If your startup just got a term sheet from an investor saying that they want to invest in your company and want to receive participating preferred stock with all of these other rights, you may be a bit overwhelmed. First off, congratulations on the proposed investment. Next, I’ll explain what all of those terms on the term sheet mean in this post starting with the participation component of participating preferred shares.
Liquidation Preference
In any liquidation, dissolution or winding up of the company, how the proceeds are paid depends on if the preferred shares are participating or non-participating. If non-participating preferred stock is used, the proceeds are paid as follows: if a liquidation event occurs, each holder of a preferred share gets their original purchase price (plus any dividends owed (either accumulated or not depending (and plus any declared but unpaid)) on each share of preferred held. A multiplier can also be included so that each preferred shareholder gets 2x or three times (or more) of their original purchase price per share. After all preferred shareholders have been paid, the rest of the funds are split pro-rata amongst the common shareholders.
If participating preferred stock is used its the same as above, except that after all payments to the prefferred shareholders have been made, the rest of the funds are split and paid (on a pro rata basis) to the common shareholders and the preferred shareholders on an as converted basis.
The ranking (seniority – see below) of the series of preferred can really matter if there is only a certain amount of cash available at a liquidation. The analogy (or metaphor) regularly used is to think of it as a large quantity of water being poured into various buckets. Each bucket is a series of preferred shares. So if there are three classes of preferred shares (Series A, Series B and Series C with rankings from earlier in the alphabet to later), the water (cash) will pour into the Series A bucket first until the Series A preferred shareholders are totally paid in full, then and only then will the water start to pour into the Series B bucket, then the Series C bucket, and then will be paid to the common shareholders (and any holder of a participating preferred share) in pro rata amounts.
Also its important to note that a cap can be placed so that after the holders of any series of participating preferred shares receive a certain aggregate amount, they cease participating in any liquidation.
Ranking
If this is your first round (seed/angel) then this is usually not a big deal. The first class of preferred shares will obviously rank highest. It will come into play for your later rounds, so for example your Series A Preferred Shareholders will rank senior to the incoming Series B Preferred Shareholders (or vice versa). I’ve heard and seen varying accounts of which series should rank senior to another, whether the later are usually ranked senior or inferior to the existing series. Its negotiable, like most things. It is also possible to have different series of preferred shares rank equal to one another, which is called in pari passu. (Lawyers still enjoy using Latin).
Dividends
These can either be preferential or non-preferential and cumulative or non-cumulative. Preferential dividends are those that (if a company pays a dividend) are paid to the preferred shareholders prior to the common shareholders. Cumulative dividends accrue each year, even if not declared (obviously better for investors and more common on the east coast than west).
Voting Rights
The preferred shareholders will usually receive the right to vote with the common shareholders on an “as converted basis”. Sometimes, the preferred shareholders will have the right to vote as a class to elect one or more members of the company’s Board of Directors. Other events that affect only the preferred shareholders will allow all of the preferred shareholders to vote together as a class (such as creation of another class of Preferred Stock which would rank higher than the class at issue).
Protective Provisions
As long as preferred shares are outstanding (or at least a percentage of them – you can negotiate the amount), the preferred shareholders have, in essence, the right to veto certain actions of the company. The items below are standard but there are other items that are added depending on the situation. The company generally cannot take any of the following actions without the affirmative vote of the required percentage of the preferred shareholders:
i) liquidatation, dissolution or winding up the Company’s affairs;
ii) a change to the provisions of the Company’s COI (most often this is limited to only changes which have an effect on the preferred shareholders);
iii) creation or issuance of other securities (or options, warrants, convertible notes, etc.) which have rank superior or equal to the preferred shares;
iv) the purchase, redemption or paying a dividend to a shareholder prior to the certain class of preferred shareholder;
v) issuance of debt above a certain limit (can be as low as $100k);
vi) owning stock in other companies which are wholly owned subsidiaries (this is less common); and
vii) enacting an increase or decrease to the size of the Board.
