemption rights, tax advisors, legal advisors, and accountants should be heavily involved in the process of negotiating the final redemption rights to mitigate sizable tax impacts on the company and its stockholders.
Disclaimer: This material is intended for general information purposes only and does not constitute legal advice. For legal issues that arise, the reader should consult legal counsel. The NVCA model documents referenced in this article are the current documents as of the date of publication and do not include any updates that may occur thereafter.