What do definitive documents for a Series A financing look like?

The National Venture Capital Association has posted model venture capital financing
documents on its web site.

The principal documents in a Series A financing include:

1. Stock Purchase Agreement

2. Amended and Restated Certificate of Incorporation
3. Investor Rights Agreement
4. Right of First Refusal and Co-Sale Agreement
5. Voting Agreement

In addition, there is a schedule of exceptions, legal opinion, officer’s certificate, secretary’s

certificate, management rights letters, indemnification agreements, form of confidential
information and invention assignment agreement, board consent, stockholder consent, good
standing certificates, stock certificates, along with any documents to deal with deferred
corporate housekeeping.

Most law firms actively involved in representing companies or investors in venture capital
financings have their own forms, including WSGR. In fact, WSGR has invested time and
resources in developing a Series A document automation system that produces an initial
draft of financing documents after completing a TurboTax-style online questionnaire.
Attorneys still need to review and further customize the drafts, but this document automation
system allows attorneys to circulate initial drafts of documents quickly and reduce time in
marking up form documents. WSGR also has an automated system to create the various
documents involved in an incorporation of a typical Delaware company.

Entrepreneurs should not read the NVCA documents and conclude that the default
provisions represent a “middle of the road” outcome between the company and investors.
There is an “East Coast” bias in the documents, which means the documents are more
investor favorable than “West Coast” market practice. Given that California alone represents
over 40% of venture capital financing transactions in the United States, I don’t think that
these documents accurately reflect what is customary in financings. In addition, there are
some technical issues with the documents that need to be addressed.

What is preferred stock and why is it issued to investors?

Preferred stock generally has rights senior to common stock. Startup companies typically
issue common stock to founders (and options to purchase common stock to employees) and
preferred stock to investors. One reason for issuing preferred stock to investors is to
preserve the ability of a company to issue options to purchase common stock at an exercise
price at a significant discount from the preferred stock price. Before accounting and tax rules

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became more stringent on the valuation of common stock, companies generally used to
value their preferred stock as ten times more valuable than common stock until the 12 to 18
month period before an IPO. In other words, if Series A preferred stock was sold for
$1.00/share, an option to purchase common stock would have an exercise price of $0.10.

If a company issued common stock to investors, then the exercise price of options to
purchase common stock would generally need to be the same price as the price to investors.
In this scenario, employees may not believe that they are receiving the benefit of “sweat
equity.” However, there are some companies, such as broadcast.com, co-founded by Mark
Cuban, that completed all of their pre-IPO financings by selling common stock.

Another reason that investors purchase preferred stock is to receive rights, preferences and
privileges senior to common stock. The most important economic right of preferred stock is
the liquidation preference, or the ability to recover the investment (and more) upon a
liquidation or sale of the company. Other important rights of the preferred stock include
voting provisions and anti-dilution protection. I will cover these and other rights in future
posts.

How do you calculate Series A price per share?

The formula is:

[Series A price per share] = [valuation] / [fully-diluted pre-money shares]

Obviously, there are two ways to affect the Series A price per share (and the resulting
dilution to pre-Series A stockholders): (1) change the valuation, or (2) change the number of
fully-diluted pre-money shares. Arguing for a change in valuation is probably
difficult. However, arguing for a different number of fully-diluted pre-money shares might be
an easier way to affect the Series A price per share.

Fully-diluted pre-money shares typically includes (1) all outstanding common stock, (2) all
outstanding preferred stock (if any, on a converted to common basis), (3) outstanding
warrants, (4) outstanding options, (5) options reserved for future grant, and (6) any other
convertible securities on an as converted to common basis.

Decreasing the size of the option pool is one way to increase the Series A price per
share. Series A investors want to make sure that there is a sufficient option pool for future
hires, and that the dilution for the option pool is borne by pre-Series A stockholders. A
company may argue that the size of the option pool does not need to be as large as
requested by the Series A investors. Generally, the option pool needs to be large enough to
hire necessary people through the next round of financing (or a time period such as 12 to 18

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months if the company does not anticipate another round of financing). Please read the
Venture Hacks article on the Option Pool Shuffle for more explanation.

In addition, there are some plausible arguments that shares issued upon conversion of a
convertible note or warrants issued in connection with the convertible note prior to a Series A
financing should not be counted in full-diluted pre-money shares. Please read the
comments to the Option Pool Shuffle article for more details.

Can you have multiple closings in a Series A financing?

Of course. Depending on the situation, additional closings can continue to be held for up to a
fixed period of time (such as 30, 60, 90 or 120 days) after the first closing. The company
may want the flexibility to hold additional closings at any time at the discretion of the board of
directors. The investors in the first closing may require that the timing and identity of
investors in an additional closing be approved by a majority (or super-majority) of investors
in the first closing. If the investors in the first closing are represented on the board of
directors, then one middle ground is that additional closings be unanimously approved by the
board of directors. The issue on additional closings is whether it is fair for investors in a later
closing to purchase at the same price as the investors in the first closing because the value
of the company arguably should increase over time.

What is a dividend preference?

I have never encountered a private venture-backed startup company that paid a dividend,
except in connection with a spinoff or other distribution to stockholders that might trigger the
dividend preference of preferred stock. Most startup companies do not generate enough
cash to pay dividends and investors typically do not expect actual dividend payments.

Dividends are typically only paid when and if declared by the board. If a company pays
dividends, then holders of preferred stock receive dividends before dividends are paid to
holders of common stock. Typically, dividend rates range from 7% to 12%, varying
somewhat to match interest rates. If dividends are only paid at the discretion of the board,
then this percentage is not very meaningful.

In some financings, the investors may require that dividends accrue and cumulate whether
or not declared by the board. Cumulative dividends are more prevalent in East Coast
venture financings than West Coast venture financings. According to WSGR data, non-
cumulative dividends are much more common than cumulative dividends.

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If dividends cumulate, companies will want all previously accrued but unpaid dividends to be
waived upon the automatic conversion of the preferred stock. In contrast, investors will want
the unpaid dividends to be paid or to be converted into common stock upon conversion or
liquidation.

Companies should be wary of dividends that cumulate because the effect on total returns
can be significant in the case of investments that remain outstanding for several years. If
dividends cumulate, unpaid accumulations will be added to the liquidation preference and
may be added to the redemption price, if applicable. In addition, companies should realize
that cumulative dividends are liabilities that generally appear on the company’s balance
sheet, which may lower the company’s ability to borrow and affect solvency analysis.

What is a liquidation preference?

The most important economic provision in a venture financing other than valuation is
probably the liquidation preference. One of the basic features of preferred stock is providing
for an ordering of returns to different classes and series of stockholders upon significant
company events. The liquidation preference provision is the principal mechanism to allow
preferred stock to receive a priority return upon these events.

The triggering events for a liquidation preference payment typically include both a winding up
of the company (e.g. a true liquidation) and a sale of the company through a merger, stock
sale, sale of assets or other acquisition of the company (also known as a “deemed
liquidation”). The liquidation preference is meaningless if the company goes public, as the
preferred stock issued to investors converts to common stock and the liquidation preference
goes away.

The structuring of liquidation preferences is critical and is not always fully appreciated by
companies and founders as they set a precedent for future financing rounds, which have
significant economic effects. The elements of the preferences can be varied to create
different incentives and returns. The key variables are: (1) the amount of the initial
preference to be paid to preferred stockholders, (2) the priority of payments among different
classes (preferred versus common) and series (series A versus series B) of stock and
(3) the extent, if any, of participation of the preferred stock with the common stockholders in
the distribution of the remaining assets.

The liquidation preference is one of the features of preferred stock that companies can point
to as a means of justifying the grant of stock options with a “fair market value” exercise price
that is lower than the purchase price for the preferred shares in the latest round of financing.
The liquidation preference justifies a high price for the preferred stock, such as $1.00/share,
while maintaining a low common stock fair market value, such as $0.10/share. This is good
for the company as employees view the discount as immediate “paper” profit.

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What is the amount of a typical liquidation preference?

The amount of the liquidation preference is a function of the risk of the investment. In typical
venture financings, the amount of the liquidation preference is the amount invested by the
investors. In other words, if the Series A was issued for $1.00/share, a holder of one share
of Series A receives $1.00 prior to any distributions to holders of common stock. This is
referred to as a 1x preference. During the 2001 to 2003 time period, liquidation preferences
of multiples greater than the purchase price (expressed as 2x, 3x, etc.) were not
unusual. Liquidation preferences of greater than 1x may be negotiated when a company
has had difficultly raising funds.

Aggressive liquidation preferences can wipe out the interests of holders of common stock
absent a “home run.” If a company raises a lot of money with liquidation preferences greater
than 1x, then the amount that the company must be sold for in order for the holders of
common stock to receive a return may be quite high. This is sometimes not fully understood
by founders and management.

What is the difference between non-participating preferred stock and participating

preferred stock?

There are two basic types of liquidation preferences: “non-participating” and “participating.”

“Non-participating” preferred typically receives an amount equal to the initial investment plus
accrued and unpaid dividends upon a liquidation event. Holders of common stock then
receive the remaining assets. If holders of common stock would receive more per share
than holders of preferred stock upon a sale or liquidation (typically where the company is
being sold at a high valuation), then holders of preferred stock should convert their shares
into common stock and give up their preference in exchange for the right to share pro rata in
the total liquidation proceeds. Non-participating preferred stock is favored by holders of
common stock (i.e. founders, management and employees) because the liquidation
preference will become meaningless after a certain transaction value.

Please note that each series of preferred stock may be economically incentivized to convert
to common stock at different transaction values due to different preference amounts per
share for the different series. This necessitates creating complex spreadsheets to model
what happens upon a sale of company at different transaction values. The most
sophisticated spreadsheets will also take into account whether options and warrants are in
the money at certain transaction values, which will affect whether or not they are exercised,
which will then affect the price per share. These circular formulas are best left to CFOs with
strong math skills or attorneys that deal with these spreadsheets all the time.

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“Participating” preferred also typically receives an amount equal to the initial investment plus
accrued and unpaid dividends upon a liquidation event. However, participating preferred
then participates on an “as converted to common stock” basis with the common stock in the
distribution of the remaining assets.

