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investor designee has legal duties to work in the best interests of the company. Sometimes the interests of the company and a particular class of shareholders diverge. Therefore, there can be times when an individual would legally have to approve something as a board mem ber in the best interests of the company as a whole and not have a protective provision to fall back on as a shareholder. While this dynamic does not necessarily benefit the entrepreneur, it's good gov ernance as it functionally separates the duties of a board member from those of a shareholder, shining a brighter light on an area of potential conflict.

While one could make the argument that protective provisions are at the core of the trust between a VC and an entrepreneur, we think that's a hollow and naive statement. When an entrepreneur asks, "Don't you trust me? Why do we need these things?" the simple answer is that it is not an issue of trust. Rather, we like to eliminate the discussion about who ultimately gets to make which decisions before we do a deal. Eliminating the ambiguity in roles, control, and rules of engagement is an important part of any financing, and the protective provisions cut to the heart of this.

Occasionally the protective provisions can help the entrepreneur, especially in an acquisition scenario. Since the investor can effectively block a sale of the company, this provides the entrepreneur with some addition leverage when negotiating with the buyer since the price needs to be high enough to garner the VCs consent on the deal. Of course, this assumes a reasonable position from the existing investor, but in most cases an experienced VCwill support the entrepreneur's decision to sell a company.

A decade ago the protective provisions took several days to ne gotiate. Over time these provisions have been hotly tested in courts of law from several important judicial decisions, so today they have become mostly boilerplate.

The Entrepreneur's Perspective

Remember, you are negotiating this deal on behalf of the company (no matter who runs it in the future) and with the investors (no matter who owns the shares in the future). These terms are not only about your current relationship with the VC in question.

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Drag-Along Agreement

Another important control provisionis the drag-along agreement. Typ ical language follows:

Drag-Along Agreement: The [holders of the Common Stock] or [Founders] and Series A Preferred shall enter into a dragalong agreement whereby if a majority of the holders of Series A Preferred agree to a sale or liquidation of the Company, the holders of the remaining Series A Preferred and Common Stock shall consent to and raise no objections to such sale.

The drag-along agreement gives a subset of the investors the ability to force, or drag along, all of the other investors and the founders to do a sale of the company, regardless of how the folks being dragged along feel about the deal.

After the Internet bubble burst and sales of companies started occurring that were at or below the liquidation preferences, en trepreneurs and founders—not surprisingly—started to resist selling the company in these situations since they often weren't getting any thing in the deal. While there are several mechanisms to address sharing consideration below the liquidation preferences, such as the notion of a carve-out, which we'll discuss later, the fundamental issue is that if a transaction occurs below the liquidation preferences, it's likely that some or all of the VCsare losing money on the transaction. The VC point ofviewon this varies widelyand is often dependent on the situation; some VCs can deal with this and are happy to provide some consideration to management to get a deal done, whereas oth ers are stubborn in their viewthat since they lost money, management and founders shouldn't receive anything.

In each of these situations, the VCs would much rather control their ability to compel other shareholders to support the transaction. As more of these situations appeared, the major holders of common stock (even when they were in the minority of ownership) began refusing to vote for the proposed transaction unless the holders of preferred stock waived part of their liquidation preferences in favor of the common stock. Needless to say, this particular holdout tech nique did not go over well in the venture community and, as a result, the drag-along agreement became more prevalent.

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If you are faced with a drag-along situation, your ownership posi tion will determine whether or not this is an important issue for you. An acquisition does not require unanimous consent of sharehold ers; these rules vary byjurisdiction, although the two most common situations are either majority of each class (California) or majority of all shares on an as-converted basis (Delaware). However, most acquirers willwant 85 percent to 90 percent of shareholders to con sent to a transaction. If you own 1 percent of a company and the VCswould like you to sign up to a drag-along agreement, it doesn't matter that much unless there are 30 of you who each own 1 per cent. Make sure you know what you are fighting for in the negotia tion, and don't put disproportionate energy against terms that don't matter.

When a company is faced with a drag-along agreement in a VC financing proposal, the most common compromise position is to try to get the drag-along rights to pertain to following the major ity of the common stock, not the preferred. This way, if you own common stock, you are dragged along only when a majority of the common stockholders consents to the transaction. This is a grace ful position for a very small investor to take (e.g., "I'll play ball if a majority of the common plays ball") and one that we've always been willing to take when we've owned common stock in a com pany (e.g., "I'm not going to stand in the way of something a ma jority of folks who have rights equal to me want to do"). Of course, preferred investors can always convert some of their holdings to common stock to generate a majority, but this also results in a ben efit to the common stockholders as it lowers the overall liquidation preference.

