This is the final 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. Option Pool: The purpose of an option pool is to put aside common shares of the company for future employees of the company, such as officers or managers. This is a method used by private companies to attract potential employees and usually accounts for 15–20% of the company’s shares. Shares in an option pool usually cannot vest until a certain amount of time has elapsed. However, the size of the option pool can be adjusted down the line once it has more funding. In an investor term sheet, this provision commonly states that these shares are to have no effect on the investor’s equity and instead will be pulled from the founder’s shares. Investors can also require that the size of the option pool is determined based on the company’s valuation before or after their investment is made. Overall, option pools are thought to increase the health of the company because its employees are more invested in its success.
2. Participation Rights: Participation rights allow preferred stockholders to recoup their investment before any other shareholders. Additionally, participation rights enable the investor to fully participate in proceeds that remain after all the investors have recouped their investments, otherwise known as pro-rata. Ideally, founders would negotiate to not include participation rights in an investor term sheet as it reduces the amount of money that they themselves can profit from or filter back into the company. Investors, on the other hand, often negotiate intensely to include this provision in their term sheet. A common compromise is a participation cap, which prevents a shareholder from receiving more than a certain, pre-approved amount of the remaining profits after their initial investment has been recouped.
3. Drag Along Rights: This provision accounts for the right of a majority shareholder to demand that a minority shareholder sell their shares of the company in the event of a third party purchaser, acquisition, merger, or liquidation. Conversely, tag along rights enable a minority investor to sell their share of the company if the majority shareholder sells theirs, which is only applicable if the drag along rights have not been exercised. This is a particularly important term for an investor because it aids in protecting their exit strategy. This is because if a company is being sold, it is often the case that the purchaser will want to buy all the shares of the company. Without drag along rights, a minority shareholder could possibly prevent the company from being sold, thus blocking the majority shareholder’s ability to recoup their investment.
4. Right of refusal/First sale rights: If any other investor wants to sell their shares, the company can get the first chance at buying the shares, and if the company doesn’t exercise these rights, Series A investors may get second pick. This condition controls who owns the majority of the shares in the company.
5. Right of co-sale: Also known as tag along rights, this allows the venture investor to participate in the sale based on the number of shares held by the participating founders so investors can make a partial exit if the right opportunity arises for the founders. If over 50% of the shares are sold, and there is a change in control, the co-sale agreements may require that the total proceeds be divided among the selling stockholders like the transaction is a “liquidation event,” giving the investors liquidation preference.