Participating preferred stock is favored by investors because they will receive a preferential
return over both low and high exit transaction values. An argument in favor of participating
preferred stock is that if a company is sold shortly after the investment, the founders may
receive a significant return on their investment (since they have typically paid a much lower
price than holders of preferred stock) while the holders of preferred stock may receive little
or no return on their investment, particularly where the liquidation preference is 1x. A
counter-argument is that if a company is sold for a high price, the holders of preferred stock
have no incentive to convert their shares into common stock and, as a result, are able to
“double-dip” into the proceeds by receiving both the preference amount and the participation
proceeds. Thus, one compromise is a participating preferred with a cap, which will be
covered in the next post.

What is a cap on a participating preferred liquidation preference?

A cap on participation limits the amount received by the preferred stock to a fixed amount.
The cap is typically fixed as a multiple of the original investment, such as 2x or 3x. Once
holders of preferred stock have received the cap amount, they will stop participating in
distributions with the common stock. Thereafter, holders of common stock receive all
proceeds until holders of common stock have received the same amount per share as the
preferred. After that transaction value, holders of preferred stock will be economically
incentivized to convert to common stock in order to receive maximum value. Unfortunately,
this math is not particularly easy to understand.

Imposing a cap on participation allows the holders of preferred stock to receive a return on
their investment without having to convert their holdings to common stock, but leaves the
incentive to convert in place where the sale or liquidation occurs at a high valuation.

What is the priority of the liquidation preference when the Series B financing occurs?

In a Series A financing, the priority of the liquidation preference vis a vis other series of
preferred is not relevant because there are no other series of preferred stock. However, in a
Series B financing, the new investors may request that their liquidation preference be senior
to the Series A. In other words, the Series B gets paid before the Series A. The Series A
investors may argue that the priority of the Series B liquidation preference should be the
same, or “pari passu,” with the Series A. Founders and companies should be very careful
when negotiating liquidation preferences (and any term) at the Series A stage. When the
Series B financing occurs, the Series B will demand at least the same level and priority of
rights as the Series A. Although a 2x preference may not seem that onerous while raising

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$2 million of Series A, a 2x preference on $20 million will significantly affect the holders of
common stock.

Why do preferred stockholders have odd economic incentives upon a sale of

company when they have non-participating preferred stock or particpating preferred
stock with a cap?

Even savvy investors often don’t understand the subtle nuances on economic incentives that
result from non-participating preferred stock or participating preferred stock with a cap in the
event of a sale of company.

Assume a simple cap table of:

10,000,000 shares of common stock

10,000,000 shares of Series A preferred stock

Also assume that the Series A preferred stock has a $1.00/share liquidation preference and
is non-participating.

If the company is sold for between zero and $10M, then all of the merger consideration
would go to the holders of Series A.

If the company is sold for $10M to $20M, the holders of Series A would still receive
$1.00/share as a rational Series A holder would never convert his/her shares to common as
the Series A holder would receive more from the Series A liquidation preference than as a
holder of common. For example, if the merger consideration is $15M, then the Series A
would receive $1.00/share and the common would receive $0.50/share. Thus, the holders of
Series A are indifferent between sale prices from $10M to $20M, which may lead to odd
economic incentives. Hypothetically, a venture capital fund holder of Series A might not
want a company to argue hard over merger valuation with an acquiror if there is no marginal
benefit to the fund and there is a risk that the deal may fall apart.

If the company is sold for over $20M, the holders of Series A would convert to common
(assuming that they are economically rational). For example, if the merger consideration is
$30M, then the common would receive $1.50/share (assuming all Series A converted). Of
course, if some holders of Series A did not act in their optimal economic interest and
convert, then the merger proceeds available to the common would increase and the
common would receive greater than $1.50/share.

Similarly, if the Series A is participating with a cap, there will be a range of merger
consideration values where the holders of Series A will be indifferent because the cap has
been met, but it still does not make economic sense for the Series A to convert.

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In the same example, assume that the Series A has a $1.00/share liquidation preference
and is participating with a 3X cap.

Like the non-participating preferred, if the company is sold for between zero and $10M, then
all of the merger consideration would go to the holders of Series A.

For merger consideration greater than $10M but less than $50M, the Series A participates
with the common on the amount over $10M. For example, if the merger consideration is
$20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which
represents the $10M liquidation preference and $5M of participation with the common), and
the holders of common would receive $0.50/share, or an aggregate of $5M.

If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an

aggregate of $30M (which represents the $10M liquidation preference and $20M of
participation with the common), and the holders of common would receive $2.00/share, or an
aggregate of $20M. At $50M, the Series A hits the 3x cap on participation by receiving
$3.00/share.

If the company is sold for $50M to $60M, the holders of Series A would still receive
$3.00/share as a rational Series A holder would never convert his/her shares to common as
the Series A holder would receive more from the Series A liquidation preference than as a
holder of common. For example, if the merger consideration is $55M, then the Series A
would receive $3.00/share and the common would receive $2.50/share. Thus, the holders of
Series A are indifferent between sale prices from $50M to $60M, which may lead to the
same odd economic incentives as the non-participating preferred stock, albeit at higher
transaction values.

If the company is sold for over $60M, the holders of Series A would convert to common
(assuming that they are economically rational). For example, if the merger consideration is
$60M, then the common would receive $3.00/share (assuming all Series A converted).

Please see the liquidation preference spreadsheet and program some examples if you want
to proof this yourself.

What are redemption rights?

A redemption right is the right of the investors to force a company to repurchase their
shares. According to the WSGR survey of private company financing trends from 2005
through Q1 2007, redemption rights were included in about one third of venture financings.
As a practical matter, redemption rights, like demand registration rights, are almost never
exercised. If the company is doing so poorly that the investors want their money back, there
probably isn’t any money left to redeem the shares. However, the threat of redemption is
probably helpful to provide investors with leverage against “walking dead” portfolio

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companies that generate enough revenue to stay alive in a niche market, but haven’t grown
enough to be interesting M&A or IPO candidate.

Due to restrictions under Delaware (and other state corporate law), a company might not be
legally permitted to redeem shares. In this case, investors may request that certain penalty
provisions take effect where redemption has been requested but the company’s does not
have enough funds to permit redemption or redemption would leave the company legally
insolvent. These penalty provisions may include the redemption amount being paid via a
promissory note and/or the investors being allowed to elect a majority of the board of
directors until the redemption price is paid in full.

The principal variables in the redemption right are when the right is triggered and the
redemption price. Most redemption rights are set so they cannot be triggered until at least 5
years after the Series A financing. This is because a company needs a sufficient amount of
time to achieve results, while a venture fund needs to be able to liquidate an investment at
the end of life a fund. The redemption price is typically the original purchase price plus
accrued but unpaid dividends. In “East Coast” investor-friendly deals, the investors may try
to add cumulative dividends to the redemption price, which essentially gives the investor a
guaranteed 8%+ rate of return, assuming of course, that there is cash available for
redemption. The redemption may be triggered by a majority or super-majority vote of
investors. Some investors may be allowed to opt out of the redemption or the redemption
provision may require all shares to be redeemed. The redemption may occur in multiple
installments over one to three years.

Why is preferred stock convertible into common stock?

Many of the provisions in a typical venture financing are designed with an IPO or an M&A
event in mind. For example, piggyback and S-3 registration rights (to be described in a later
post) are designed to ensure liquidity for an investor after an IPO. A liquidation preference is
designed to dictate the order of payment of proceeds in a merger. It would be difficult for an
investment bank to market an IPO of common stock of a company where there still was
preferred stock outstanding. Therefore, venture capital preferred stock is designed to convert
upon an IPO. In certain states, such as California, amending the articles of incorporation or
sale of the company require a majority vote of each class of stock, which means common as
a class and preferred as a class. In some cases, the preferred stock may want to convert
into common stock in order to outvote the common stock. While there are plenty of examples
of preferred stock that have debt-like characteristics and are not convertible to common
stock, they are not used in venture financings.

When should preferred stock be automatically converted into common stock?

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Preferred stock should automatically convert upon a majority (or super-majority) vote of the
preferred stock or upon an IPO.

Preferred stock will typically convert to common stock with the consent of a majority of the
preferred stock. In some financings, the threshold will be raised to 2/3 or higher in order
ensure that there is sufficient consensus for conversion. When preferred stock converts into
common stock, all of the rights of the preferred stock contained in the certificate of
incorporation (such as liquidation preference, protective voting rights, anti-dilution protection)
disappear.

Investors in different series of preferred stock may have different economic interests in
converting in connection with a merger. For example, with a non-participating preferred
stock, the Series A may determine that it is economically beneficial to convert even at a low
transaction value because they will receive more merger proceeds as a common stockholder
rather than keeping the liquidation preference of the Series A. At the same time, the Series B
may determine that it is economically beneficial not to convert until a higher transaction
value because the liquidation preference is greater than the merger proceeds to the common
stockholders. In that case, having all of the preferred stock convert (and lose their liquidation
preference) upon a majority vote of all preferred would result in a less than optimal economic
outcome for the Series B. Therefore, some investors will insist that the trigger for conversion
is by a series vote, instead of a vote of all preferred.

Typically, there are a couple of thresholds that need to be met for the preferred stock to
convert in an IPO: amount raised and price per share. The amount raised is generally set
high enough (such as $25 million or more) in order to ensure that the IPO is a legitimate
IPO. The investors want to protect themselves against the preferred stock converting in an
IPO on a minor stock market raising very little money because there will likely not be a liquid
market for the stock. Thus, the defined term in the documents is typically “Qualified IPO.”

The price per share trigger is typically set at three to five times the per share investment
price. In a Series A financing, the per share trigger is typically 5x. In a later stage financing,
the trigger is typically 3x or lower. This is because the valuation of an early stage company in
as Series A financing may be under $10 million, and 5x would only be $50 million, which
would still be well short of the $250 million or $300 million market capitalization that a
company would need for a legitimate Nasdaq IPO. In a later stage financing with a $100
million valuation, the per share trigger could be set a 2x or 3x, in order to ensure that the
valuation in the IPO is $200 million or $300 million. If the amount raised or per share
threshold is not met, then a company would need to rely upon a majority or super-majority
vote of the preferred (or by series) to convert.

What is anti-dilution protection?

