Going Into a Series A Financing: Part Two
Part One of this series, we looked at several steps every startup should consider taking to make sure the company is prepared before entering into negotiations for its first equity funding round.
In this Part Two of the Going Into Series A series, we will be addressing issues to be aware of when you are negotiating your Series A term sheet. The Series A term sheet contains more than just a proposed pre-money valuation and VC investment amount. It will be filled with numerous other terms – often wholly unfamiliar to an entrepreneur new to equity funding rounds. These terms can profoundly impact the future of your startup, your role in it, and how much you share in any potential exit.
But launching into esoteric legal terminology puts us in danger of missing the forest for the trees. Knowing what really matters (and, therefore, focusing on what really matters) will make sure you use your leverage where it counts and save you from wasting time and expense negotiating over things that don’t really matter.
So, what “really matters” in negotiating a term sheet? As a founder, you want to come out of the financing with as much overall control of the company and flexibility in shaping the future of the company as possible and as much of a share in the future economic prosperity of the company as possible. With these principles in mind, let’s take a look at five important terms that will likely appear in your Series A term sheet. This is not an exhaustive list of terms, nor can this newsletter address all of the considerations with respect to the terms covered below. But the important thing is to get you thinking about the practical way to approach the Series A term sheet to ensure greater control and ownership of the company following the financing.
Part Two: The Series A Term Sheet
1. Board Composition and the CEO Board Seat
Your Series A lead investor will almost certainly demand board representation. While it is fairly standard to give a board seat to the lead investor, it important to retain overall control of the board through the Series A financing. Retaining board control gives you control over many major company decisions, and veto rights on others – from hiring/firing officers to approving an exit offer.
Even if your lead investor is amenable to the founders retaining control of the board during your early verbal negotiations, the formal term sheet will present it in a way to weight the balance of power in favor of the VC and against the company. Quite often, a VC term sheet will propose a board of three members, as follows: “one director designated by the investor and two directors designated by the holders of a majority of the common stock, one of whom shall be the CEO.” Given one of the founders is usually the CEO and on the board at the time of the financing, founders will often think this is perfectly fine. But they aren’t thinking about what happens if a new CEO is brought in. Suddenly, you no longer have control of the board. And if you’re still vesting, you could risk losing your shares in the event of a termination.
Strategy: After the first equity round, common stock will usually still dominate the cap table. Therefore, you should argue that there is no basis for common stock not to control the board, even if the CEO is replaced in the future. This is an important provision and one for which it is worth using a company’s negotiating leverage. The VC will argue that, for various business reasons, the CEO should have a board seat and that is why they are proposing the “1 Series A Director, 1 Common Director and 1 CEO Director” board composition. Everyone can be made happy by proposing something like the following: “1 Series A Director and 2 Common Directors. But if “founder” ceases to be CEO, then the board is expanded to 5 members, as follows: 3 Common Directors, 1 Series A Director and 1 CEO Director.” That’s just one of many ways to address the VC’s concerns and the founder’s concerns at the same time. The CEO is on the board, but the founder (i.e. the common holders) still have a majority of board votes.
2. Be Wary of What Shares Are Considered Part of the Fully-Diluted Capitalization
The price-per-share in an investment round is the pre-money valuation divided by the fully-diluted capitalization of the company. But how one calculates the fully-diluted capitalization is a negotiating point itself. The more shares that are included, the lower the per-share-price and the more the VC gets.
Strategies: Make sure any converting securities in the round, such as notes or SAFEs, are not considered part of the pre-money fully diluted capitalization. Try to push for only the existing option pool to be part of the fully-diluted capitalization, rather than any negotiated option pool increase. If you really have leverage, you can push to only include granted options in the fully-diluted capitalization, rather than the pool, but this is a tough sell. The message is still the same – everything is negotiable. Use your leverage
3. Too Many Protective Provisions
Although you may have voting control on the Board and in the cap table, the Series A holders will obtain what are called “protective provisions” in the company’s charter documents. These provisions prohibit the company from taking certain enumerated actions without the approval of a majority of the Series A shares. Essentially, the preferred stock holders will have a veto right on most of your major decisions. With the rise of open source equity financing documents (seriesseed.com; NVCA model documents), there has become a default litany of protective provisions. These provisions can seriously hamper your ability to take corporate actions.
Strategy: Although the VCs may try to convince you otherwise, there are no default protective provisions. Don’t just accept the protective provisions in the term sheet. At a minimum, even if the NVCA model is being used, make sure you put as much limiting language from the NVCA model as the deal will allow.
4. Being Judicious With Participation Rights
Many VCs, as well as angel investors, will request participation rights in your future financing rounds. This may seem innocuous and fine in theory but it can have negative impacts on the company. Participation rights can be an administrative hassle, can delay funding due to notice issues, and future investors may balk at having their interest in the company be less than what their target was due to other investors having participation rights. Also, having existing investors fail to exercise their participation rights can send a bad signal to your Series B investors.
Strategy: Limit participation rights to only your “major investors” and include ‘pay-to-play’ provisions so that such rights terminate if the investor fails to exercise in the next round. Finally, fight against granting “gobble-up rights” or “over-subscription rights” to minimize the actual impact on the new investors.
If you have any questions about any of the information in this article or wish for assistance in considering your next funding round, please do not hesitate to contact us
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