tl;dr – A Series A term sheet will serve as the document that defines your definitive deal documents which serve as a baseline for future rounds. Understanding key terms in the term sheet empowers you to better negotiate your rights and understand investor wants while raising capital. The terms in the term sheet revolve around the economics of the deal and control of your company.
Raising a Series A round is a noteworthy achievement for startup founders. It signals to your team, customers, early investors, vendors that you have achieved product market fit and that your company is on solid ground. More importantly it allows you to grow the company and put some gas on the fire. However, before you sign a Series A term sheet there are certain things you need to understand to protect your company as well as yourself.
In your seed round, it is likely that you were able to simply send over a one- or two-page term sheet to investors. It was short, sweet, and you knew the terms. However, with a Series A term sheet, you should expect something along the lines of six or seven pages that incorporates more detail as the VCs generate the terms. The terms dictate the economics of the deal and control of the company.
We continue our #MoneyTalks series with understanding key terms in Series A term sheet
Series A Key Terms
Pre & Post-Money Valuation – The value of the company as determined by new investors based upon company performance and future predictions.
Pre-money valuation = Post-money valuation – New investment
Valuation matters for many reasons and impacts dilution to founders and other equity holders. A $2M investment with a an $6M pre and $8M post is more dilutive than a $2M investment with a $8M pre and $10M post. It is important that founders also understand whether the valuation is on a pre or post-money basis and get on the same page as the investor.
Common Stock & Preferred Stock – Common stock is a class of stock that is generally held by founders, employees, advisors and contractors. Preferred Stock is typically held by investors who are granted certain economic and control rights (e.g. board seats, liquidation preferences, etc.). Series A investors will receive preferred stock.
Pro-Rata Rights – The right (but not an obligation) for investors to participate in future funding rounds. Investors like having this so they can double down on winning investments and avoid dilution.
Liquidation Preference – A liquidation preference is a right of investors to receive a certain amount of proceeds, typically 1x of their initial investment, before common stock shareholders are paid in the case of company liquidation.
Liquidation preferences can be participating or non-participating. Participating preferred stock allows investors to receive their initial investment plus a pro-rata share of gains. Non-participating preferred stockholders can receive either their initial investment or the share of remaining liquidation proceeds – not both. Non-participating preferred is currently market.
One important note is that if you have convertible securities then those convertibles will have a liquidation preference equaling the new money price per share even if they are converted at a discount. This is called liquidation overhang but can be addressed in your convertible documents with language that creates a shadow class of preferred that grants a liquidation price that is equal to the converted price per share not the new money price per share.
Available Option Pool – This term revolves around stock options that are reserved for future employees. Subsequent funding rounds may decrease the size of the initial option pool and may affect the startup’s overall price. An option pool offered post-money capitalization priced at pre-money valuation would expand the stock option pool before a new funding round, diluting the pool for past shareholders, including the founders. Expanding the stock option pool after a new funding round dilutes all shareholders, including new investors.
Anti-Dilution – Anti-dilution provisions protect investors if the Company issues future equity at a price lower than the Series A (a down round). The language is essentially a way to ensure that the investors are not heavily diluted and results in additional conversion shares of common stock being issued to the investors.
Anti-dilution can either be weighted so investors and founders take the hit from a down round or full ratchet where the founders take the entire hit. I recommend you become even more familiar with the anti-dilution intricacies and calculations. Reading Venture Deals by Brad Feld is a good start before while you should also contact counsel.
Protective Provisions – Protective provisions are a negotiated set of actions that your company cannot take without the consent of the holders of a certain percentage (usually a simple majority) of shares of Series A. Normally these actions cover items such as the following:
- • Sale of the company
- • Changing the certificate of incorporation of the company as this can impact the rights to the Series A investors
- • Raise a new round
- • Take on debt in excess of a certain amount
The actions requiring Series A investor approval are actions that can either harm your company or the Series A investors.
I counsel companies to create a pro forma cap table when reviewing term sheets so they can see holdings post deal as well as understand which investors will be needed to approve of actions falling under the protective provisions.
Board Composition – If you have not given up a board seat prior to a Series A you will almost certainly give up a seat at this stage. However, it is unlikely you will give up control of the board. If you are attractive target investors will likely let you hold the board with no independent director. Otherwise you are likely to end up with two seats being held by the founders and two seats being held by the investors with one mutually decided upon director filling a fifth seat. In any event it is likely that a Series A director approval will be needed for things like changing a founders compensation structure.
Economics and Control
Right of First Refusal and Co-Sale – The Right of First Refusal (ROFR) allows the Company and then the investors to buy founder shares should the founder look to sell them. The ROFR gives investors more control over the entry of new shareholders and enables them to better maintain voting power relative to other investors. The Right of Co-Sale allows investors to tag along on a deal where a founder is looking to sell their shares. The two items help reduce risk for investors when a founder is looking to liquidate part of their holdings in the company.
Drag Along – This is a mechanism by which majority shareholders can drag minority shareholders into a sale of the company. This is important because an acquirer can demand that all investors holding one percent of the company or more sign and agree to a transaction. If you do not have a drag along provision in your documents a minority shareholder can hold up or even blow up the sale.
The terms you decide upon in your initial Series A round will serve as a baseline for subsequent rounds of funding, so a clear understanding of what you are agreeing to moving forward is highly important.
Avoid the temptation of agreeing to nonstandard terms in your Series A in an effort to hurry the process along, telling yourself that you’ll cut that term at the next round. It can complicate future funding and you might find investors asking for similar terms or reluctant to drop any previous less-than-ideal terms.
The process of meeting with investors and raising venture money is different for every company — reach out to me (firstname.lastname@example.org) or continue reading my blog if you want to learn more.