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Almost all venture financings have some form of anti-dilution protection for investors. In the
context of a venture financing, anti-dilution protection refers to protection from dilution when
shares of stock of stock are sold at a price per share less than the price paid by earlier
investors. This is known as price-based anti-dilution protection. Anti-dilution protection, along
with the liquidation preference, are two of the fundamental features distinguishing preferred
stock typically sold to investors from common stock generally held by founders and
employees.

Preferred stock is normally convertible at the option of the holder at any time into common
stock, usually on a share for share basis, and is typically automatically converted upon the
occurrence of a qualified initial public offering. Price-based anti-dilution adjustments involve
increasing the number of shares of common stock into which each share of preferred stock
is convertible. In addition, an anti-dilution adjustment will affect the voting rights of the
company’s stockholders because the preferred stockholder is almost always entitled to vote
on an as-converted to common-stock basis. The primary difference between the various
anti-dilution formulas to be described in upcoming posts is the magnitude of the adjustment
under different circumstances.

Although an investor may be diluted in the sense that it may own a smaller percentage of the
company following any new stock issuance, the value of the portion of the company owned
by such investor has theoretically increased due to the increase in the total company
valuation due to the higher price per share paid by the new investor. Occasionally, absolute
anti-dilution protection is requested by investors (or executives) against any dilution arising
as a result of the subsequent sale of stock, which basically guarantees a certain percentage
ownership of the company for a specified time period or until the occurrence of a certain
event, such as a initial public offering. However, these provisions may impair the company’s
ability to raise financing.

The other type of anti-dilution protection that preferred stock investors always obtain is
structural anti-dilution protection. This is an adjustment of the conversion price of their
preferred stock into common stock upon the occurrence of any subdivisions or combinations
of common stock, stock dividends and other distributions, reorganizations, reclassifications
or similar events affecting the common stock. For example, in a stock split, an investor will
expect a provision to the effect that, to the extent the common stock is subdivided by a stock
split into a greater number of shares of common stock, the conversion price of each series of
preferred stock then in effect shall, concurrently with the effectiveness of such subdivision,
be proportionally decreased. This type of anti-dilution protection ensures that the investor
holding preferred stock is treated as if such investor held common stock without the need to
actually convert into common stock and lose the features associated with the preferred stock
held by such investor.

[Note: this post and others on anti-dilution are based on (and complete sections of text
copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike
O’Donnell and Anton Commissaris.]

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What is weighted average anti-dilution protection?

The most common anti-dilution protection is called “weighted average” anti-dilution

protection. This formula adjusts the rate at which preferred stock converts into common
stock based upon (i) the amount of money previously raised by the company and the price
per share at which it was raised and (ii) the amount of money being raised by the company
in the subsequent dilutive financing and the price per share at which such new money is
being raised. This weighted average price (which will always be lower than the original
purchase price following a dilutive financing) is then divided into the original purchase price
in order to determine the number of shares of common stock into which each share of
preferred stock is then convertible, which will be greater than one. Thus, a new reduced
conversion price for the preferred stock is obtained, which results in an increased conversion
rate for the preferred stock when converting to common stock.

If new stock is issued at a price per share lower than the conversion price then in effect for a
particular series of preferred stock, the conversion price of such series will be reduced to a
price determined by multiplying the conversion price by the following fraction:

[Common Outstanding pre-deal] + [Common issuable for amount raised at old conversion
price]

[Common Outstanding pre-deal] + [Common issued in deal]

There are two primary variations of the weighted average formula depending on what
constitutes “Common Outstanding” in the above formula. The first, and more common, is
referred to as “broad-based weighted average” while the second is referred to as “narrow-
based weighted average.”

Broad-based weighted average formula

The calculation of “Common Outstanding” in the broad-based formula includes all shares of
common stock and preferred stock (on an as-converted to common basis) outstanding,
common issuable upon exercise of outstanding options, common reserved for future
issuance under the company’s stock option plan and any other outstanding convertible
securities, such as warrants.

Below is an example of how broad-based anti-dilution protection works.

Assume that the pre-financing capitalization of the company is:

1,500,000 Common Stock

2,500,000 Series A Preferred Stock (issued at $1/share)

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2,000,000 Series B Preferred Stock (issued at $2/share)

1,000,000 Options

7,000,000 Total

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series
C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

Series A adjustment

The Series A Conversion Price will be adjusted as follows:

Series A Conversion Price = $1.00 multiplied by

[Common outstanding prior to deal] + [Common issuable for amount raised at old conversion
price]

[Common outstanding prior to deal] + [Common issued in deal]

= 7,000,000 + 1,000,000

7,000,000 + 2,000,000

= $1.00 * (8/9) = $0.88

Thus, the number of shares of common issuable upon conversion of Series A is:

(2,500,000) x ($1.00 / 0.88) = 2,812,500

This results in a Series A Conversion Rate of 1.125:1

Series B adjustment

The Series B Conversion Price will be adjusted as follows:

Series B Conversion Price = $2.00 multiplied by

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[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion
price]

[Common outstanding pre-deal] + [Common issued in deal]

= 7,000,000 + 500,000

7,000,000 + 2,000,000

= $2.00 * (7.5 / 9) = $1.67

Thus, the number of shares of common issuable upon conversion of Series B is:

(2,000,000) x ($2.00 / $1.67) = 2,400,000

This results in a Series B Conversion Rate of 1.20:1

Narrow-based weighted average formula

The narrow-based formula only includes the common stock issuable upon conversion of the
particular series of shares of preferred stock in “Common Outstanding” in the formula. The
narrow-based formula can be stated as follows:

Common Outstanding = Only the number of shares of the series of Preferred that is being
adjusted.

Another version of the narrow-based formula would include the common stock issuable upon
conversion of all shares of preferred stock outstanding in the Common Outstanding.

The effect of including the additional shares in the broad-based formula reduces the
magnitude of the anti-dilution adjustment given to holders of preferred stock as compared to
the narrow-based formula. The narrow-based formula provides a greater number of
additional shares of common stock to be issued to the holders of preferred stock upon
conversion than the broad-based formula. The extent of the difference depends upon the
size and relative pricing of the dilutive financing as well as the number of shares of preferred
stock and common stock outstanding.

Using the same example, the narrow-based formula works as follows:

(Common Outstanding = Common issuable upon conversion of particular series of preferred

stock)

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Series A adjustment

The Series A Conversion Price will be adjusted as follows:

Conversion Price of Series A = $1.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion
price]

[Common outstanding pre-deal] + [Common issued in deal]

= 2,500,000 + 1,000,000

2,500,000 + 2,000,000

= $1.00 * (3.5/4.5) = $0.77

Thus, the number of shares of common stock issuable upon conversation of Series A
Preferred Stock =

(2,500,000) x ($1.00/$0.77) = 3,214,285

This results in a Series A Conversion Rate of 1.29:1

Series B adjustment

The Series B Conversion Price will be adjusted as follows:

Conversion Price of Series B Preferred Stock = $2.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion
price]

[Common outstanding pre-deal] + [Common issued in deal]

= 2,000,000 + 500,000

2,000,000 + 2,000,000

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= $2.00 * (2.5 / 4.0) = $1.25

Thus, the number of shares of common stock issuable upon conversation of Series B
Preferred Stock =

(2,000,000) x ($2.00/$1.25) = 3,200,000

This results in a Series B Conversion Rate of 1.6:1

Variations on weighted average formula

There are variations on both the traditional broad-based and narrow-based weighted
average formulas. Among such variations is what might conveniently be called the “middle”
formula. The difference depends on what constitutes “Common Outstanding.” The middle
formula can be written as follows:

Common Outstanding = only common stock and preferred stock (on an as-converted
to common basis) outstanding (in other words, don’t include common issuable upon
conversion/exercise of debt, options and warrants).

Another company favorable variation of the weighted average formula that I have never seen
in practice involves upward and downward conversion price adjustments if shares are issued
at prices both greater and lesser than the applicable conversion price, although the
conversion price will never be greater than the original purchase price of the preferred stock.

Once again, this proves that startup company lawyers need strong math skills. If someone
spots something wrong with the math, please let me know.

[Note: this post and others on anti-dilution are based on (and complete sections of text
copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike
O’Donnell and Anton Commissaris.]

What is full ratchet anti-dilution protection?

Full ratchet anti-dilution protection is conceptually much simpler than the weighted average
approach, and its effect on the company is considerably more severe in the event of a
dilutive financing. Under the full ratchet formula, the conversion price of the preferred stock
outstanding prior to such financing is reduced to a price equal to the price per share paid in
the dilutive financing.

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For example, if the outstanding preferred stock was previously sold at a price of $1.00 per
share, and the new preferred stock in the dilutive financing is sold at a price of $0.50 per
share, the effective price of the previously outstanding preferred stock would be reduced to
$0.50 per share with the result that each share of such preferred stock previously convertible
into one share of common stock would now be convertible into two shares of common stock.

Under the full ratchet formula, this same result is obtained whether the company raises
$100,000 at a price of $0.50 per share or raises $10,000,000 at a price of $0.50 per share.
In contrast, the amount of money raised in the dilutive financing is an important factor in
determining the new conversion price in the weighted average formula.

Below is an example of how full-ratchet anti-dilution protection works.

Assume that the pre-financing capitalization of the company is (same as example

for weighted average anti-dilution protection):

1,500,000 Common Stock

2,500,000 Series A Preferred Stock (issued at $1/share)

2,000,000 Series B Preferred Stock (issued at $2/share)

1,000,000 Options

7,000,000 Total

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series
C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

Series A adjustment

The Conversion Price of Series A Preferred Stock becomes $0.50.

Thus, the number of shares of common stock issuable upon conversion of Series A
Preferred Stock =

(2,500,000) * ($1.00/$0.50) = 5,000,000

This results in a Series A Conversion Rate of 2:1

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Series B adjustment

The Conversion Price of the Series B becomes $0.50.

Thus, the number of shares of common stock issuable upon conversion of Series B
Preferred Stock =

(2,000,000) * ($2.00/$0.50) = 8,000,000

This results in a Series B Conversion Rate of 4:1

Problems with the full ratchet

At first glance, the full ratchet formula seems very attractive for investors as it completely
protects their investment from any subsequent price erosion until the occurrence of a
liquidity event (at which time the preferred stock would normally be converted to common
stock). The company should argue that it is unfair to have the company bear all the
downside price risk where there is no limit on the upside potential for the investors.