Conversion Rights
Sometimes the preferred shareholders will want the right to convert at any time on a 1 for 1 basis (subject to adjustments) into common shares – they will almost never do this however, as they would give up a lot of the rights outlined in this post. There are also automatic conversion triggers such as an IPO over a certain amount or a merger/acquisition. In these cases the preferred shares are usually deemed to have converted immediately prior to the transaction which triggers it so that they can participate in it (other times it may not be automatic and they have the option of converting with prior notice provided to them).
Anti-dilution Rights
These rights give the preferred shareholders the right to have the preferred shares they hold convert into more than on a 1 for 1 basis. This lets the preferred shareholders ensure that their investment doesn’t get diluted. There are certain actions which dilute the preferred shareholders investment and these rights attempt to make them whole. There are various formulas that can be used to account for the new conversion price (the actual formula is a bit too complex for this post, I’ll cover it and others later):
1. Weighted Average formula
2. Broad based Weighted Average
3. Full Ratchet
An example to see how these work is to assume I am a Preferred Shareholder and to get my shares (1,000,000) I paid $1,000,000, so that the price per share was $1. My 1,000,000 preferred shares I can convert on a 1 to 1 basis to common shares. If, however, your company then has a “down round” where it sells shares for less than $1 (and hence a lower overall valuation of the company than when I purchased), one of the above formulas will be used so that my new conversion price is less, meaning I can convert my 1,000,000 preferred shares into more than 1,000,000 common shares (sometimes many many more).
Note, that certain actions are carved out and will not trigger the formula adjustments (regardless of which formula is used). This will usually be conversion of preferred shares, convertible notes, warrants, options, stock splits, dividends and options or restricted stock issued out of the Company’s stock option pool.
Pay-to-Play
I don’t see this very often but its out there, and I guess its not an actual “right” that the preferred shareholders have. This can be mandatory or you can make it so that if it will only be operative if a certain percentage of the preferred holders choose to make it so for any round of investment. Or it can only apply to investors that you designate as the “major” investors. So if this provision is operative, and an equity round occurs, the investors this provision applies to will have to purchase their pro-rata share set aside by the Board for them to purchase. If they don’t consumate the purchase, then they can lose certain rights – either the anti-dilution rights or the right to participate in future rounds, or instead of losing rights the preferred shares can be automatically converted into common shares and the preferred shareholders can forfeit their board seat, if any. Or any other penalty that you can come up with.
Put Options or Redemption Rights
Occasionally investors will require the right to get their money back. This can be set as either a put option or redemption right which will require the company to purchase the preferred shares back from the preferred shareholders, usually at the original purchase price, but sometimes with interest and any dividends that accumulated or became due. Either all at once or in phases.
Registration Rights
These usually only become operative when and if the Company files a registration statement with the SEC. In that event, the investors will usually have the right to request the Company file all or a portion of the shares they hold so that they can be sold on the market. There are many ways to do this and its a bit too much for this post.
Participation Rights
This right allows the preferred shareholders to participate and purchase their pro-rata amount of any additional shares offered by the company so that the preferred shareholders maintain their current ownership percentage.
Right of First Refusal/Co-Sale
Usually the company and investors (in that order) will have the right to buy any securities offered for sale by the Company’s founders (and sometimes employees that hold a certain amount) before the securities can be sold to third parties. Usually there is also granted a right of co-sale similar to a tag-along right.
The term sheet will also have other provisions about the types of agreements that will be used, representations, indemnification, condition to close, who will pay for the drafting of the legal documents. Most of it isn’t binding and will be flushed out in the panoply of deal documents your lawyer will prepare (or review). We’ll hit on some of the above in more depth in later posts. While the above is important as it all can have serious effects down the road, don’t forget that the overall valuation that the company and investors agree upon (and the resulting per share price) is the driving force behind any investment round.