Once an investor has decided to invest in startup through a preferred stock financing, such as a Series A preferred stock financing, the company and the investor will negotiate the principal terms of the financing in a non-binding “term sheet.”
 
Term sheets define the rights, privileges and preferences of the investors in the preferred stock financing.  Term sheets can be daunting for investors new to venture capital financings.
 
I have prepared an annotated term sheet for a Series A preferred stock financing, which provides an overview of the key terms as well as links to blog posts relating the topics in the term sheet.
 
The term sheet can be obtained below:

Please let me know if you have any suggestions on how to improve the term sheet.

© Allen J. Latta.  All rights reserved.

 
In a prior post, “Pre-Money and Post-Money Valuation,” we introduced the basics of pre-money valuation and post-money valuation and how they are related.  This post expands that post to discuss the impact of option pool refreshes on pre- and post-$ valuations.
 
In the prior post, we looked at FlintRubble.com which was formed by Wilma and Betty.  The two founders invested $5,000 each and received 50,000 shares.  After the issuance, the ownership looks like this: 

​Simple Agreements for Future Equity, known as “SAFEs,” are a popular financing tool for seed and early-stage companies.  Developed by the well-known startup accelerator Y Combinator in 2013, SAFEs have become a standard financing tool for startups.
 
SAFEs have some similarities to convertible notes, but are very different.  We discussed convertible notes in the post “Convertible Notes: An Overview.”  I recommend reading that post before continuing reading this post.
 
Let’s dive in.

​Convertible notes provide start-up companies with cash to operate the business until the company can raise a more formal financing round.  Convertible notes and their cousins, Simple Agreements for Future Equity, or SAFEs, are popular “bridge” financing strategies for start-ups, and have grown in use over the past few years.
 
This post explores convertible notes.  A future post will explore SAFEs.

​Warrants to purchase stock in private companies enable the holder of the warrant to buy shares of stock in the company at a specified price for a certain period of time.  Warrants are issued by private companies to investors, lenders, vendors and partners as part of a transaction or as an incentive to enter into a transaction or a financing. 
 
Warrants are very flexible agreements and can be customized for a particular situation.  This post provides an overview of private company warrants.

​Imagine being an early employee of a startup and being granted stock options as part of your compensation package.  A few years later the company goes public and your stock options are worth several million dollars.  This is a story that has been repeated many times the start-up world.
 
Stock options provide a way for officers, directors, employees and consultants to share in the upside in the equity value of a company.  Companies issue stock options to attract and retain talent, and to reward these people with upside in the company’s value.  Investors in start-ups recognize the value of stock option plans, and make sure the company will have a suitable stock option plan in place to attract and retain top-level talent.
 
This post provides an overview of stock option plans.

​Drag-along rights enable a group of stockholders (such as a majority of the preferred stockholders) to force a sale of the company.  These rights are called “drag along” because the stockholder group exercising the right are in effect dragging the other stockholders along in the transaction.
 
Why do preferred stock investors in start-up companies (such as venture capital firms) want these rights?  To ensure that if the preferred stockholders want to sell the company, they can.
 
Drag-along rights are a bit complex, and this post will try to demystify them.

​In the prior post “Preferred Stock Financings: Rights of First Refusal” we discussed the right that the company and stockholders have to acquire the shares of stock being offered for sale by an existing stockholder.
 
A related right is the Co-Sale right, also known as “tag-along” right or “take me along” right.  A Co-Sale applies when an existing preferred stockholder in a privately-held company has received an offer from a potential buyer (known as a “third party”) to buy its stock.  The Co-sale right enables existing stockholders to sell their stock alongside the selling stockholder in this transaction.
 
Let’s explore the mechanics of a Co-Sale right.

Have you heard the term “ROFR” (pronounced “Roafer”)?  This term is well known by professional investors.
 
ROFR means Right of First Refusal.  We will do a deep dive on ROFRs in this post.

​This post is a continuation of the post “Preferred Stock Financings: Registration Rights Part 1.”
 
In the prior post, we discussed the registration process, which enables the company and/or existing stockholders to sell shares to the public on a stock exchange, such as the New York Stock Exchange (“NYSE”) or NASDAQ.  We discussed S-1 registration statements and S-3 registration statements, which are the primary ways for the company to sell stock to the public.
 
In this post, we explore “demand” registration rights and “piggyback” registration rights, which are rights held by the preferred stockholders in order to be able to register their shares so they can be sold in the public markets.

​There are two key events that occur for an investor in a private company:  The purchase of the stock and the exit (an “exit” is the sale or exchange of the stock for cash or publicly traded stock).  The primary exits are when a company is sold and the investor receives cash for its stock, and when the investor sells their shares into the public market as part of a registered offering, such as an IPO.
 
“Registration rights” are the rights that preferred stock investors obtain to allow them to sell their stock in a registered offering. 

​There’s a lot to discuss here, so buckle up and let’s get going.

I am pleased to be moderating a panel at the Carmo Middle Market Private Equity Web Conference on February 9-10, 2021.  I will be moderating the panel "Consumer & Business Services: A Conversation on Value.  The link to the conference is here: ​https://www.carmocompanies.com/middle-market-private-equity-web-meeting

When you buy stock of a publicly-traded company, there's lots of information available about the company's business and finances.  This is because publicly-traded companies are required by law to publish their financials and other company information.  