However, a full ratchet formula can also be problematic for the investors in a
syndicate. Because the prior money invested is fully protected with regard to price
decreases, if the company’s prospects deteriorate and the company is forced to undertake a
dilutive financing, there is no incentive for all of the investors to participate in the new dilutive
round. Therefore, the lead investor(s) may have difficultly inducing the smaller investors in
the syndicate to continue to participate, and the burden of continuing to fund the company
can fall heavily on the lead investor(s). In addition, the application of the full ratchet will be
disclosed to the incoming invstors in the new round upon review of the company’s charter
documents in the due diligence process. This will make the company appear significantly
less attractive to invest in and will exacerbate the problems of an otherwise already difficult
financing. Because the number of pre-financing shares outstanding increases due to the
anti-dilution adjustment, the price per share of the new series of preferred stock will
decrease. This results in a circular formula, that requires strong spreadsheet skills to solve.

In addition, as a result of the anti-dilution protection for the preferred stock, the percentage
ownership of the common stock will decrease, which decreases the incentive of
management and employees.

What are carveouts to anti-dilution protection?

A company will want to ensure that certain types of stock issuances do not trigger anti-
dilution protection. This is especially true with full-ratchet anti-dilution protection because the

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issuance of even 1 share at a price lower than a series of preferred stock will result in an
adjustment of the conversion price of all shares of that series of preferred stock.

A list of company-favorable carveouts to anti-dilution protection from a term sheet may

include:

There will be no adjustment to the conversion price for issuances of (i) shares issued upon
conversion of the Preferred; (ii) shares or options, warrants or other rights issued to
employees, consultants or directors in accordance with plans, agreements or similar
arrangements, but not to exceed a total of [__________] shares issued after the closing date
[or such greater number as unanimously approved by the board]; (iii) shares issued upon
exercise of options, warrants or convertible securities existing on the closing date;
(iv) shares issued as a dividend or distribution on Preferred or for which adjustment is
otherwise made pursuant to the certificate of incorporation (e.g., stock splits); (v) shares
issued in connection with a registered public offering; (vi) shares issued or issuable pursuant
to an acquisition of another corporation or a joint venture agreement approved by the board;
(vii) shares issued or issuable to banks, equipment lessors or other financial institutions
pursuant to debt financing or commercial transactions approved by the board; (viii) shares
issued or issuable in connection with any settlement approved by the board; (ix) shares
issued or issuable in connection with sponsored research, collaboration, technology license,
development, OEM, marketing or other similar arrangements or strategic partnerships
approved by the board; (x) shares issued to suppliers of goods or services in connection with
the provision of goods or services pursuant to transactions approved by the board; or
(xi) shares that are otherwise excluded by consent of holders of a majority of the Preferred.

Investors and the company will argue about the scope of the carveouts and potentially the
number of shares in any given careveout. In order for some of the carveouts to apply, the
investors may require that the issuance of stock be unanimously approved by the board or
approved by the directors nominated by the preferred stock.

A company generally wants flexibility in the carveouts to avoid anti-dilution protection being
triggered and bothersome amendments to the certificate of incorporation to waive anti-
dilution adjustments. Although an anti-dilution adjustment may be waived by a specific
shareholder, I’m not sure the waiver would be valid against a subsequent holder of the
shares that did not know about the waiver. Therefore, a properly drafted certificate of
incorporation should allow for the waiver of an anti-dilution adjustment upon a certain vote of
the preferred stock or applicable series of preferred stock, without the need to amend the
certificate of incorporation.

What are protective provisions?

Protective provisions give the preferred stock or a series of preferred stock the ability to
block certain company actions.

Typical preferred stock protective provisions

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Typical preferred stock protective provisions from a term sheet may include:

So long as [any] of the Preferred is outstanding, consent of the holders of at least [50]% of
the Preferred will be required for any action that (i) alters any provision of the certificate of
incorporation [or the bylaws] if it would [adversely] alter the rights, preferences, privileges or
powers of or restrictions on the preferred stock or any series of preferred; (ii) changes the
authorized number of shares of preferred stock or any series of preferred; (iii) authorizes or
creates any new class or series of shares having rights, preferences or privileges with
respect to dividends or liquidation senior to or on a parity with the Preferred or having voting
rights other than those granted to the preferred stock generally; (iv) approves any merger,
sale of assets or other corporate reorganization or acquisition; (v) approves the purchase,
redemption or other acquisition of any common stock of the Company, other than
repurchases pursuant to stock restriction agreements approved by the board upon
termination of a consultant, director or employee; (vi) declares or pays any dividend or
distribution with respect to the [preferred stock (except as otherwise provided in the
certificate of incorporation) or] common stock; [or] (vii) approves the liquidation or dissolution
of the Company[; (viii)increases the size of the board;] [(ix) encumbers or grants a security
interest in all or substantially all of the assets of the Company in connection with an
indebtedness of the Company;] [(x) acquires a material amount of assets through a merger
or purchase of all or substantially all of the assets or capital stock of another entity;] [or
(xi) increases the number of shares authorized for issuance under any existing stock or
option plan or creates any new stock or option plan].

These protective provisions are typically contained in the certificate of incorporation of a

Delaware company. I think provisions (i) through (vii) are fairly standard (although I think
some of the provisions in brackets are not necessarily standard). I think that provisions (viii)
to (xi), along with anything not listed above, are investor favorable and not as typical in West
Coast venture financings. However, all of these provisions are subject to discussion
depending on the negotiation strength of the parties.

Minimum threshold to maintain protective provisions

The company should argue for a minimum number of outstanding shares of preferred stock
to maintain protective provision. For example, if only one share of preferred stock remains
outstanding as a result of redemptions or optional conversions to common stock, the holder
of the one share should not have the ability to block certain company actions. However,
many protective provisions say that they are effective as long as “any” shares are
outstanding.

Voting threshold for protective provisions

The necessary vote to bypass the protective provision is typically set at 50%. In many
cases, the percentage is set higher, such as 66 2/3%, because the investor group consists
of multiple investors, and a fund or group of funds that holds a significant amount of the

20
preferred want to ensure that a sufficient percentage of preferred shareholders favor the
action.

“Series” protective provisions

Upon a Series B or later financing, the later round may request a separate protective
provision. The company generally would prefer that the preferred stock have a
single protective provision as a group, rather than each series of preferred stock having its
own protective provision. A separate protective provision may make sense in a later round
of financing where the investor is also receiving a senior (as opposed to pari passu)
liquidation preference. However, the company and investors will want to ensure that a
series of preferred stock that represents a small percentage interest of the company or
represents a small dollar amount of investment does not receive a separate protective
provision.

Board level protective provisions

In some cases, investors request additional board level protective provisions. The board
level protective provisions from the sample investor-favorable NVCA term sheet are:

[So long as [__]% of the originally issued Series A Preferred remains outstanding] the
Company will not, without Board approval, which approval must include the affirmative vote
of [____] of the Series A Director(s): (i) make any loan or advance to, or own any stock or
other securities of, any subsidiary or other corporation, partnership, or other entity unless it is
wholly owned by the Company; (ii) make any loan or advance to any person, including, any
employee or director, except advances and similar expenditures in the ordinary course of
business or under the terms of a employee stock or option plan approved by the Board of
Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any
subsidiary arising in the ordinary course of business; (iv) make any investment other than
investments in prime commercial paper, money market funds, certificates of deposit in any
United States bank having a net worth in excess of $100,000,000 or obligations issued or
guaranteed by the United States of America, in each case having a maturity not in excess of
[two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already
included in a Board-approved budget, other than trade credit incurred in the ordinary course
of business; (vi) enter into or be a party to any transaction with any director, officer or
employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under
the Exchange Act) of any such person [except transactions resulting in payments to or by
the Company in an amount less than $[60,000] per year], [or transactions made in the
ordinary course of business and pursuant to reasonable requirements of the Company’s
business and upon fair and reasonable terms that are approved by a majority of the Board of
Directors]; (vii) hire, fire, or change the compensation of the executive officers, including
approving any option plans; (viii) change the principal business of the Company, enter new
lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or
encumber technology or intellectual property, other than licenses granted in the ordinary
course of business.

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These provisions are not common in West Coast venture financings, but are more common
in East Coast venture financings, and standard in venture financings for Cayman
incorporated Chinese companies. As a practical matter, almost all of these provisions will
require board approval anyway for good corporate governance. The issue is whether the
Series A director(s) should have the ability to veto these actions despite majority board
approval. This type of control might be reasonable in the context of a joint venture, but may
not be reasonable when the Series A director only represents a small fraction of the
outstanding shares.

Board level protective provisions are usually placed in the investor rights agreement or
document other than the certificate of incorporation. If these provisions were placed in the
articles of incorporation of a California company, the California Secretary of State would
reject the articles on the theory that this gives the Series A director more power than other
directors.

Drafting issues

Investors wanting protection through protective provisions must make sure that the
provisions are drafted carefully and clearly. In the WatchMark (2004) and Benchmark (2002)
cases in Delaware, the certificates of incorporation clearly required the consent of the
opposing stockholders to amend their terms as contemplated by a proposed financing.
However, the same approval was not necessary for an amendment effected through a
merger (with a subsidiary). Thus, the companies were allowed to achieve a result indirectly
that was otherwise prohibited under the protective provisions. To avoid this result,
the certificates of incorporation should have specifically prohibited changes to preferred
stock terms “whether effected, directly or indirectly, by means of an amendment, merger,
consolidation or otherwise.”

All rights in preferred stock provisions, even if considered standard or customary, must be
“expressly and clearly stated.” Courts in Delaware will not imply or presume meaning or
language from other provisions of the charter.

In addition, most certificates of incorporation contain a “no impairment” clause. These

clauses are provisions that generally prohibit a company from seeking to avoid or impair the
rights of the preferred stock. The WatchMark court held that no impairment clauses, like
other preferred stock provisions, will be interpreted very strictly. A generic “no-impairment”
clause will not provide the preferred stock with any particular protection beyond what is
specifically provided in the certificate of incorporation.

What are information rights?

Information rights force a company to provide investors with financial statements and other
company information. These rights are typically contained in an Investor Rights Agreement.

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A typical information rights provision from a term sheet provides:

The Company will deliver to each holder of at least [500,000] shares of Preferred,
(i) [un]audited annual financial statements within [90] days following year-end, (ii) unaudited
quarterly financial statements within [45] days following quarter-end, (iii) unaudited monthly
financial statements within [30] days of month-end, and (iv) annual business plans. The
information rights will terminate upon an initial public offering.