The Entrepreneur's Perspective

This is one of those terms that matter most if things are falling apart, in which case you probably have bigger fish to fry. And it cuts both ways—if you have a lot of investors, for example, this term can force them allto agree to a deal, which might save you from a lot of agitation down the road. Of course, it is best to not be in a fire sale situation, or at least to have enough board members whom you control (at least effectively, if not contractually) so that you can prevent a bad deal from happening in the first place.

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Conversion

While many VCs posture during term sheet negotiations by saying things like "That is nonnegotiable," terms rarely are. Occasionally, though, a term willactually be nonnegotiable, and conversion is one such term.

The Entrepreneur's Perspective

Amen. 'This is nonnegotiable" is usually a phrase thrown out by junior members of VC firmswhen they don't knowany better. In particular, watch out for the "This is how we alwaysdo deals" or "This is a standard deal term for us" negotiating tactic as being ultra-lame and a sign that the people you're negotiating with don't really know what they are doing.

In all the VC deals we've ever seen, the preferred shareholders have the right—at any time—to convert their stake into common stock. Following is the standard language:

Conversion: The holders of the Series A Preferred shall have the right to convert the Series A Preferred, at any time, into shares of Common Stock. The initial conversion rate shall be 1:1, subject to adjustment as provided below.

This allows the buyers of preferred to convert to common should they determine on a liquidation that they would be better off getting paid on an as-converted common basis rather than accepting the liquidation preference and the participation amount. It can also be used in certain extreme circumstances whereby the preferred wants to control a vote of the common on a certain issue. Note, however, that once converted, there is no provision for reconverting back to preferred.

A more interesting term is the automatic conversion, especially since it has several components that are negotiable.

Automatic Conversion: All of the Series A Preferred shall be automatically converted into Common Stock, at the then appli cable conversion price, upon the closing ofa firmly underwritten public offering of shares of Common Stock of the Company at

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a per share price not less than [three] times the Original Pur chase Price (as adjusted for stock splits, dividends, and the like) per share and for a total offering of not less than [$15] million (before deduction of underwriters' commissions and expenses) (a "Qualified IPO"). All, or a portion of each share, of the Se ries A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price in the event that the holders of at least a majority of the outstanding Series A Preferred consent to such conversion.

In an IPO of a venture-backed company, the investment bankers will almost always want to see everyone convert into common stock at the time of the IPO. It is rare for a venture-backed company to go public with multiple classes of stock, although occasionally you will see dual classes of shares in an IPO as Google had. The thresholds for the automatic conversion are critical to negotiate. As the entrepreneur you want them lower to ensure more flexibility, whereas your investors will want them higher to give them more control over the timing and terms of an IPO.

Regardless of the actual thresholds, it's important to never allow investors to negotiate different automatic conversion terms for dif ferent series of preferred stock. There are many horror stories of companies on the brink of going public with one class of preferred stockholders having a threshold above what the proposed offering would result in; as a result, these stockholders have an effective veto right on the offering.

For example, assume that you have an early stage investor with an automatic conversion threshold of $30 million and a later stage investor with an automatic conversion threshold of $60 million. Now, assume you are at the goal line for an IPO and it's turning out to be a $50 million offering based on the market and the demand for your company. Your early investor is ready to go, but your later stage investor suddenly says, "I'd like a little something else since I can block the deal and even though you've done all of this work to get to an IPO, I don't think I can support it unless. ..." In these cases, much last-minute legal and financial wrangling ensues given the lack ofalignment between your different classes ofinvestors. To avoid this, we strongly recommend that you equalize the automatic conversion threshold among all series of stock at each financing.

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The Entrepreneur's Perspective

Understand what the norms are for new IPOs before you dig your heels in on conversion terms. There's no reason to negotiate away other more critical terms over a $20 million threshold versus a $30 million threshold if the norm is $50 million. Besides, a board decision to pursue an IPOwill put pressure on a VCto waive this provision.

J E R

Other Terms of the Term Sheet

*p to this point we've been exploring terms that matter a lot and fall under the category of economics or control. As we get further into the term sheet, we start to encounter some terms that don't matter as much, are only impactful in a downside scenario, or don't matter at all.

This chapter covers those terms, which include dividends, re demption rights, conditions precedent to financing, information rights, registration rights, right of first refusal, voting rights, restric tion on sales, proprietary information and inventions agreement, co-sale agreement, founders' activities, initial public offering shares purchase, no-shop agreement, indemnification, and assignment.

Dividends

Whereas private equity guyslove dividends, many venture capitalists, especially early stage ones, don't really care about them. In our ex perience, the VCs who do care about dividends either come from a private equity background or are focused on downside protection in larger deals.

Typical dividend language in a term sheet follows:

Dividends: The holders of the Series A Preferred shall be enti tled to receive [non]cumulative dividends in preference to any dividend on the Common Stock at the rate of [8 percent] of the Original Purchase Price per annum [, when and as declared by the Board of Directors]. The holders of Series A Preferred also

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shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis.

