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.
In this, the second to last post in our “Financing Term Sheet Deep Dive” series, we turn to the concepts of “First Refusal” and “Co-Sale”; two related ideas designed to limit changes to a Company’s capital structure after a financing has been concluded.
While both concepts are complicated enough to require their own definitive document as part of a closing (a “Right of First Refusal and Co-Sale Agreement”), they are simple enough to be summarized in the NVCA model term sheet in only one paragraph.
Let’s take a look at the model language.
Company first and Investors second (to the extent assigned by the Board of Directors,) will have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by Founders [and future employees holding greater than % of Company Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)], with a right of oversubscription for Investors of shares unsubscribed by the other Investors. Before any such person may sell Common Stock, he will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors.
As we’ve come to expect when looking at these provisions, there is a fair amount to unpack here, so let’s separate some of the concepts.
The Right of First Refusal
Company first and Investors second (to the extent assigned by the Board of Directors,) will have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by Founders…
The first thing that jumps out in this language is that the term we are concerned about, the “right of first refusal”, is not separately defined. If you are not familiar with the term, this is an area where consulting with folks like lawyers and investment bankers can come in handy as otherwise the section may make little or no sense.
In this context, a “right of first refusal” is a right for the Company to “step in” and take the place of any proposed third-party buyer of a Founder’s shares. In other words, if a Founder wishes to sell, he or she must first offer such sale to the Company, which has the “first” right to “refuse” such offer. As described in the model term sheet, if the Company elects to not exercise this right, it will be offered to the other, non-transferring Investors.
(While in the model term such “secondary” right is said to be based on the assignment of it by the Board of Directors, I do not often see such a requirement in the term sheets presented to my clients, nor do I ordinarily draft to require such an assignment. Either the Investors receive such a right or they do not. From an Investors perspective, there is actually cause for alarm with the inclusion of such language, as it may permit the Board to “manipulate” the Company’s capitalization through the use of unbalanced assignments. As the relevant governance and voting thresholds were negotiated based on the original capitalization, Investors should be wary of seeing them altered.)
…with a right of oversubscription for Investors of shares unsubscribed by the other Investors.
Oversubscription, or “overallotment”, is effectively the third prong of the refusal right, allowing the Investors that bought shares through the exercise of their original refusal right to “take up” the entirety of a Founder’s proposed sale, even if all the Investors in the aggregate did not otherwise participate in the original purchase.
For additional clarity, let’s take a look at an example.
Founder X has decided to sell his 1,000 shares of stock in the Company to a third-party. Investors Y and Z, the Company’s sole other shareholders, each hold 1,000 shares of their own (i.e., the Company has 3,000 total shares of stock outstanding).
*In connection with the proposed sale, Investor X must first offer the shares for sale to the Company (the Company holds the “first” right).
*If the Company elects not to purchase such offered shares, Founder X must then offer them for sale to Investors Y and Z (generally pro rata in accordance with their respective ownership interests). In this case, each of Investors Y and Z would be offered the right to purchase 500 of the shares proposed for sale. This is the Investors’ “secondary” right.
* Supposing now that Investor Y purchases its 500 offered shares, but Investor Z does not, Founder X must then offer the remaining 500 shares to Investor Y. This is Investor Y’s “oversubscription” (or “overallotment”) right.
The effect of such “overallotment” is that if any one Investor is participating in purchasing the shares proposed to be sold by a Founder, all such shares may be purchased without their going to an unaffiliated third-party. In this way, the Company can keep its equity ownership “in the family”.
(Note that the model term sheet does not do a good job establishing that the Investors are to hold their secondary right on an aggregate or pro rata basis. While the inclusion of the oversubscription concept is nonsensical in any other scenario (and thus pro rata allocation can be implied), these are the kind of language vagaries and ambiguities that can cost time and money when the definitive documents are being negotiated. Good legal assistance can be invaluable at the term sheet level to help avoid such instances.)
You may have noticed in reading the above that we skipped over one bit of language included in the NVCA’s right of first refusal provision:
…proposed to be transferred by Founders [and future employees holding greater than % of Company Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)]…
In short, this provision describes just whose shares are required to be offered to the Company (and the Investors) before they can be sold.
As a restriction on sales, even if a soft one (that does not prevent the ultimate sale), application of a right of first refusal can have a “chilling” effect on the ability of the subject stockholder to sell their interests. After all, if you are looking to buy someone’s shares, you probably don’t want to have to wait until those shares are offered to 1, 2, or 100 parties first.
Because of that, the application of a right of first refusal is often a critical point to be negotiated. Almost always, the right applies to shares held by the Founders of the Company. Those folks that hold significant interests and were there from the beginning. In the language above, the right is also applied to other non-Investor stockholders (generally, employees or consultants) who wind up holding a material interest in the Company; the level for materiality being established at 1% (this is market standard).
Rarely (very rarely), the right is also applied to the shares being purchased by the Investors, so that should an Investor seek to sell their interests, they must first be offered to the rights holders. Generally Investors don’t like such an application, however, and it is really only made if there is some other reason to believe that additional controls need to be placed on the Investor syndicate.
Right of Co-Sale
From the NVCA model terms:
Before any such person may sell Common Stock, he will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors.
Here we have the fail state counterpart to the right of first refusal, the right of “co-sale”. If the Company and the Investors don’t fully exercise their rights of first refusal, then the Founder (or other applicable individual) is permitted to sell their shares. The right of “co-sale”, however, comes in to say that the Founder isn’t permitted to sell all of his or her shares. Instead, the Founder must permit the Investors to “take up” their proportionate portion of any sale.
In the above example, if none of the shareholders exercised their right of first refusal, Founder X’s proposed sale of 1,000 shares would be permitted to go through, but only if each of Investor Y and Investor Z were permitted to sell up to 333 shares in lieu of Founder X (such numbers owing to each shareholder’s holding 33.3% of the total equity of the Company). With full participation in the right of co-sale then, each of Founder X, Investor Y, and Investor Z would sell roughly 333 shares (one party would sell 334), and the 1,000 shares would get sold, just not all solely out of the Founder’s ownership interest.
So even if the Founder’s proposed sale survives the first refusal process, the Founder may still see their ability to sell shares limited through the exercise of the Investor’s right of “co-sale”. As you can imagine, like the existence of the right of first refusal this has the effect of “chilling” sales from the other side of equation as a Founder’s desire to even seek out potential sales partners will be limited. This is a “feature” and not a “bug” of the term in question.
(Note that the Investors and the Founders do not often hold the same series or class of stock in the Company. Because of this, the Right of First Refusal and Co-Sale Agreement must deal with the possibility of Investors that would like to participate, but do not have the appropriate assets to sell.)
Please join us next week for the final entry in the Financing Term Sheet Deep Dive Series, where we will be discussing certain other miscellaneous or less substantive provisions contained in the model terms, as well as offering conclusions on the entirety of our analysis.
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.