Most information rights also include the opportunity to visit the company’s facilities, inspect
the company’s books and records and discuss matters with company officers. As a practical
matter, I don’t think that most venture backed companies are in 100% compliance with
information rights provisions, especially the time periods for delivery of the information. For
example, audited financial statements for private companies never seem to be completed
within the specified time period.

One issue that gets negotiated in the information rights provision are the number of shares
that an investor needs to hold to receive information rights. This concept of “major investor”
is often used to limit the investors that receive preemptive rights and rights of first refusal
and co-sale (to be covered in future posts). The number of shares is typically set low
enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives
information rights and high enough to avoid giving rights to numerous small investors. In
addition, companies may wish to avoid commiting to delivering annual business plans or
monthly financial statements

Information rights provisions also contain provisions that ensure that investors keep the
information confidential. This is important because directors have a fiduciary duty to keep
company information confidential, but investors do not have a similar obligation absent a
contractual confidentiality provision.

What is a pay to play provision?

A solution to incentivize investors to participate in a financing is called the “pay to play”

provision. Basically, investors that do not participate to their full pro-rata percentage of the
financing are punished by losing certain rights.

Pay to play provisions tied to dilutive financings provide that only investors that participate in
the dilutive financing are entitled to the benefit of the anti-dilution formula in
effect. Investors that do not participate do not receive any anti-dilution protection. This
technique is beneficial for both for the company and for the investor group because it
encourages all investors to continue to fund the company during those times when such
incentive is most needed, i.e., when the company is undertaking a difficult financing.

23
The incentive to participate in a dilutive financing can be strengthened by a variation on the
pay to play concept. Instead of merely losing anti-dilution protection with regard to the initial
dilutive financing in which the investor does not participate, the investor loses anti-dilution
protection with regard to such initial financing and all subsequent dilutive financings which
may occur. Mechanically, this can be accomplished by creating a “shadow” series of
preferred stock identical in all respects to the original series but without any anti-dilution
protection. In the event that an investor fails to participate in a dilutive financing, all shares
of preferred stock held by such investor are automatically converted into the shadow
preferred.

Another harsher variant of the pay to play concept provides that upon an investor’s failure to
participate in a dilutive (or potentially any) financing, such investor’s preferred stock is
converted into common stock with the result that such investor will lose not only its anti-
dilutive protection, but also its liquidation preference and other special rights of the
preferred. This approach may appear to be somewhat draconian, as it seems unfair where a
particular investor may be unable to participate due to circumstances outside of its
control. This may be especially applicable to funds out of money, or strategic investors or
angels that do not expect to participate in subsequent rounds. Most investors do not want to
give up the liquidation preference and preferred rights other than anti-dilution protection
merely because they decided not to participate in a particular dilutive financing.

A disadvantage of the automatic conversion approach, whether into common stock or

preferred stock, is that once an investor has been converted, the pay to play provision
provides no further incentive for that investor to participate in the next dilutive financing. If
the goal for the company and the lead investors is to maximize the incentive for all investors
to participate in all dilutive financings, the better approach would be to provide that if an
investor fails to participate in the initial dilutive financing, such investor receives no anti-
dilution protection with regard to such financing, but in the event that such investor elects to
participate in a subsequent dilutive financing, such investor would be entitled to anti-dilution
protection with regard to such subsequent financing. Although this formula can be
implemented with regard to multiple dilutive financings by creating several series of shadow
preferred, each having a different conversion rate, this approach results in a very
complicated capital structure for the company which can become overly cumbersome.

Another approach involves providing for a “springing warrant” which is then issued to each
investor that participates in a dilutive financing. This warrant is exercisable (at a nominal
exercise price) for the additional number of shares of common stock equal to the number of
additional shares which the applicable anti-dilution formula would allocate to such
investor. This approach results in a simpler capital structure for the company as it avoids the
necessity of creating the shadow series of preferred.

The pay to play concept is based upon requiring participation by the investor in the dilutive
financing. The appropriate level of participation needs to be carefully considered. Pay to
play clauses are often written to require each investor to participate in the dilutive financing
to the extent of its percentage ownership of the company. Although this is typically the
amount of the financing which the investors are entitled to purchase by reason of their

24
contractual rights of first refusal, this approach may not work properly because the sum of
the ownership percentages of the various investors will be less than 100%, and the primary
purpose of the pay to play clause is to assist the company in raising the total amount of
financing which it requires. Requiring each investor to purchase a percentage of the dilutive
financing equal to its pro rata ownership among the investor group won’t quite work either
because the sum of these percentages will always be 100%, leaving no room for a potential
new investor.

Conceptually, the optimal approach is to require each investor to purchase a percentage

equal to its pro rata ownership among the investor group of that portion of the financing
allocated to the existing investors by the board of directors of the company, with the balance
of the financing (if any) being purchased by the new investors. Under this formula, if all of
the preceding investors participate, together with any new investors, the company will
receive 100% of the funds it is seeking to raise. If the required percentage is higher than the
percentage which such investor has a contractual right to purchase, the company must offer
the investor the opportunity to purchase this greater amount in order to implement the pay to
play clause.

What are registration rights?

Registration rights entitle investors to force a company to register shares of common stock
issuable upon conversion of preferred stock with the Securities and Exchange Commission.

Federal and state securities laws place certain limitations on the transfer of shares that have
not been registered. Rule 144 of the Securities Act of 1933 requires that securities be held
for at least one year before being sold. Among other things, Rule 144 also requires that
certain current public information about the company be available and limits the volume of
shares that can be sold, unless the seller has held the securities for at least two years and is
not an affiliate of the company. Registration allows venture funds to freely sell the shares
without complying with these restrictions even if they are deemed affiliates due to significant
shareholdings or a director on the board.

Registration involves filing a registration statement with the SEC, which is a expensive and
time consuming process. Please see the initial filing of Google’s registration statement for its
IPO as an example of the complexity of the document. Legal, accounting and other fees in
connection with an IPO can easily exceed $2M.

As a practical matter, registration rights are rarely used and have little practical effect on a
company until after an IPO. However, some venture funds and attorneys seem to spend a
long time negotiating these provisions, when they have little practical impact. Registration
rights are negotiated between the company and the investors, well before underwriters are
involved. At the time of an IPO and subsequent underwritten public offerings, underwriters
will have the ability to dictate whether investors are allowed to sell, which makes the

25
registration rights negotiated at the time of the venture financing a mere starting point for
discussions with the company and the underwriters.

What is a right of first offer or right to maintain proportionate ownership in future

financings?

A right of first offer allows an investor to purchase its pro rata percentage of issuance of new
securities until an IPO. Below is a typical term sheet provision.

Each holder of Series A Preferred will have a right to purchase its pro rata share of any
offering of new securities by the Company, subject to customary exceptions. The pro
rata share will equal the ratio of (x) the number of Series A Preferred shares held by such
holder (on an as-converted basis) to (y) the Company’s fully-diluted capitalization (on an as-
converted and as-exercised basis). This right will terminate on an IPO.

The items typically negotiated in the right of first offer provision include:

 Major investor. Like information rights, the concept of “major investor” is often used to
limit the investors that receive preemptive rights. The number of shares that an
investor needs to hold to have these rights is typically set low enough to ensure that
the smallest venture fund (or significant angel) in a syndicate receives the rights and
high enough to avoid giving rights to numerous small investors.

 Accredited investors. Sometimes, the right of first offer will be limited to accredited
investors (to be covered in a future post). Federal and state securities laws limit offers
and sales of securities to a limited number and certain types of investors.

 Percentage calculation. The pro rata calculation may be tweaked by aggressive

investors so that the denominator in the formula is the aggregate number of preferred
shares, which would result in existing investors having the opportunity to purchase
100% of the securities offering in the financing.

 Carveouts. The right of first offer typically not apply to certain issuances of securities.
This list is generally the same as the types of issuances that do not trigger anti-
dilution.

 Super pro rata rights. Investors sometimes ask to have a right to purchase more that
their pro rata percentage ownership. This is not a common term in a typical venture
financing. However, it may be requested in an early stage financing where the investor
did not obtain a large percentage ownership because the company wanted to limit
dilution, but investor expects to invest in additional rounds and wishes to increase their
percentage ownership. Please read the commentary from AsktheVC and Venture
Hacks for more thoughts on this provision.

 Over-allotment. If some investors with pro rata rights do not fully participate, then the
participating investors may want the right to purchase the shares that the non-

26
 participating investors did not purchase. This potentially adds additional delay to
completing the financing due to the need to comply with various notice periods for the
initial offer and the over-allotment.

What is a right of first refusal and co-sale agreement?

The right of first refusal and co-sale (“ROFR/Co-sale”) work together to prevent a founder or
major common shareholder for selling shares without the company and the investors being
allowed to purchase the shares or participate in the sale of the shares. Below is a typical
term sheet provision.

In the event [__________] proposes to transfer any Company shares, the Company will
have a right of first refusal to purchase the shares on the same terms as the proposed
transfer. If the Company does not exercise its right of first refusal, holders of Preferred will
have a right of first refusal (on a pro rata basis among holders of Preferred) with respect to
the proposed transfer. [Rights to purchase any unsubscribed shares will be reallocated pro
rata among the other eligible holders of Preferred.] To the extent the rights of first refusal are
not exercised, the holders of Preferred will have the right to participate in the proposed
transfer on a pro ratabasis (as among the transferee and the holders of Preferred). The
rights of first refusal and co-sale rights will be subject to customary exceptions and will
terminate on an initial public offering.

The items typically negotiated in the ROFR/Co-sale include:

 Common holders subject to the ROFR/Co-sale. Generally, investors will want holders
of large amounts of common stock to be parties to the ROFR/Co-sale. The company
(and founders) will want to minimize the number of holders of common stock that need
to be subject to the ROFR/Co-sale. The hassle associated with a large number of
parties becomes evident in subsequent rounds of financing when the ROFR/Co-sale
agreement needs to be amended.

 Exceptions to the ROFR/Co-sale. Founders will want various share transfers to be

exempt from the ROFR/Co-sale such as transfers to family members or for estate
planning purposes. In some cases, a founder may want to transfer up to a certain
number of shares each year without being subject to the ROFR/Co-sale.