For early stage investments, dividends generally do not provide venture returns—they are simply additional juice in a deal. Let's do some simple math. Assume a typical dividend of 10 percent (divi dends will range from 5 to 15 percent depending on how aggressive your investor is; we picked 10 percent to make the math easy).

Now,assume that the VChas negotiated hard and gotten a 10 per cent cumulative annual dividend. In this case, the VC automatically gets the dividend every year. To keep the math simple, let's assume the dividend does not compound. As a result, each year the VC gets 10 percent of the investment as a dividend. Assume a home run deal such as a 50x return on a $10 million investment in fiveyears. Even with a 10 percent cumulative annual dividend, this increases the VCs return from $500 million to only $505 million (the annual dividend is $1 million, or 10 percent of $10 million, times five years).

While the extra money from the dividend is nice, it doesn't really move the needle in the success case. Since venture funds typically have a 10-yearlife, the dividend generates another 1x return only if you invest on day one of a fund and hold the investment for 10years.

This also assumes the company can actually pay out the dividend. Usually the dividends can be paid in either stock or cash, typically at the option of the company. Obviously, the dividend could drive additional dilution if it is paid out in stock, so this is the one case in which it is important not to get head-faked by the investor, where the dividend becomes another form of antidilution protection—one that is automatic and simply linked to the passage of time.

We are being optimistic about the return scenarios. In downside cases, the dividend can matter, especially as the invested capital in creases. For example, take a $40 million investmentwith a 10 percent annual cumulative dividend in a company that was sold at the end of the fifth year to another company for $80 million. In this case, assume that there was a simple liquidation preference with no par ticipation and the investor got 40 percent of the company for his investment (at a $100 million postmoney valuation). Since the sale price wasbelow the investment postmoneyvaluation (i.e., a loser, but not a disaster), the investor will exercise the liquidation preference and take the $40 million plus the dividend ($4 million per year for five years, or $20 million). In this case, the difference between the

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return in a no-dividend scenario ($40 million) and a dividend sce nario ($60 million) is material.

Mathematically, the larger the investment amount and the lower the expected exit multiple, the more the dividend matters. This iswhy you see dividends in private equity and buyout deals where big money is involved (typicallygreater than $50 million) and the expectation for return multiples on invested capital is lower.

Automatic dividends have some nasty side effects, especially if the company runs into trouble, since they typically should be included in the solvency analysis. If you aren't paying attention, an automatic cumulative dividend can put you unknowingly into the zone of insol vency, which is a bad place to be. Cumulative dividends can also be an accounting nightmare, especially when they are optionally paid in stock, cash, or a conversion adjustment, but that's why the accoun tants get paid the big bucks at the end of the year to put together the audited balance sheet.

That said, the noncumulative dividend when declared by the board is benign, rarely declared, and an artifact of the past, so we typically leave it in term sheets just to give the lawyers something to do.

The Entrepreneur's Perspective

The thing to care about here isensuringthat dividendshave to be approved by a majority—oreven a supermajority—of your board of directors.

Redemption Rights

Even though redemption rights rarely come into play, many VCs are often overly focused on them in the deal because they provide additional downside protection. A typical redemption rights clause follows:

Redemption at Option of Investors: At the election of the hold ers of at least a majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three an nual installments beginning on the [fifth] anniversary of the

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Closing. Such redemptions shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.

There is some rationale for redemption rights. First, there is the fear (on the VCs part) that a companywillbecome successful enough to be an ongoing business but not quite successful enough to go public or be acquired. In this case, redemption rights were invented to allow the investor a guaranteed exit path. However, a company that is around for a while as a going concern while not being an attractive initial public offering (IPO) or acquisition candidate generallywon't have the cash to pay out redemption rights.

Another reason for redemption rights pertains to the life span of venture funds. The average venture fund has a 10-year life span to conduct its business. If a VC makes an investment in year five of the fund, it might be important for that fund manager to secure redemp tion rights in order to have a liquiditypath before the fund mustwind down. Aswith the previous case,whether or not the company has the ability to pay is another matter.

Often, companieswillclaimthatredemption rights create a liabil ityon their balance sheet and can make certain business optics more difficult.Byoptics,wemean howcertain third-parties view the health and stabilityof the company such asbankers, customers and employ ees. In the past few years, accountants have begun to argue more strongly that redeemable preferred stock is a liabilityon the balance sheet, not an equity feature. Unless the redeemable preferred stock is mandatorily redeemable, this is not the case, and most experienced accountants will be able to recognize the difference.

There is one form ofredemption that we have seen in the pastfew years that we view as overreaching—the adverse change redemption. We recommend you never agree to the following term that has recently crept into term sheets:

Adverse Change Redemption: Should the Company experience a material adverse change to its prospects, business, or finan cial position, the holders of at least a majority of the Series A Preferred shall have the option to commit the Company to immediately redeem the outstanding Series A Preferred. Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.