By: Jacob Plotnik

It is essential that startup founders consider their startup’s governance policies (i.e., its management, processes, and practices).[1] A company, though, encompasses a lot of competing interests—the company’s, the founders’, and the investors’, to name a few.[2] A startup’s rules of governance, then, will fuse these varying interests.

 

When startups are fundraising, company representatives will typically negotiate with their investors. A term sheet will memorialize these negotiations and detail what the startup is selling (equity in our case), and what the startup is getting in return (MONEY!!!).[3] Term sheets also outline how both the company and the investors will act to protect the venture investment and their respective interests.[4]

The most important provisions in a term sheet will impact economics and control.[5] Economic provisions dictate what the startup and its investors will financially receive as a result of a liquidity event (e.g. a sale, a merger, etc.).[6] Control provisions will allow investors to either affirmatively exercise control over the startup, or to veto a company’s decisions.[7] It’s paramount that startup founders understand control terms so that the founders can come to the negotiation table informed on how these provisions will impact the company’s governance policies.

Some of the most important control terms will be highlighted in this blog post. (For an overview on some important economic terms, see http://www.wolverine-startuplaw.com/2017/12/07/1134/.)

 

Board of Directors

 

Our first term relates to a company’s board of directors. A board of directors sets company policies, and makes major company decisions,[8] including appointing officers and sometimes structuring transactions. Consequently, how the board is made up and who determines that makeup are important considerations for a startup. The understanding between companies and their investors as to how the board will function is usually embodied in a board of directors clause in a term sheet.[9]

 

In early-stage companies, there will typically be three or five board seats.[10] These seats will be occupied by some combination of venture investors, founders, CEO’s, outsiders, or others.[11] Venture investors are concerned with having board influence so that they can ensure that their money is utilized appropriately. The startup’s representatives will want to have board seats so that they can maintain clout in the company’s decisions.

Routinely, startups have an odd number of board seats, with one outside board member so that if there are competing interests, there will be a tie-breaking vote that can determine the best direction of the company. The mechanism for selecting that tiebreaker outside board member will likely be written into the term sheet.

 

Protective Provisions

 

Second, let’s focus on protective provisions, which  give investors the right to block or veto certain startup actions (even if the board of directors authorizes that action).[12] Protective provisions are something that sophisticated venture investors will always require.[13]

 

There are a lot of protective provisions, including the ability to block a change of terms in the stock owned by the investors, a change of the size or compositions of the board of directors, a sale of the company, etc.[14] Importantly, investors can also interrupt a startup’s ability to license away the IP of the company, which would effectively result in a sale of the company.[15] Investors will also likely require a protective provision for any issuance of debt beyond a predetermined threshold—this limit will often rise with more mature companies.[16] Although certain thresholds can be negotiated, founders should be aware of these provisions and understand that it is standard practice for investors to include them.[17]

 

It’s imperative for startup representatives to understand the various protective provisions; but it’s equally important for startup representatives to understand that they should advocate for investors to vote to exercise their protective provisions as a single class amongst themselves.[18] This will keep investor interests aligned, and united with company interests.[19]

 

Drag-Along Agreement

 

Third, a term sheet may include a “drag along.” If a certain threshold of shareholders votes for company action, minority shareholders can be “dragged along” to reluctantly participate in that action. This process will be embodied in a drag-along provision of a term sheet. Drag along agreements can be broken out into two different flavors, though they both contain similar ideas.[20]

 

The first type of drag-along provision—the traditional one—prevents minority shareholders from obstructing a sale or liquidation of the company.[21] According to this first flavor, when there is a preferred shareholder (investor) vote on a sale or liquidation event and a required percentage threshold is met, regardless of the common shareholders’ contrary preferences, those common shareholders will be “dragged along” to grudgingly cooperate with the liquidation.[22]

 

The second flavor of drag-along agreements is a more recent phenomenon[23] and says that when a founder leaves a company, their stock will be “dragged along” and forced to participate in the shareholder vote.[24] This prevents departed founders from holding out and apathetically disrupting a company’s voting matters.[25] In a term sheet, the company and investors can (and typically do) structure the founder’s shares to be dragged along in the same proportion as the shareholder vote.[26]

