Financing Terms & Structures

Deciphering a preferred stock term sheet

Term sheets for venture capital financings include detailed provisions describing the terms of the preferred stock being issued to investors. Some terms are more important than others. The following brief description of certain material terms divides them into two categories: economic terms and control rights.

A. Economic Terms:

(1) Valuation/Purchase Price. Pre-money valuation is used to determine the purchase price and resulting percentage ownership of the investors in the company immediately following the closing of the financing. What shares are included in the purchase price calculation is also important. Investors typically include shares reserved for future issuance (but not yet issued) under an option pool in the calculations and so the option pool has the effect of diluting founders and other existing shareholders and not the new investors. This means the larger the option pool, the lower the purchase price (meaning more dilution to existing shareholders).

(2) Dividends. A dividend is a distribution by a corporation to its shareholders from its profits or retained earnings. While it is typical for a term sheet to include a provision regarding dividends, venture-backed companies rarely pay cash dividends, because any cash generated by the business is typically needed to fund operations. If a dividend is “accruing,” it automatically accumulates on the preferred stock investment (like interest on a loan), even though never declared by the company’s board. The accrued dividends are then paid upon a sale of the company (also redemption of preferred stock), thereby increasing the payout to investors in preference to the common shareholders.

(3) Liquidation Preference. Liquidation preference refers to the dollar amount that a holder of preferred stock will receive prior to holders of common stock in the event that the company is sold (or the company is otherwise liquidated and its assets distributed to shareholders). If preferred stock is “participating,” investors get paid their money back first from the proceeds of a sale of the company and then share the remaining proceeds with common shareholders based upon ownership percentage in the company. “Non-participating” preferred stock means that investors receive their money back or share the proceeds with common shareholders based on ownership percentage—but not both. Read more about liquidation preferences.

(4) Anti-Dilution Protection. Preferred stock is generally convertible into common stock. So you can calculate a common or preferred shareholder’s ownership percentage on an as-converted basis (meaning, by assuming that all of the preferred stock has converted into common stock). Typically, the conversion rate is initially fixed at 1-for-1 (meaning each share of preferred stock is convertible into one share of common stock). However, this conversion rate or ratio may be adjusted in favor of the preferred shareholders if the company sells additional securities at a price less than the price paid by investors. So instead of receiving one share of common stock upon conversion of each share of preferred stock, each share of preferred stock would convert into 1x or more shares of common stock. “Weighted-average” anti-dilution determines the adjustment in the conversion rate using a formula based on the dilutive price and the number of shares issued, whereas “full ratchet” anti-dilution only takes into account the dilutive price. Weighted-average anti-dilution is more common and is generally viewed as being more fair, whereas full ratchet anti-dilution is more punitive to the company and the common shareholders.

(5) Preemptive Rights. Investors will have the right to participate in future rounds of financing, to maintain their ownership percentage in the company.

B. Control Rights:

(1) Board Composition. Investors typically request at least one seat on the board of the company. Each time the company raises a new round of capital, the lead investor of that round will seek representation on the board. Most venture-backed companies have a board comprised of founders or other management (e.g., the CEO), representatives of the investors and independent members. While board actions generally require the affirmative approval of a majority of the members of the board, the investors typically require that certain actions of the board include the approval of the directors representing the investors.

(2) Protective Provisions. Investors typically seek additional control by requiring the company to obtain the separate approval of the preferred shareholder for material actions to be taken by the company. These special approval rights typically include decisions relating to: company sale, future financings, changes in the capital structure, transactions with affiliates, bank loans, etc.

(3) Drag Along. Investors may require common shareholders to vote in favor of a company sale if it is approved by preferred shareholders (and often the board). This could have the impact of forcing a sale when it would not otherwise be approved by management/founders.