 Minimum investor shareholding to have ROFR/Co-sale rights. The company may want
to limit the rights to investors that hold a minimum number of shares.

The ROFR/Co-sale forces a founder to provide written notice to the board and the investors
of any potential transfers, which allows the company and the investors time to evaluate if
they want to purchase (or participate in the “co-sale” of) the shares. I have never heard of a
co-sale right actually being used, although I know that lots of companies remind former
founders about their ROFR obligations.

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The ROFR/Co-sale agreement rarely receives more than cursory comments in a typical
venture financing.

What is a drag-along or bring-along provision?

The drag-along or bring-along provision forces a stockholder to vote in favor of a sale of

company if a certain threshold of stockholders and/or the board of directors approve the
transaction. Below is a typical term sheet provision.

“Drag–along” right: Subject to customary exceptions, if holders of [50]% of the Preferred

approve a proposed sale of the Company to a third party (whether structured as a merger,
reorganization, asset sale or otherwise), [__________] will agree to approve the proposed
sale. This right will terminate upon a Qualified Public Offering.

The items typically negotiated in the drag-along provision include:

 Parties subject to the drag-along. Generally, investors want common stockholders

with significant holdings to sign up to the drag-along. This is especially important for
companies that may be subject to the California long-arm statute, which would
require the holders of a majority of common stock to approve the transaction. Major
investors also typicaly want the other investors to be subject to the drag-along to
ensure that minority investors also approve the transaction. If significant stockholders
exercise dissenters rights, which would allow them to receive cash in the transaction,
they could interfere with the tax-free nature of certain mergers.

 Threshold to trigger the drag-along. The trigger is typically a certain percentage of

stockholders (such as 50% or 2/3 of the Preferred, or a specific series of Preferred)
and sometimes board approval. The percentage to trigger and the group of
stockholders that control the trigger are typically negotiated.

 Minimum price. Due to liquidation preferences, some stockholders (especially

common and junior preferred) may not receive any proceeds in a merger. Forcing
these stockholders to vote in favor of a merger in which they receive no consideration
may be objectionable to them. Therefore, some stockholders may try to negotiate
minimum price thresholds for the drag-along to apply. For example, a common
stockholder may try to argue that the drag-along should only apply if the common
stockholder receives at least a certain price per share (such as the Series A purchase
price) or the valuation of the company is greater than a certain amount in the
transaction. Investors will likely resist these modifications to the drag-along because
the purpose of the drag-along is to force a vote in the event of a sale of company
transaction that might not be entirely supported by the stockholders subject to the
drag-along.

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  Limitation to cash/freely tradeable securities. Many stockholders would object to
having to vote in favor of (and waive dissenters rights in) a taxable merger transaction
in which they receive illiquid securities. Therefore, some stockholders argue that the
drag-along should only apply if the merger consideration is cash or freely tradable
securities.

 Limitation on representations, warranties and covenants made by the dragged

party. Some stockholders may argue that the drag-along should not force them to give
representations, warranties and covenants in the transaction that go beyond
ownership and authority to sell the shares. This is typically agreed to by investors.

Many acquirors will require a certain percentage stockholder vote in favor of a merger in
order to minimize the risk of stockholders exercising dissenters rights. If the thresholds for
the drag-along are set at a level where various stockholder constituencies are protected
against transactions that are not economically beneficial to them, the drag-along provision
serves a good housekeeping function to make sure that minority shareholders vote in favor
of the transaction.

Occasionally, some savvy investors will also require the drag-along provision to be included
in the company’s option agreement so that any optionholder that exercises and holds
common stock will be subject to a drag-along.

What should the composition of the board be like and how are the board seats
allocated?

Investors in venture financings almost always demand representation on the board of

directors. In a VC-led Series A financing, there are typically three or five directors
immediately after the financing. As a practical matter, smaller size boards are easier to
manage (i.e. scheduling board meetings for larger boards is extremely difficult; meetings
seem to go faster when there are less people in the room whose opinions needs to be
heard).

If there is one lead investor, then there are typically three directors, consisting of one Series
A investor designee, one common designee (typically the founder/CEO) and one
independent person (approved by the investor and the common stockholders or the common
designee). The independent seat will oftentimes be left vacant at closing, with the intention
of filling the seat sometime after closing.

If there are two lead investors, there there are typically five directors, consisting of two
Series A investor designees (one from each investor), one common designee, the CEO
(which will be a seat elected by the common stockholders) and one independent person.

In later rounds of financing, investors in the later rounds will also inevitably demand a board
seat, which results in larger boards dominated by investor representatives. Investors in later
rounds will sometimes request that investors in previous rounds relinquish their board seat to

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limit the size of the board. These early investors are typically given board observation rights,
which allow them to attend and participate in board meetings, but not have an official vote in
board decisions.

For the entrepreneur’s point of view on the subject, please read the Venture Hacks articles
“Create a board that reflects the ownership of the company” and “Make a new board seat for
a new CEO,” along with Dick Costolo’s post on “Early Stage Board of Directors.”

In some financings, especially non-VC led Series A financings, the board composition can
simply be a closing condition to a financing with no other mechanism to guarantee a certain
board composition. In such case, the composition of the board in future elections typically
defaults to one vote per share (preferred converted to common basis) and may be favorable
to the common stockholders as they typically control a majority of the outstanding shares.

In most venture financings, however, the board composition is set forth in the certificate of
incorporation (i.e. common may elect one board member, Series A may elect one board
member and the common and preferred voting together may elect all other board members).
A voting agreement among the common and preferred stockholders forces the stockholders
to vote in favor of director nominees selected in a certain manner (i.e. all of the Series A
stockholders agree to vote in favor of the nominee from VC Fund X for the Series A seat).

In my experience, it seems like founders are overly concerned about board composition
compared to other provisions in a term sheet. At the end of the day, most founders typically
don’t control the board after a VC-led financing, as the investors won’t allow a situation
where the common stockholders have significant control or veto power. As a practical
matter, investors will typically end up with a significant amount of control due to
the protective provisions and the drag-along provision, aside from board composition.

What are board observer rights?

Some investors request that they have the right to have an observer at board meetings. The
observer attends board meetings and may participate in board discussions, but does not
have the ability to vote on matters. Some investors request that they have a board observer
in addition to a board seat. An observer right is typically contained in a side letter in
connection with a venture financing or one of the investment documents.

Board observers are sometimes excluded from portions of meetings in order to preserve
attorney client privilege. This occurs when the board is discussing litigation or potential
litigation. Communications between an attorney and a client are considered confidential and
generally cannot be forced to be disclosed in litigation. For purposes of the privilege, board
members are considered part of the “client,” but board observers are not. Depending on the
culture of the company/board, observers may also be excluded from executive sessions of
the board, where the board may discuss sensitive personnel matters or strategic matters.

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One reason to limit board observer rights is to limit the number of people in a room during a
board meeting, as larger meetings are more difficult to manage. Depending on the culture of
the company/board, observers may participate in discussions like any board member or may
be expected to remain silent (especially in the case of junior representatives of investors). As
a practical matter, most companies/boards will allow an investor to bring another person to
board meetings from time to time without a formal observer right.

What is a management rights letter?

Venture funds often request a management rights letter when investing in a company. The
management rights typically include the ability to attend advise and consult with
management of the company, attend board meetings and inspect the company’s books and
records.

Venture funds request these rights in order to obtain an exemption from regulations under
the Employee Retirement Income Security Act of 1974. Absent an exemption, if a pension
plan subject to ERISA is a limited partner in a venture fund, then all of the venture fund’s
assets are subject to regulations that require the venture fund assets to be held in trust,
prohibit certain transactions and place fiduciary duties on fund managers.

However, a “venture capital operating company” is not deemed to hold ERISA plan assets.
To qualify as a VCOC, a venture fund must have at least 50% of its assets invested in
venture capital investments. In order to qualify as a venture capital investment, the venture
fund must receive certain management rights that give the fund the right to participate
substantially in, or substantially influence the conduct of, the management of the portfolio
company. In addition to obtaining management rights, the fund is also required to actually
exercise its management rights with respect to one or more of its portfolio companies every
year.

What should legal fees in a Series A financing be?

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Company counsel legal fees in venture financings have increased since the 1990s. Legal
fees in Series A venture financings routinely exceed $50K, and fees easily exceed $100K in
complicated and later stage financings. In my experience, many companies also need to
complete some corporate cleanup in connection with venture financings, especially with
regard to capitalization matters, which leads to increased costs. Generally, working with
competent counsel will be less expensive than fixing problems later or dealing with deferred
housekeeping at the time of a venture financing.

Please keep in mind that the company also needs to pay legal fees for investor counsel. This
is because venture funds receive a management fee of 2% to 2.5% for managing the
money, which pays for day to day operating expenses of the fund, such as salaries, office
space and other costs. Venture funds do not want legal fees to be paid from management
fees and instead want them paid from the fund itself, via the portfolio company. Sometimes
investor counsel legal fees are deducted from the wire transfer that the company receives
upon the closing of the financing. Occasionally, venture funds will try to have the company
pay legal fees even if the financing does not close.

Legal fees for investor counsel may be capped in routine financings, although some venture
funds will not cap legal expenses and will expect payment of “reasonable” expenses. These
caps may be as low as $20K or range as high as $100K or more in complicated financings. If
investors need to conduct specialized IP or regulatory due diligence, fee caps or
expectations may be higher, as the investors may engage separate patent or regulatory
counsel to conduct due diligence.

Fees for company counsel are typically 2X investor counsel fees because company counsel
(at least on the west coast) typically drafts financing documents, coordinates due diligence
and delivers a legal opinion, which requires more work than investor’s counsel. In my
experience, it is difficult to adequately represent an investor in a venture financing without
incurring less than $25K to $35K in legal fees, simply due to the time necessary to review
documents and conduct due diligence.

If investors are not represented by counsel, such as in some angel financings, then company
counsel legal fees can be significantly lower. This is partially due to the lack of back and
forth negotiations among the attorneys and also due to the fact that these companies may
be fairly early stage with few due diligence issues. In my experience, I believe that it would
be difficult to complete a simple angel Series A financing for less than $20K to $25K on the
company side.