 

Conversion Rights

 

Fourth, term sheets will include conversion rights. VC investors are normally issued shares of preferred stock, and not common stock.[27] Preferred stock carries with it preferences, and one of them typically is the right and ability to convert shares of preferred stock into common stock.[28]

 

There are two kinds of conversion rights. The first type is optional conversion.[29] Optional conversion provisions give the preferred shareholders (investors) the right, at any time, to convert their shares into common stock.[30] This conversion is typically executed on a one-to-one basis.[31] During a liquidation event, investors will likely exercise this right when a conversion to common shares will be more profitable to them, as opposed to sticking with their preferred shares.[32] This is typically a term that is nonnegotiable for VC investors.[33]

 

The second form of conversion rights is automatic conversion (also known as mandatory conversion).[34] Here, preferred shareholders are required to convert their shares into common stock.[35] Automatic conversion will usually come into play when there is an initial public offering (IPO), as the investment bankers involved in the IPO will only want to see one class of stock.[36] In contrast to optional conversion, automatic conversion provisions are negotiable, and typically the threshold for automatic conversion is a topic to negotiate.[37] Although conversion provisions have economic characteristics to them, this threshold is why conversion is considered a control term. The company will want the IPO threshold set low, and investors will want the threshold set high; the parties will negotiate this threshold, with both jockeying for control over the parameters of a potential IPO. It’s vital, though, that these automatic conversion thresholds not be different for different series of preferred shareholders, as this can create major headaches for startups that want to go public.[38]

[1] James Chen, Corporate Governance, Investopedia (Mar. 1, 2018), https://www.investopedia.com/terms/c/corporategovernance.asp.

[2] See id.

[3] Alejandro Cremades, Term Sheet: Here Is Everything Entrepreneurs Must Know When Fundraising, Forbes (July 7, 2018), https://www.forbes.com/sites/alejandrocremades/2018/07/07/term-sheet-here-is-everything-entrepreneurs-must-know-when-fundraising/#8a630d043ef1.

[4] Id.

[5] See Brad Feld & Jason Mendelson, Venture Deals Venture Deals 38 (3d ed. 2016).

[6] Id.

[7] Id.

[8] James Chen, Board of Directors (B of D), Investopedia (Dec. 18, 2017), https://www.investopedia.com/terms/b/boardofdirectors.asp.

[9] Brad Feld & Jason Mendelson at 68.

[10] Id. at 69.

[11] Id.

[12] Scott Edward Walker, Demystifying the VC term sheet: Protective Provisions, Venture Beat (Mar. 28, 2011), https://venturebeat.com/2011/03/28/demystifying-the-vc-term-sheet-protective-provisions/.

[13] Id.

[14] Brad Feld & Jason Mendelson at 71.

[15] Id.

[16] Id. at 70 – 71.

[17] See id. at 70.

[18] Id. at 73.

[19] Id.

[20] Id. at 75.

[21] Drag-Along Rights, The Business Professor, https://thebusinessprofessor.com/knowledge-base/drag-along-rights/.

[22] Brad Feld & Jason Mendelson at 75.

[23] Id. at 76.

[24] Id.

[25] Id.

[26] Id.

[27] Scott Edward Walker, Demystifying the VC term sheet: Conversion Rights, Venture Beats (June 6, 2011), https://venturebeat.com/2011/06/06/demystifying-the-vc-term-sheet-conversion-rights/.

[28] Id.

[29] Id.

[30] Brad Feld & Jason Mendelson at 78.

[31] Walker, Demystifying the VC term sheet: Conversion Rights.

[32] See Brad Feld & Jason Mendelson at 78.

[33] Id.

[34] Walker, Demystifying the VC term sheet: Conversion Rights.

[35] Id.

[36] Id.

[37] Brad Feld & Jason Mendelson at 78 – 79.

[38] Id. at 79.