Issues to Consider When Negotiating the Term Sheet: The Series A Round

Joseph W. Bartlett, Co-Chair of VC Experts & Special Counsel, McCarter & English, LLP

4 minutes to read

1. Should there be a no shop, no solicit clause in the term sheet, which will be binding? From the investor's standpoint, this is often a preferred way to proceed. It avoids the contingency that the Company will "shop" the terms offered by, in this case ABC, LLC, with other potential investors and pick the winning number. This is viewed as a problem for investors, because they will be wasting their time and money on a process which they did not realize would be, in effect, an auction. But what are the enforcement remedies if the Company sneaks around the investor's back and whispers the pitch material to another prospect, then let's the no shop time period run out? Is a no shop essentially a matter of good faith?

2. The Series A Preferred often is redeemable at the option of the holder after, say, five years. The idea is that, while registration rights do not work to stimulate the founder to put the company up for sale or otherwise provide an exit for the preferred stock holders, the threat of turning the preferred stock, an equity security, into a debt security is often enough to get the founder (who is always thinking that prosperity is just around the corner) off the dime and agree that the Company be sold … in this case, perhaps, to a strategic partner such as ABC, LLC. The enemy of investors is a "life style" company … just enough to support the founder's life style.

3. Cumulative dividends or the Preferred? The idea is that the Company should be rewarded (or not penalized) for achieving milestones which will place it on a pathway to an exit within a reasonable period of time. The second way, somewhat more elegant than the redeemable preferred, (which is never redeemed in accordance with its terms), is a cumulative dividend which will count not only as liquidation preference but on conversion. The thought is that the founder and the equity holders (angels, friends and family) who are pari passu with the founder or founders will be stimulated, in order to avoid dilution, to get the Company into play as soon as it is ready.

4. On the anti-dilution provisions, it is customary to use these provisions as a backdoor way of empowering the preferred stock to keep a cap on the dilutive effect of the option plan. What you say is that any grants to employees in excess of, say, 15 percent of the outstanding will trigger anti-dilution provisions.

5. I do not pay much attention to the registration rights agreement, except to focus on one point. When and as the holder of preferred (presumably a significant holder of common stock after the IPO) wants to sell in an underwritten secondary offering, the Company will indemnify the underwriter and will pay the expenses of the registration, other than the underwriter's compensation. The point is that the time to get those obligations supported by fresh consideration is now … rather than at some subsequent date, when the question will arise … what's the fresh consideration for the Company assuming such obligations? None, you say? Well, then why is it legal?

6. On employee vesting, the question often arises whether the preferred stockholders, as consideration for their fresh infusion of cash, can insist on "reverse vesting" of the founder's shares. This is a draconian provision, often viewed as insulting by the founder; but, if there is a possibility that the founder might take off if times get tough and perhaps work for a competitor, it is a provision to consider.

Joseph W. Bartlett, Special Counsel,

Full Biography

McCarter & English, LLP

McCarter & English, LLP is a full-service law firm with over 400 lawyers with offices in Boston, Hartford, Stamford, New York City, Newark, Philadelphia, Washington DC, and Wilmington. In continuous business for more than 170 years, it is among the oldest and largest law firms in America.

McCarter offers a broad spectrum of interdisciplinary legal services to our clients—Fortune 100, 500 and middle market companies—which include some of the nation’s leading financial services, high-tech, pharmaceutical and retail entities. The firm handles national, regional and local business transactions and litigation, and counsels governments, non-profits, emerging companies, institutions and individuals, representing clients across all major industries, stages of growth, and practice areas. McCarter possesses the depth of knowledge and range of skills necessary to serve clients in a variety of disciplines and practices, both nationally and internationally—putting in the effort to learn its clients’ business to provide them with efficient, cross-disciplinary legal services around the globe.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Joseph W. Bartlett. This work reflects the law at the time of writing October 2014.