Please also see the post by Jason Mendelson on Ask the VC answering the question: “How
Much Should I Pay Lawyers to Complete My Financing?” Dick Costolo has a humorous
(and fairly insightful) post about legal fees entitled “Legal Fees: Start Swearing Now.”

In any event, actual mileage may vary.

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What are the conditions to closing of a Series A financing?

Almost all Series A Stock Purchase Agreements are drafted so that they contemplate a
signing of the agreement, then a closing after certain conditions are met. These closing
conditions may include:

 Representations and warranties are correct and covenants have been complied with;
 Securities laws have been complied with;
 The Certificate of Incorporation has been filed with the Secretary of State of Delaware;
 Ancillary agreements (such as the Investor Rights Agreement, Right of First Refusal
and Co-Sale Agreement, Voting Agreement, Indemnification Agreements and
Management Rights Letter) have been executed and delivered;
 Various closing certificates (such as an officer’s certificate, secretary’s certificate,
and good standing certificates) have been delivered;
 A legal opinion has been delivered;
 Necessary consents and waivers have been obtained;
 The Board consists of specified persons; and
 A minimum number of shares is being sold in the closing.

As a practical matter, most venture financings are signed and closed simultaneously. Once
company counsel and investors’ counsel have finalized the financing documents, company
counsel collects stockholder consents and files the Certificate of Incorporation. In financings
involving multiple investors, wire transfers (and checks) may be sent to a trust account at
company counsel prior to or on the closing date. Signature pages for the various documents
are also collected by company counsel and investors’ counsel. The funds and signature
pages are held in escrow pending the closing. Once company counsel receives confirmation
of filing of the Certificate of Incorporation, the financing is deemed closed (assuming that
funds are held in escrow with company counsel). Company counsel will then wire transfer
the funds to the company (and deliver any checks), which occasionally may occur the day
after the official closing due to wire transfer deadlines.

If funds have not been held in escrow, then the investors may initiate wire transfers directly
to the company after filing of the Certificate of Incorporation and the financing is deemed
closed when the company has received the funds. As a practical matter, stock certificates

33
are typically not delivered to the investors until sometime after the closing, although some
investors demand to see a copy of the stock certificate before initiating the wire transfer.

How do the sample Y Combinator Series AA financing documents differ from typical
Series A financing documents (or what’s the difference between seed and venture
financing terms)?

Y Combinator recently published forms of Series AA equity financing documents that YC

portfolio companies have used when raising angel financing. YC provides a three month
startup program for entrepreneurs twice a year in Cambridge, MA and Mountain View,
CA. YC typically provides $5K plus $5K per founder of seed funding for usually 6% of the
equity in common stock (which, as an aside, Sarah Lacy seems to question, but in my mind
seems like something that I would jump at if I were a fledgling entrepreneur).

[Disclaimer/disclosures: Please read the disclaimer on the documents and on my website. I

write this blog in my personal capacity and my opinions may differ from my
colleagues. WSGR represents Y Combinator and many of its portfolio companies. I
represent a YC portfolio company that provides the Chatterous application and have worked
with Y Combinator founder Trevor Blackwell’s company Anybots. I have also represented
investors that have invested in a couple of YC portfolio companies. I may update this post in
the future.]

I was planning to write a post on the differences between angel financing terms and venture
capital financing terms, and thought that the YC documents provided a good opportunity to
explain the differences. I’ve already noticed some commentary about the documents and
decided to provide some more detailed explanations and the situations that they might be
used.

If you want to review annotated Series A venture capital financing documents, please review
the NVCA model venture capital financing documents. (Please note that I think that the
default provisions in the NVCA documents are generally fairly investor-favorable and reflect
east coast practice rather than Silicon Valley practice. I will probably write a post about
these documents at some point in the future.) This post assumes that you have a basic
understanding of Series A financing terms. If you don’t, please educate yourself on this
site, Venture Hacks and the term sheet series by Brad Feld/Jason Mendelson, among other
places.

What situations should these documents be used in?

The YC documents are probably fine in situations where the investor (i) wishes to purchase
equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than
percentage ownership of the company, liquidation preference and right of first offer in future

34
financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is
only investing a small amount (i.e. a couple hundred thousand dollars or less).

In my experience, sophisticated angel investors expect to receive a full set of Series A

documents with rights essentially the same as venture capital investors, so the Series AA
documents may not be acceptable in these situations. I think these documents are most
appropriate in a friends and family equity seed financing. However, I believe that companies
are generally better off with convertible debt rather than an equity financing at a low
valuation.

Why is it called Series AA?

To differentiate it from typical “Series A” preferred stock, which comes with certain
expectations with regard to rights. I’ve had clients rename their Series A, B and C to Series
A-1, Series A-2 and Series A-3, so that their first institutional venture capital financing was
called the Series B. There is no real rule to what a particular series of preferred stock is
called (i.e. Series FF for the Founders Fund invention). I suppose that YC could have
named it Series YC, instead of Series AA, for better branding.

What rights does the Series AA have in the sample YC documents?

Obviously, please read the term sheet. The primary rights in these documents, ranked in
order of importance in my opinion are:

 Non-participating preferred liquidation preference. The investor receives their money

back and the remainder goes to the common. According to WSGR’s survey of venture
financings, a non-participating preferred is in around 40% of financings, with the
liquidation preference in the remainder of deals being more investor-favorable.

 Limited protective provisions. Among other things, the company can’t be sold without
consent of a majority of the Series AA.

 Right of first offer on future financings. Please note that these documents provide that
the right of first offer expires five years after the financing, which I believe is not
standard (but happens to be the company-friendly default in the WSGR form of
documents that the Series AA documents were based on).

 Information rights. The investor receives unaudited annual and quarterly financial
statements.

There are situations where an investor might receive stock with even less rights. For
example, if a founder contributes a significant amount of cash (i.e. enough to buy a car) to
fund the company, then I might suggest that the company issue preferred stock with a
liquidation preference and no other rights to the founder, as opposed to issuing common
stock. The reason for issuing preferred stock instead of common stock is to preserve a low

35
common stock value for option grants as explained in this post, and providing the stock with
a liquidation preference.

What are the primary rights that are missing from the these documents that a VC or
sophisticated angel would expect?

Some people have suggested that various terms are unnecessary in early stage Series A
financings. See the VentureBeat article titled “Reinventing the Series A.” In the sample YC
documents, there are various terms that are missing that one would typically expect in a
company-friendly Series A term sheet (i.e. one from Sequoia Capital).

 Dividend preference. Deleting the dividend preference is not a big deal, as almost all
startup companies don’t declare dividends. The only practical situation that I can think
of where a dividend preference is beneficial to a stockholder is where a company does
a partial sale of assets and wishes to distribute the proceeds to stockholders. The
liquidation preference would not apply in this situation, and any distribution to
stockholders would trigger the dividend preference.

 Registration rights. As a practical matter, I don’t think that most investors should really
care about registration rights, especially in light of the shortening of the Rule 144
holding period to 6 months. (I suppose I will write a boring post about Rule 144 at
some point.)

 Anti-dilution protection. Deleting anti-dilution rights saves several pages of text in the
Certificate of Incorporation. Given that the Series AA is issued at a fairly low valuation,
anti-dilution protection is probably not that important, as a “down round” from a low
valuation in the Series AA is unlikely.

 Comprehensive protective provisions. The YC documents are fairly light on protective

provisions compared to a typical Series A financing.

 Right of first refusal and co-sale. These rights are missing. This is probably okay
assuming that the founders restricted stock purchase agreement has a right of first
refusal on transfers until a liquidity event. The right of first refusal on founder stock
transfers in a typical restricted stock purchase agreement is in favor of the
company. (Please note that when I say typical, I mean an agreement drafted by
attorneys experienced in venture financings, not the boilerplate you might get from an
online incorporation service.) The typical RFR/co-sale agreement in a venture
financing gives the investors a right to purchase the shares if the company does not
exercise its right.

 Voting agreement. An optional bracketed provision in the Certificate of Incorporation

provides for a Series AA board seat. In a typical venture financing, there would also
be a voting agreement that governs how specific board seats will be filled. In angel
financings, I typically eliminate the voting agreement anyway and simply have a
closing condition that the board consist of certain persons.

36
  Comprehensive representations and warranties. The Series AA Preferred Stock
Purchase Agreement has fairly limited reps and warranties. As a practical matter,
investors don’t sue companies for a breach of reps and warranties, so reps and
warrants basically serve to flush out diligence issues. In an early stage company,
extensive reps and warranties are probably unnecessary.

 Legal opinion. A company counsel legal opinion is missing in these documents. A

legal opinion for a newly-incorporated early stage company probably doesn’t add
much to the due diligence process and is probably unnecessary compared to the
incremental cost to prepare.

 Legal fees. Each side pays its own legal fees in these documents. Venture funds
expect the company to pay investor counsel fees.

Do I need an attorney to help me complete a financing if I have these documents?

Yes. Absolutely. These documents are not intended to be “fill in the company name,” sign
the docs and collect checks/wire transfers. The fact that certain rights were intentionally
omitted from the documents compared to typical VC financing documents is a judgment call
that requires the guidance of an experienced attorney. There are always various corporate
housekeeping matters that need to be cleaned up in connection with a financing. Please
don’t try to use the YC documents without working with a competent attorney.

How do the sample Series Seed financing documents differ from typical Series A
financing documents?

After the recent announcement of the Series Seed Financing documents by Marc
Andreesen, Brad Feld points out that there are now four sets of “open source” equity seed
financing documents:

 TechStars Model Seed Funding Documents (by Cooley)

 Y Combinator Series AA Equity Financing Documents (by WSGR)
 Founders Institute Plain Preferred Term Sheet (by WSGR – disclaimer, I represent the
Founders Institute and was involved in drafting this document)
 Series Seed Financing Documents(by Fenwick & West)

My general opinion is that anything that makes the financing process faster and easier or
otherwise educates entrepreneurs is a good thing. (A reminder that anything I write on this
site is only my personal opinion and does not represent the views of WSGR or anyone else
from WSGR.) In addition, I think that a “peace treaty” between early-stage investors and
startup companies on standard terms (at least at a term sheet level) is a step in the right
direction.