The world is very different when investing in private companies.  Absent an agreement, private companies have very few requirements to provide investors with information on the company’s business and finances.  That’s where information rights come in.
 
This post explores information rights typically obtained by preferred stockholders in private companies.

​Here’s a scenario inspired by real events that I have experienced:  a startup telecom company was all the rage and the company’s Series A preferred stock financing was heavily oversubscribed.  As a result, the deal was “take it or leave it” for investors and the Series A preferred stockholders invested without obtaining many of the normal provisions protecting their investment.  The company raised significantly more money than they needed at that stage.  With all this cash burning a hole in the company’s pocket, the company decided to buy some land and build itself a new headquarters building.  The company also gave management huge raises and bonuses and lavishly spent on marketing (sponsoring a race car and hiring a celebrity spokesperson), office décor, company retreats and parties.  Not surprisingly, the company blew through all of its cash very rapidly, with little progress to show for it.  The company then tried to raise another round of financing but couldn’t agree with investors on valuation (the investors wanted a very low valuation) and the company went out of business.
 
Moral of the story: If the investors in the financing described above had obtained protective provisions, this financial debacle may not have occurred.
 
This blog post is about protective provisions.

​Boards of directors for early-stage companies are very important and serve a number of critical functions.  The board hires the company’s CEO and other senior management (and sometimes fires them), and decides other major events for the company, such as whether and when to raise additional capital, enter into important contracts, sell the company, go public or to wind the company down.  In addition, the board often has committees, including an audit committee (to review the financials of the company) and a compensation committee (to establish officer compensation) that meet separately from the board.
 
Members of the board of directors are elected by the stockholders, and represent the stockholders’ interests.  In preferred stock financings, the lead investor will usually obtain the right to appoint a director to the board.  If the lead investor doesn’t obtain a board appointment right, then the investor may obtain the right to be a “board observer.”  Board observer rights are sometimes granted in addition to board appointment rights.
 
This blog discusses an investor’s rights to appoint a member of the board and/or a board observer.

​Redemption rights are rights held by preferred stockholders to require a company to repurchase its stock from the preferred stockholders.  Redemption rights are sometimes referred to “put rights,” meaning the preferred stock investors have the right to “put” its shares to the company.  A “put” in finance is the right to sell a security (usually stock) to another party at a certain price.
 
Redemption rights are rare in early-stage venture capital financings, but can sometimes be found in later stage financings, down rounds or in restructurings.
 
Let’s get started.

​In a convertible preferred stock financing, one of the most heavily negotiated terms is the liquidation preference. 
 
A liquidation preference is a priority payment right given to preferred stockholders when a company has a “liquidation” event – which means a sale of the company or the bankruptcy/winding down of the company.  In the event of a liquidation, the liquidation preference determines how the liquidation proceeds are prioritized and paid to the preferred stockholders and the common stockholders.  These payments are called a “liquidation waterfall.”
 
Liquidation preferences can be pretty complex, so let’s break this down into components.

A “dividend” is the payment of "excess cash" by a company to its shareholders (it’s a bit more complicated than that, but we’ll get to that later).  If the company pays dividends, the stockholders will receive the dividends based on their ownership in the company.
 
For privately-held companies, especially early-stage companies, dividends are generally not paid as these companies generally don’t have excess cash, and even if they did, they would use any excess cash to grow the company’s business.  But even though dividends are generally not paid by privately-held companies, it is important to understand how dividends work because preferred stock investors may negotiate dividend provisions that could result in substantial sums of money being paid to the preferred stockholders in certain situations.

​ 
When private companies hold financing rounds with venture capital and other professional investors, these investors acquire convertible preferred stock from the company.  The “convertible” or “conversion” feature of the preferred stock is fundamental to many of the rights, privileges and preferences granted to the preferred stock investors.
 
So what is the convertible feature of convertible preferred stock?  Read on.

​Anti-dilution provisions protect existing stockholders from value dilution and/or ownership dilution. They are powerful investor protections and they come in different flavors.  
 
In a prior post, we discussed Rights of First Offer (also known as Pre-Emptive Rights) which offer protection against ownership dilution.
 
This post will explore anti-dilution protections that protect against value dilution.

​A “right of first offer,” also known as a “pre-emptive right,” provides an investor in a company with the right to participate in future financing rounds so that the investor can maintain its ownership percentage in the company.  Rights of first offers are referred to in shorthand as ROFOs.
 
There are many elements to ROFOs.  Let’s break them down.

This is second part of the post on dilution.  The first post discussed ownership dilution, also known as equity dilution.  The first post can be found here:  http://www.allenlatta.com/allens-blog/dilution-part-one-understanding-ownership-dilution
 
As discussed in part one, I view dilution as having two components: ownership (equity) dilution and value dilution.  These concepts are related.  Let’s now explore value dilution.

I am pleased to be participating in a webinar for family offices presented by the Context Family Network on September 25, 2020.  I will be interviewing the Chief Investment Officer for a family office that actively invests directly in private technology companies.  The Context Family Network website can be found here: contextfn.com/.

​The word “dilution” is used often private equity, particularly in venture capital financings.  One can hear venture capitalists and founders say they don’t want to be diluted.  But what are they talking about when they say this?  That’s the topic of this post.
 
I view dilution as having two components: ownership dilution and value dilution.  These concepts are related.  In this post, we’ll take a look at ownership dilution.  We’ll look at value dilution in a later post.