This was going to be one post, but it reached 5000 words, so I broke it into two.

If Vinod Khosla is standing there ready to write you a check for $10 million, perhaps you should take the money (and not worry about the 1x preference with full participation and 8% dividend) before he changes his mind. These days, clients are having a hard time finding any financing. So, almost always, you take what you can get.

However, let’s engage in the willing suspension of disbelief. A name brand VC has handed you a term sheet with everything slanted her way. You are feeling feisty, and you are ready to negotiate. What should you care about and what should you let go?

I am not going to discuss valuation, except to say that it is a black art (not a science). One piece of evidence to support this observation is that way too many deals are done on what looks like a formulaic basis. The five on five valuation happens way too often to be random. Obviously, negotiate the best deal you can get, but I am going to leave valuation to another post. 

I am also not going to discuss full ratchet antidilution. (It has its place is some (very few) deals, but it is not a typical Series A term.) If Vinod presents you with a term sheet that has a full ratchet provision, tell him you will save him from investing in a founder stupid enough to sign up to that.

Finally for this post, I am going to take the words of the various provisions I comment on from the NVCA form term sheet. I strongly recommend that you familiarize yourself with that form (and the related deal docs). They are a gold mine of useful information about all the legal stuff in the investment docs.

Here is my list of six terms you should negotiate over:

(1)          Dividends. Hate them dividends. According to us (see, EEC Perspectives), 70% of series A venture deals in New England in Q4 of ’09 had a dividend provision. Dividends ran from 3% to 8% per annum. Let’s assume, for purposes of this post, that the term sheet has this in the dividend provision:

The Series A Preferred will accrue dividends at the rate of 8% per annum, payable only when and if declared by the Board or upon a liquidation or redemption. For any other dividends or distributions, participation with Common Stock on an as-converted basis.

A couple of things to note here (assume per below that the term sheet also provides for a 1x participating preferred): This provision (taken with the provision for a participation) means that, when you sell your company to Google for a princely sum, your investor will get her investment back plus accrued interest at the rate of 8% per annum before you get one penny. BTW, this is also the amount that you would have to pay upon redemption (should that provision ever come into play).

I have reason to believe, based on research, that the average number of years from inception to exit is about 10 years. I also know, based on anecdotal evidence, that the average number of years from initial investment to exit for portfolio companies of top tier venture funds is about 8 years. (Years to exit depends upon so many factors that it is hard to make sense of.)

According to the rule of 72, at 8% in 9 years the amount of the investment will double. So, if the initial investment is $10 million and you exit in 9 years, your investor will get $20 million before you get one penny. In low to mid valuation exits, this can be painful. It also gives the investment a debt like feel rather than an equity feel. Finally, it creates a set of outcomes in which the investor may want to exit and you may not.

So, knowing that in the last quarter 30% of deals didn’t have dividends, I would push back. Argue that it misaligns the interests of the investors and founders. When your investor says that they always get dividends, don’t believe them.   (Our firm keeps a database of deals that tracks who the investors are and what the terms are. As a result, we can tell you, on an investor by investor basis (for the years since we have been keeping the data), whether, and how often, they get dividends.) Try to get no dividends or low dividends. It could be real money to you, and you want everyone’s interests aligned.

(2)            Participating Preferred. Sometimes referred to (when there are no VCs around) as “pig preferred”. So here is the hypothetical participation provision in your yummy term sheet:

First pay one times the Original Purchase Price plus accrued dividends on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

It should be clear from point number 1 what this means, but just in case, when you sell the business (not in an IPO situation) even in a good scenario, the investor gets its bait back plus the 8% interest (which after 9 years means twice its bait) before you get anything. Then, you and the investor share pro rata on an as converted to common stock basis.

            We know, and we have published for all the world to see, that in the last quarter of 2009, 32 % of Series A deals in New England had a 1x participating preferred without a cap on the participation, 9% had a capped participation and 54% had no participation. (The remaining 5% had greater than a 1x preference and are outliers.)

