In this second part of this two-part blog post, we continue to review additional key terms, including founder re-vesting, board seats, legal fees, opinions, no-shops and preferred approval thresholds.
9. Founder Re-Vesting
Another investor request that often comes up in financings is founder re-vesting.
Note that in a term sheet, this is often NOT an explicit term, but will simply be a provision or language in the term sheet that says that “founder equity or vesting subject to investor due diligence” or something similarly vague.
As a result, this often comes up AFTER a term sheet is accepted, during due diligence when investor counsel discovers that the founders have already vested more than 50% or more of their founder shares as of the first priced round financing. Investors will then ask for “revesting” amending the founder stock agreement to change the vesting such that prior vesting is “knocked back” or changed such that previously vested shares become unvested, and/or the vesting terms are amended to change (typically elongate) the vesting period.
While investor rationale for revesting is understandable – they want to be sure founders still have significant “skin in the game” in the form of ongoing vesting after the financing – this can significantly change the economics for founders and therefore is also often subject to negotiation.
To the extent a term sheet is unclear on revesting, or where founders have already vested a large portion of their equity prior to a financing, founders or founder counsel should consider asking about revesting up front, especially if a founder is comparing term sheets between different investors and has some leverage to negotiate.
10. Board Seats
Many of the important terms of a term sheet are about the economics of a deal – the size of the round, valuation, dilution, founder equity, etc. However, just as important are terms that affect the ongoing governance and control of a company, including the size of a Board and who gets Board seats.
Experienced founders often understand how important these provisions are, and negotiate these types of provisions as much as the more obvious economic provisions.
For a given financing round, investors of that round (eg the “Seed” or “Series A investors”) usually ask for a board seat to be appointed by investors of that particular round/class of shares. Often that seat will be designated by the lead investor for that financing round.
Founders should expect that investors of each round (eg the Series B, Series C, etc.) will also ask for their own board representative. As such, it’s possible that founders (who typically also hold board seats) may find themselves out numbered or outvoted unless they plan accordingly.
For that reason, founders should strongly consider conferring with counsel regarding possible ways to negotiate board provisions and/or potentially structuring the board PRIOR to a financing to ensure the founders retain control of the board.
11. Protective Provisions & Investor/Preferred Shareholder Approval Thresholds
Another control provision that is sometimes overlooked by founders are investor approval rights or protective provisions. Most term sheets should list out the approval rights or protective provisions that investors are asking for, although in other cases short form term sheets may simply reference “customary” or “standard” investor approval rights or protective provisions.
Most of these provisions relate to actions that a company cannot take (such as taking on debt, issuing new shares, etc.) without seeking approval of some threshold of investor shareholders. In other cases, such provisions may separately require approval of the preferred director (director appointed by the investor) for certain types of actions, either in lieu of, or in addition to, preferred shareholder approval.
While many of these provisions are fairly common and typically agreed to by most companies, some investors will ask for non-market provisions or provisions that while for some companies may not be an issue, for other companies may create operational overhead or delays given the type of business they are in.
Founders should strongly consider having counsel review such provisions – once a term sheet is signed, investor counsel will rarely concede on language agreed to in a term sheet (even if non-binding).
12. Preferred Priority
In the recent past, it’s generally been the default that each different series of Preferred (Series Seed, Series A, Series B, etc.) is treated “equally” from a standpoint of priority (who gets paid first in a sale/liquidation) and approval rights (referred to in legal parlance as “pari passu”).
In some cases, especially where new investors believe they have leverage to extract more favorable terms, investors in a new financing round may ask that their new series of preferred shares be “senior” to prior series of preferred (eg get paid prior to the other preferred) or have certain separate class approval rights or blocking rights (eg some company actions will require approval of the new class of preferred shares, separately from any other preferred shareholders or common holders).
Agreeing to such provisions can be problematic, both from the perspective of the prior investors (who may NOT want to grant the new investors priority over their rights and shares), and from the company perspective (separate class approval or blocking rights can be problematic for the company to manage in the future).
Founders should always confer with counsel to ensure term sheets are clear as to whether investors are asking for separate approval rights, blocking rights and/or priority over prior preferred investors.
13. Legal Fees
Despite the fact that investors are issuing and negotiating the term sheet, and negotiating the financing documents as part of a financing, investors will typically ask that the company pay for the legal fees and expenses of the lead investor related to the financing (typically to be paid out of the investment funds received by the company after the closing).
While this is a customary provision which companies typically are required to accept, the actual amount specified in the term sheet is negotiable. Depending on the type and size of the deal, the amounts will vary, although for an early stage Series Seed or Series A type financing, the typical range is $30K to $50K. However, this provision is negotiable and the company should feel comfortable pushing back on the amount.
Finally, note that while term sheets will often have language about reimbursement of investor counsel fees “up to” a certain amount, it is standard practice across the board that investor counsel will bill companies a flat rate for the exact amount in the term sheet (which will not contain any itemized billing information due to attorney-client privilege issues).
While some founders in the past have accepted a higher fee number, thinking the actual fee will end up lower, in actuality a company should expect to be billed the amount in the term sheet, and therefore should always try to negotiate that number if it seems too high.
14. No-Shops
Term sheets typically include a no-shop or exclusivity provision near the end of the term sheet, that is typically not negotiable and will prevent the company from shopping the term sheet after it is signed.
To the extent a company wishes to “shop” a term sheet, as discussed in a prior blog post, in addition to the no-shop the company will also need to consider confidentiality provisions and reputational issues before it does so. Once the term sheet is signed, such “no-shop” provisions are binding, although they typically are subject to a time period (usually 30 or 45 days) before the no-shop expires.
Other than the time period (typically 30 or 45 days), most founders do not negotiate this term, although if a term sheet contains a no-shop for longer than the typical 30-45 days, a founder should consider negotiating that period down or discussing with its counsel as to why an investor may have asked for such period to be longer.
15. Legal Opinions
An investor request that is often overlooked by founders is the requirement that the Company’s counsel deliver a “legal opinion” as part of a financing. This amounts to a legal audit of the company’s historical capitalization history and can add significant cost to the transaction, particularly where the counsel delivering the opinion has not been involved in the issuance of all existing stock. Although a standard request, particularly in larger or later-stage deals, the Company should attempt to eliminate the requirement for earlier stage or smaller transactions.
16. Binding vs Non-Binding
As noted in a prior blog post, term sheets are historically non-binding, meaning that except for some specific terms that are expressly called out, either party can walk away from the deal at any time without liability. The only typical exception to this is that if the term sheet contains an exclusivity provision (also colloquially known as a “no-shop”) or a confidentiality provision.
Although non-binding, the term sheet does offer significant “moral” authority when it comes to final negotiations. If a term has been discussed in the term sheet, absent a material change in circumstances, it is highly unlikely that term will be changed in the final deal documents.
Therefore although term sheets are nominally “non-binding” the reality is founders should always involve counsel to negotiate a term sheet PRIOR to signing the term sheet.
17. Confidentiality
Term sheets should typically have a mutual confidentiality provision that ensures information shared between the investor and company is treated as confidential. While some companies may ask investors to sign a separate confidentiality or non-disclosure agreement, it’s still typically the case that venture capital firms shy away from signing a separate non-disclosure agreement.
If a term sheet does not contain a confidentiality provision, then a company should ask for one, as the confidentiality provision primarily benefits the company, not the investor. In addition, as discussed above, while a term sheet is typically treated as non-binding, the confidentiality provision should be treated as binding on the parties.
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