This is the third of four parts in this series.
When your company is raising money, you may be focusing on what that investment can do for your business. However, you need to understand what you're giving investors, and what they are providing in return. Here are some essential terms to understand, straight from a term sheet.
1. Dilution (or Anti-Dilution): Dilution of stock value is basically means the decrease in value of the company’s stocks once new shares are issued or converted to a different type of stock. It’s basic economics; a sudden increase in supply will result in a sudden drop in price. Investors and founders want to make sure that they don’t lose monetary value of their total stake in the company when these shares are issued. Also, if the shares are being converted to a different instrument (as the shareholders’ agreed) and dilution might be necessary to sell new stock for financing purposes, these ‘anti-dilution’ measures will ensure that the parties of the agreement do not lose a significant stake in their investment. In other words, when the new shares are issued and dilution of the stocks’ value takes place, investors and founders want to be sure that their percentage ownership in the company has not changed, the total value of all their shares has not changed, and their rights as shareholders has not changed. There are several different alternatives for these provisions. The first one is to do nothing. This is a risky choice, since all power is placed in the hands of those who have the power to issue more shares on the company’s behalf. If a stakeholders’ shares become very diluted, they can lose serious value of their shares’ monetary value and their power/rights within the company. The second most common option is known as “Full Ratchet.” Full ratchet is an adjustment ratio applied to all the shares of the company after issuing a new stock or security. The third most common option is to use a “weighted average” formula which adjusts the conversion price (or the price at which shareholders’ will exchange their old stock for the new) to bring about a specific monetary value in which shareholders can fairly exchange their shares.
2. Right to Participate in Future Rounds: This provision gives the “pro rata”(or proportional) right to shareholders to invest the company during future investment rounds based on their equity stake in the company. These do not include specific shares that have specific “anti-dilution” provisions attached to them that related to future rounds of investment. In other words, when the new round of funding takes place, it will be the shareholders’ right to participate in that round (by giving money) based on the percentage of their ownership equity. For example, if an investor already own 25% of a given company, that investor has right to put up 25% of the new round of funding and is entitled to provisions in the new funding round. This applies to all future rounds of funding, so long as the investor continually participates.
3. Board Composition: Upon signing on as an investor in the company, it is likely that the shareholder will require representation on the company’s board of directors. This provision of a term sheet is closely tied to the Voting Rights provision, as it is often the case that those eligible to vote on company proceedings are those on the board of directors. The amount of seats allotted to the shareholder may or may not depend on the amount of equity the shareholder acquires based on their investment, it is entirely up to negotiation. This amount can also change throughout the duration of the shareholder’s investment. For example, an early stage investor may not desire a majority presence on the board until the company’s valuation increases. The shareholder itself can elect to occupy one of their given seats, if it is a singular person, or it can elect representatives. It is not always the case that the company has an input on who is added to their board of directors, however someone that the company trusts can only aid in creating a productive atmosphere.
4. Registration Rights: If given registration rights, this allows the investor to require that the company registers their securities, documentation that a share has been sold, with the U.S. Securities and Exchange Commission. Registering with the SEC enables investors to more easily sell their shares in the company. Registration rights can manifest in two ways: demand or piggyback. With demanded registration rights, the investor has the power to decide when the company goes public without the consent of the company founders. Conversely, piggyback registration rights allow the investor to attach their shares to the company’s initial public offering, whenever the company itself decides to go public. The company’s success can determine if a shareholder chooses to exercise their demand registration rights, as it provides the possibility for a clear exit out of the shareholder’s investment. However, exercising these rights can complicate the relationship between the shareholder and the company members if the company does not wish to go public at that time.
5. Right to Information: The right to information primarily gives an investor access to all records of the company’s proceedings. This can include, but is not limited to, budget forecasts, financial statements, minutes from the board of directors’ meetings, and inspecting the company premises. This provision can go as far as to detail when each of the above mentioned records needs to be delivered to the investor and how often. This is an essential section to an investor because it enables them to keep a constant watch over the company to ensure that their money is being spent properly and wisely, as they may or may not be present for all company activity.
Stay tuned for Part 4 of Understanding the Investor Term Sheet, coming soon!