            When coupled with a dividend provision, it makes the venture investment work like a note with a warrant – giving the investment a debt-like feel. (BTW, VCs also get board representation – sometimes a majority on the board. I have sometimes wondered why they have not been sued on a lender liability theory, but that is a topic for another post.)

            So, the problem with participating preferred is that in low and mid-value exits, the common holders take it on the chin. You do the math. If you raise $30 million and six years in you sell the business for $60 million, what is left for the common. Remember, the founders will not be the only holders of common. You could end up with a meager payday. Maybe that is just and fair, but it certainly misaligns the founders and the investors. Keep in mind that investors have a ten year life on their funds. If they make an investment in year four and then wait six years, they are under pressure to liquidate. You may think you are on the cusp of greatness, and a single may be looking pretty good to your VC. (Also, remember what the numbers say about years to exit.)

            Fight this one. Ask for no participation and, perhaps, settle for a capped participation. Just to be clear, in the capped participation scenario, the investor gets the greater of (a) 1x plus dividends plus participation up to an agreed number perhaps 2x the investment or (b) what they get upon a simple conversion to common (i.e. without any participation or preference).

(3)            Founder Representations. A great war has raged over this point between east coast and west coast. For many years, east coast VCs demanded and got founder reps on Series A deals. On the west coast, the view seems to have been that the practice was something close to diabolical. Fortunately for entrepreneurs, the west coast VCs are very close to beating their east coast brethren into submission on the point.

            Here is what your term sheet provision might say:

Standard representations and warranties by the Company. Representations and warranties by Founders regarding technology ownership, conflicting agreements, litigation etc.

            Try the Nancy Regan defense. Just say no. If that does not work, then focus on setting limits to your liability. Even the most rabid east coasters will accept a limit on liability to your shares in the company. This issue should not come up on B or later rounds.

(4)            Option Plan Vesting; Founder Vesting; Option Pool Provisions. I have noticed an increasing number of VCs that are looking for five year vesting on options (as opposed to four year vesting that has long been the norm). Your term sheet could say something like:

All employee options to vest as follows: 20% after one year, with remaining vesting monthly over next 48 months.

            The investors that like the five year vesting argue that you don’t get close enough to an exit in four years and they are going to have to reload and give away more options and dilute everyone etc. All good points, by the way, and, it might also be a tacit admission of the 8 years to exit issue that I pointed out earlier.

            Your problem with this approach is that it will be an impediment to hiring the best people (all of whom are expecting a four year vesting schedule). In today’s market it may not matter so much since there is a lot of talent available out there, but as things get better it may. I would resist on this ground and see if the investor does not give it up.

            Then there is founder vesting. You might think of this as adding insult to injury, but VCs investing in true early stage series A deals frequently want the founders to agree to some vesting schedule. It is not like option plan vesting just discussed where there is broad agreement on four years and a few looking for five. Here, as the saying goes, you get what you negotiate. Having said that, experience indicates that most VCs will agree readily to something between 25% and 50% fully vested and the rest over three years. BTW, this only applies to true founder shares. To the extent that you pay real dollars for stock, that you keep. The arguments to use in connection with this point have to do with how much time and sweat you have into the business. The more you have in the business; the better your argument for more immediate vesting.

I have been dreading getting to the option pool discussion because I get an inordinate number of questions about how big the pool should be and should it dilute everyone or just the founders. Unfortunately, the answers are not great for the founders (not necessarily bad in a business sense, but you are going to eat the dilution). Your term sheet will have a provision along these lines (BTW, the pool will also appear in the cap table):

Immediately prior to the Series A Preferred Stock investment, [______] shares will be added to the option pool creating an unallocated option pool of [_______] shares.

            Unfortunately, because the data is only sometimes publicly available, the sample size for our data on option pool size in New England deals is small. Having said that, option pools for Series A deals cluster around 15% to 20% of the fully diluted capitalization of the company.

