Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.
In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor. Check out an overview here.
As we get closer to the end of our “Financing Term Sheet Deep Dive” Series (only a few weeks left!) the rights and responsibilities at issue are generally less contentious. That doesn’t mean that they aren’t important, or that they don’t affect the Company and its Investors. It does mean, however, that the contours of the rights are a bit more “expected”; that there is, perhaps, a bit less to negotiate.
Today we discuss one of those “less contentious” rights: the right to “participate” in future equity sales of the Company.
Let’s take a closer look.
The NVCA model form includes the following “participation right” term:
All [Major] Investors shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans), to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet). In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares.
So, the baseline rule is that if you are an Investor, you get “first dibs” on any future fundraising the Company tries to do through the sale of its equity. This is important, as the existence of a future fundraising round generally means one of two things: (i) that the Company is doing so well that it has a clear vision for commercialization and profit, but needs (potentially a lot) more money to get there, or (ii) that the Company has fallen on hard times and needs a “bailout” of funds in order to, among other things, meet payroll.
In the first instance, Investors may well want to “double down” on their initial investment as the possibility of a big exit gets more and more likely. They may also want to participate if the terms of the round are much “sweeter” than those initially offered to the Investor (usually because the Company needs to attract so much more money).
In the second instance, the Company is likely seeking to sell its equity at a significant discount to the prices paid by the Investor. While the Investor is likely protected from the dilutive effects of such an offering by the presence of anti-dilution provisions in the Company’s governing documents, those protections (i) may be waived by the other Investors (if the Company is going to “go under” without a significant capital infusion, for instance), and (ii) offer little comfort in all but the context of a liquidation.
In either case, the Investor may be incented to participate in the next round. The Company, for what its worth, likely doesn’t mind giving participation rights to the Investors, for the most part. Money is money, and there are actual advantages to keeping an investor group small. As a result, the “participation right” term is not one that sees a lot of fighting around the negotiation table.
Now, let’s take a closer look at the language:
All [Major] Investors shall have a pro rata right…
The very first “option” we see here is the bracketed “Major”. As with many of the terms we’ve discussed in this series, at issue is just how big of a stake in the Company should be required in order for an Investor to be entitled to certain rights. In the model term sheet, the definition of “Major” is established as one who has purchased a set dollar amount of the equity offered.
The brackets here are important though. The Company doesn’t have a strong incentive to deny participation rights to smaller investors. Chances are, if the “Major” winds up being included it is because the larger Investors requested it.
The Meaning of Pro Rata
…based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans)…
Now, this is interesting. The above language sets the “denominator” for the fraction of a future round that the Investors are collectively entitled to purchase.
In the model term sheet, such denominator is just about the entirety of the Company’s outstanding equity (its “fully-diluted” capitalization). (Though it’s worth noting that the model does not include shares reserved for issuance under an incentive plan). This means that if the Series A represents 25% of such fully-diluted number (because the Company has issued common stock or options equal to the other 75%), the Series A Investors only have the right to “take up” 25% of the Company’s hypothetical Series B.
This is not the way the term is always written.
The most common alternative to the model’s language is to state that each Investor is entitled to participate in a portion of the Company’s future rounds determined against such Investor’s ownership stake in the current round. In other words, even if the Series A represents only 25% of the Company on the whole, the Series A Investors would be entitled (collectively) to purchase 100% of the Series B if they so desired. The pro rata language is used, in other words, to establish a given Investor’s percentage interest in a future round against the other Investors, not against the Company on the whole.
Unfortunately, despite these wildly different treatments of the term, many term sheets simply state that the Investors are entitled to purchase their pro rata allotment of any future round, without any clarification of what “pro rata” means.
…to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet).
Though not fully related to the participation concept, the model terms use the list of issuances that do not trigger anti-dilution protection as the list of issuances that do not trigger participation rights. This is market standard. Such issuances are generally related either to (i) convertible instruments that have already been granted by the Company (options, warrants, convertible debt, etc.), or (ii) grants made by the Company without the primary motivation of raising capital (joint ventures, strategic partners, etc.).
They are discussed in more detail in my post on anti-dilution linked above.
In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares.
We refer to the above concept as an “over-allotment” right. Not to be confused with the overall participation percentage established by the denominator (discussed above), this right does not change the collective ability of all Investors to participate in a future offering. Instead, it establishes that if a given Investor does not want to participate in a future round, the other Investors can “take up the slack”. In other words, the Company does not get to sell future equity reserved for the Investors (collectively) to a third party, just because a given Investor does not participate.
Note that use of the over-allotment right can (and will, if exercised) alter the relative ownership percentages among the Investor class. Various parties can thus attempt to use such over-allotment right in combination with future offerings to give advantage to Investors with “deeper pockets”, if desired. This (as one might expect) can cause friction among the groups, particularly if the Company does not appear to have an immediate need for additional funds at the time.
Though not expressly stated in the model terms, the participation rights of the Investor class can generally be waived by the class acting collectively. The threshold for such waiver is usually set as the same threshold applied to the protective provisions contained in the Company’s governing documents. As in other cases where the group can act on behalf of the individual, this is worth consideration; particularly for minority Investors.
In some ways a “pay-to-play” provision, i.e., a provision that penalizes investors who do not participate in future offerings, is the opposite of a “participation right” term. The traditional penalty contained in such a provision is to have a non-participating Investor’s shares be converted automatically into shares of the Company’s common stock.
That said, such provisions are a rarity in today’s term sheets and used primarily only if there is some skittishness among the Investors that make up a syndicate. Because of that, penalties, and the “failure” that triggers them can vary wildly.
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at firstname.lastname@example.org.