            Your investor is going to make her investment with the assumption that every option in the pool will be granted. So, if she wants 50% of the company, she means 50% after you have granted all the options in the pool. If the pool is 20%, that leaves 30% for the founders. You are not going to out fox her and get her to agree to a post money pool. (That is she won’t go for 50/50 pre-pool and 40/40/20 post pool. What she might do is 40 for you /60 for her pre-pool (or whatever the numbers are) so that she gets to the 50% place after the pool.)

            Keep in mind that all players will agree that they need a pool to attract quality employees. With that in mind if you can make a decent argument for a pool that is on the smaller side, the shares you save may end up in your pocket. 

            When thinking about the size of the pool, think about whom you need to hire. If you happen to have the key players in place (and they have founder’s stock) you may only need a pool sufficient for the rank and file. This might be a good argument for a smaller pool. BTW, experience indicates that option pools are rarely large enough. They have to be reset to some extent with almost every round of financing. VCs know this better than you do. Nevertheless, under the right conditions, you might save a percent or two on the pool size.

(5)            Board of Directors. Board composition is often highly negotiated. (I am not sure why because it frequently comes out with two for the investors, two for the founders/common holders and a tie breaker who is, at least notionally, independent.) In any case, you want to make sure you have an arrangement that works for you. Here is the NVCA approach:

At the initial Closing, theBoard shall consist of [______] members comprised of (i) [Name] as [the representative designated by [____], as the lead Investor, (ii) [Name] as the representative designated by the remaining Investors, (iii) [Name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors]

This provision contemplates a very full board; experience indicates that a lot of start-ups don’t have five board members when they close the A round. Look at it this way: Every substantial fund investor gets a seat on the board. Many (most) VCs like to travel in pairs. That means two seats for the VCs. Sometimes you get some smaller investors in the A round. They typically don’t get board seats. However, they sometimes ask for (and sometimes get) observer rights. If they do, you need a specific agreement with the observers so you can easily exclude them from anything that might implicate attorney client privilege. Sometimes the observers are strategic investors and you may want to exclude them from competitively sensitive information as well. It should go without saying, but you want to be sure that you are on the board. An important ask to add in for the founder is to provide that he is still on the board, even if he is no longer CEO.

(6)            Drag Along. My last candidate for a provision that merits some discussion is the drag. (I admit I could have put some other provisions here instead of the drag, like preferred stockholder veto rights, but I wanted to stick with the artificial constraint of my six point list, so I put them later.) You will never get it out (well, never say never, how about almost never). The drag ensures that you must sell when the VCs want to sell (without regard to the structure of the deal). Imagine that your term sheet has words like this in it:

Holders of Preferred Stock and the Founders and all future holders of greater than 1% of Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options) shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred and which is approved by the Board of Directors and the holders of ____% of the outstanding shares of Preferred Stock, on an as-converted basis.

            In the off chance that you are getting a minority investment, you should resist this on the grounds that the tail should not wag the dog. However, in our imaginary deal, your investor is getting 50% of the fully diluted and you have 30% of the fully diluted. We sometimes see founders negotiate for, and sometimes get, vetoes on the drag.   We sometimes also see provisions where a majority of the preferred together with a majority of the founders are needed to approve the deal to drag everyone else. The investor’s argument is that she does not want you to be able to block a good exit. 

            Having said all that, I predict that you will lose the larger argument (i.e. there is likely going to be a drag), but you can, and should, place conditions on your participation in the drag. The footnote to the NVCA form term sheet puts it this way:

This provision is typically subject to a number of negotiated conditions, including: the representations and warranties required are limited to authority and title to shares, liability for breaches of representations by the Company is limited to a pro rata share of any escrow amount withheld, any liability is several and capped at the stockholder’s purchase price and that the stockholder receive the same form and amount per share of consideration as other holders of the same class or series of stock.

You should get these qualifications on the grounds of simple fairness. For example, the notion that you would be contractually obligated to accept liability beyond the purchase price in a deal you have to be dragged to seems patently unfair. I think most (all?) investors would agree.

My next post will go into six things not to negotiate (much).

This should be of particular concern to directors appointed by holders of preferred stock. 

At the recent NVCA document group meeting there was a lot of discussion around a recent Delaware case (Trados) that pushes the law of fiduciary duty owed by directors generally in the direction of common stockholders. Jeffrey Wolters of the well known Delaware firm Morris, Nichols, Arsht & Tunnell LLP, recently sent around an email to the group noting another recent Delaware decision (QuadraMed) that is consistent with the Trados case. 

This is not going to be a lawyer's discussion of the case and the fact and the holding. We may prepare a client alert separately (and I am happy to discuss it with anyone who wants to).

The larger point is that the way Delaware law is trending is that the directors owe their fiduciary duties to the holders of common stock and the holders of preferred stock will have whatever rights they bargained for and that is that.

While those of you who “represent” the holders of preferred stock may not like this result, it does lend conceptual clarity to fiduciary the obligations of directors. Companies enter into contracts (and preferred stock is a contract albeit one among three parties the company that issues the stock, the purchaser/holder of the preferred stock and the State of Delaware whose corporation laws define certain rights limits etc of the preferred stock), and companies have a legal obligation to meet their contractual obligations. 

If companies fail to meet their obligations, bad things happen: They get sued for breach. But companies are not obligated to do more than is required under a contract. You fulfill the contract and that is the end of the obligation.

Once the company has fulfilled its contractual obligations, the board owes a duty to the common stock to run the company with the interest of the common stock in mind.

While this seeming conceptual clarification leaves a lot of questions to be decided and worked out, at least it starts to get us away from a world in which directors could, potentially, have conflicting duties to holders of preferred and common.

One good example of how the NVCA forms try to balance fairness and current practice is in the area of founder representations. Founder representations are rare (extremely rare) in west coast deals but appear with some frequency in east coast deals. In general, the trend is away from founder reps. So, the forms (in their next iteration) will provide a footnote explaining this (and going through the limitations commonly seen in connection with founder reps, when they appear).

Having said this, to the extent that there are obvious areas of unfairness that have found their way into regular market practices, then the forms just reflect the prejudices of the market. One example of this is the ubiquitous presence of weighted average antidilution provisions. I believe that (with the exception of deals that have full ratchet provisions – far worse for entrepreneurs) all VC investments have weighted average antidilution provisions. Despite what I am about to say, don’t try to get these provisions out of VC docs; you will fail and will waste time, resources, and will leave an impression that you are difficult to deal with.

How can anyone justify antidilution? As far as I can tell the reasoning is that it is up to management to increase shareholder value. If management fails to do this, the argument goes; they should take a hit for that failure. As far as it goes, that argument has some merit.

If we agree with this argument, how do we deal with the effect of antidulition provisions on common stockholders other than management (angel investors for example). By the way, management is often holding options, and they are often "topped up" with more options. In effect, the people who suffer the ill effects of antidilution are not the people who are responsible for the performance of the company.

If you get past the issue I just described, how do you deal with declines in shareholder value that are not due to poor management? For example, what if there is a world-wide recession that affects all businesses, without regard to the quality of management? What justification is there to put greater risk of macro-economic events on management (or the common holders) than on investors?

Let me be clear, if you try to get antidilution provisions out of VC investment docs, you will (a) fail and (b) cause people to think that you are weird. So don’t try.

Based on comments at the meeting, there will be some modest revisions to the documents. Perhaps the most noteworthy is that we will be going back to the future: The next round of forms will (when done) include an additional form of charter with a pay-to-play provision. If my memory serves me well, we included pay-to-play when we did the original version of the charter seven or eight years ago (can it really be that long ago?).

Another noteworthy discussion revolved around whether or not registration rights should be deleted from the forms. They won’t be – at least not this time. Let’s hope that by the time this group meets again next year, there will have been a few (more than a few) IPOs and everyone will start feeling like reg rights are important after all, even if rarely used.

One final note, Ted Wang from Fenwick, discussed model seed series financing documents (based on the NVCA docs) that he prepared and will be making publicly available. This is another great project and great service to the entrepreneurial community.