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I previously wrote a post titled “How do the sample Y Combinator Series AA financing
documents differ from typical Series A financing documents (or what’s the difference
between seed and venture financing terms)?” Much of the commentary on the Y
Combinator documents is also applicable to the Series Seed documents. (In fact,
I recyled part of that post in writing this post. I also reviewed the TechStars documents last
year and they are similar in concept to the Y Combinator documents as the chart below
indicates.)

This post assumes that you have a basic understanding of Series A financing terms. If you
don’t, please educate yourself on this site, Venture Hacks and the term sheet seriesby Brad
Feld/Jason Mendelson, among other places. If you really want to understand the nuances in
venture capital financing documents, please review the NVCA model venture capital
financing documents.

What situations should the Series Seed documents be used in?

The Series Seed documents are probably fine in situations where the investor (i) wishes to
purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms
other than percentage ownership of the company, liquidation preference and right of first
offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million
dollars), and (iv) is only investing a small amount (i.e. under $500K).

I was actually somewhat surprised that the following investors have agreed to use the Series
Seed documents in certain of the their deals: Baseline, Charles River Ventures, SV Angel
(Ron Conway), First Round Capital, Harrison Metal Capital, Mike Maples, Polaris Venture
Partners, SoftTech VC and True Ventures. In contrast, Fred Wilson says while he is “hugely
supportive of his intent here, I can’t and won’t get behind the Series Seed forms because
they leave out some critical stuff that we simply won’t do a deal without.”

I think that there are certain situations where the Series Seed and other stripped down
equity financing documents might be appropriate, but I know that there are lots of situations
where early-stage investors probably wouldn’t agree to the Series Seed terms.

Recently, I have seen a lot of seed stage financings being structured as convertible debt with
a price cap, which is an alternative to the equity financing contemplated by the Series Seed
documents. Certain angel investors refuse to do convertible debt deals, but will be okay if
there is a price cap. In fact, I have seen convertible debt used to raise up to $1.0 million, but
it seems like the sweet spot is around $500K. Convertible debt documents are generally
much more simpler to draft and read than equity financing documents, so I typically
recommend convertible debt for companies raising below around $750K.

In my experience, if a company is raising, say $1.0 million, the investors expect to receive a
full set of Series A documents with rights essentially the same as venture capital
investors. Therefore, the Series Seed documents may not be acceptable in these

38
situations. I think that the Series Seed documents are probably most appropriate in a friends
and family equity seed financing, as opposed to a round led by a professional investor.

Why is it called Series Seed?

To differentiate it from typical “Series A” preferred stock, which comes with certain
expectations with regard to rights. There is no real rule to what a particular series of
preferred stock is called.

What rights does the Series Seed have?

Ted Wang explains most of the highlights of the documents. The primary rights in these
documents, ranked in order of importance in my opinion are:

 Non-participating preferred liquidation preference. The investor receives their money

back and the remainder goes to the common.

 Limited protective provisions. Among other things, the company can’t be sold without
consent of a majority of the Series Seed.

 Future rights. If new investors get better rights in a future equity financings (such as
registration rights, price-based anti-dilution, redemption rights, etc.), then the holders
of the Series Seed get these better rights.

 Right of first offer on future financings. Self-explanatory.

 Board seat. The Certificate of Incorporation gives the Series Seed a board seat, while
the common get two board seats.

 Information rights. The investor receives unaudited annual and quarterly financial
statements.

 Drag along. The Series Seed documents include a fairly harmless drag-along
provision, which requires the investors and the key common stockholders to vote in
favor of a “deemed liquidation event” (which basically means sale of company
transaction) if a majority of the holders of common stock, a majority of the holders of
the Series Seed and the board approve the transaction. Given the general theme of
the documents to eliminate unnecessary provisions, it strikes me as somewhat odd
that there would be a drag-along. If I represent investors in a later Series A financing, I
would probably use the existence of the drag-along as an excuse to implement a more
aggressive drag-along provision — which does not require the approval of the holders
of common stock to trigger.

 Legal fees. The company is obligated to pay $10K for investors counsel. I suspect
that this seems reasonable if there is basically no due diligence due to the early stage

39
 of the companies. (By the way, the TechStars documents and the Y Combinator
documents do not have a provision to reimburse counsel for the investors, probably on
the theory that the situation where the documents are used don’t require counsel to
review the documents on behalf of the investors.)

What are the primary rights that are missing from the these documents that would be in a
typical Series A financing?

In the Series Seed documents, there are various terms that are missing that one would
typically expect in a company-friendly Series A term sheet.

 Dividend preference. Almost all startup companies don’t declare dividends, so

deletion of a dividend preference is irrelevant to an investor. The only practical
situation that I can think of where a dividend preference is beneficial to a stockholder
is where a company does a partial sale of assets and wishes to distribute the
proceeds to stockholders. The liquidation preference would not apply in this situation,
and any distribution to stockholders would trigger the dividend preference.

 Registration rights. As a practical matter, I don’t think that investors should really care
about registration rights.

 Anti-dilution protection. Deleting anti-dilution rights saves several pages of text in the
Certificate of Incorporation. Given that the Series Seed is issued at a fairly low
valuation, anti-dilution protection is probably not that important, as a “down round”
from a low valuation in the Series Seed is unlikely.

 Comprehensive protective provisions. The Series Seed documents are fairly light on
protective provisions compared to a typical Series A financing.

 Co-sale rights. These rights are missing, which is probably okay since I have never
heard of a co-sale right being used before.

 Voting agreement. In a typical venture financing, there is a voting agreement that

governs how specific board seats will be filled. In angel financings, I typically eliminate
the voting agreement anyway and simply have a closing condition that the board
consist of certain persons.

 Comprehensive representations and warranties. The Series Seed Stock Purchase

Agreement has fairly limited reps and warranties. As a practical matter, investors
don’t sue companies for a breach of reps and warranties, so reps and warrants
basically serve to flush out diligence issues. In an early stage company, extensive
reps and warranties are probably unnecessary.

 Legal opinion. A company counsel legal opinion is missing in these documents. A

legal opinion for a newly-incorporated early stage company probably doesn’t add

40
 much to the due diligence process and is probably unnecessary compared to the
incremental cost to prepare.

Why will or why won’t people adopt the Series Seed documents?

 Investor pressure. The only way that the Series Seed documents will be widely used
is if investors demand use of the documents.

 Investors want additional protections. I suspect that things like lack of anti-dilution
protection, a desire to have participating preferred stock and weak protective
provisions will make it difficult for some investors to agree to use the documents
without modification. Once you start making substantial changes to the forms, then I
think some of the value of standardization goes away.

 Law firm resistence. As a reference point, WSGR generally does not use the NVCA
documents in a Series A financing when it represents the company unless the investor
specifically demands that the NVCA documents be used. This represents
approximately 20% of all venture financings in the U.S. I’ve read the WSGR form
Series A documents hundreds of times (and probably have most of the provisions
memorized). I think I’ve only come across the NVCA forms a couple of times, and
both times were on deals with Boston-based company counsel, where use of the
NVCA documents is more widespread. In addition, WSGR’s Series A documents can
be created using the document automation software behind the WSGR term sheet
generator. Therefore, using WSGR form documents when I represent a company is
much more efficient than using the NVCA documents.

 Drafting issues in later rounds. One thing that I don’t like about stripped down
documents is that adding provisions in the future is painful — especially if the
documents are not written in a modular fashion. For example, adding in the anti-
dilution provisions into the Series Seed documents requires the insertion of a couple
of pages of text into the Certificate of Incorporation. It’s somewhat painful to ensure
that all of the section references (including Microsoft Word auto-reference codes) and
defined terms work properly. Therefore, in my opinion, it’s actually more difficult to
add the modular sections than it would be to start from a new robust template and
tweak it to fit the term sheet. I’d encourage the Series Seed project to have redlines of
at least the Series Seed Ceritificate of Incorporaiton against the form of Series A
Certificate of Incorporation that it was based on in order to show that the documents
can easily be modified in a Series A financing to include anti-dilution and other
provisions. (It seems like the Series Seed Certificate of Incorporation is mostly based
on the NVCA form of Certificate of Incorporation with various formatting and
simplification-related changes.)

 Use of different forms for later Series A financing. As a practical matter, in a typical
Series B financing, the Series A documents will generally be tweaked slightly for the
Series B, and company counsel will send redlines to investor counsel to show
changes from the Series A (which are typically minimal). When a company does a
Series A financing and the Series Seed documents are in place, the Series Seed

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 Stock Purchase Agreement and Investors Rights Agreement will probably not be re-
used. As discussed above, the Certificate of Incorporation will need to be amended
and restated and various provisions will need to be plugged in. (By the way, restated
means that the entire document is redone in its entirely, as opposed to just an
amendment, which might refer to discrete sections like: “Article IV shall be amended
such that the number of shares of Common Stock shall be 15,000,000.”) The Series
Seed Stock Purchase Agreement has no lingering obligations, so Series A investors
will want a more traditional stock purchase agreement with closing conditions and
closing certificates — and it is much easier to use a typical Series A Stock Purchase
Agreement than modify the Series Seed Stock Purchase Agreement. In addition,
there will be so many new provisions added to the Investor Rights Agreement (such as
registration rights) that starting from a more robust form is easier than adding
provisions to the Series Seed Investor Rights Agreement.

What’s the difference between the Series Seed documents, the TechStars documents, the Y
Combinator documents and TheFunded Plain Preferred term sheet?

The Y Combinator documents were released in August 2008. The TechStars documents
were released in February 2009. TheFunded released their “Plain Preferred” term sheet in
August 2009. The Series Seed documents were released in March 2010. Below are some
of the material differences between the Series Seed, Y Combinator and TechStars
documents. (I won’t bother outlining the differences in TheFunded term sheet, as it was
more intended for a typical Series A institutional venture capital financing, as opposed to the
seed stage contemplated by the other documents.)

Series Seed Y Combinator TechStars

Name of security Series Seed Series AA Series AA

Principal documents COI, SPA, IRA COI, SPA, IRA COI, Subscription Agt.

Dividend preference Pro rata with common Silent Pro rata with common

Liquidation preference 1x non-participating 1x non-participating 1x non-participating

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Redemption rights None None None

Anti-dilution None None Broad-based weighted

average

Board composition 2 common; 1 preferred 2 common, 1 preferred 2 common, 1 preferred (if

Series AA is at least 5% of

fully-diluted)

Protective provisions Typical list for company- Changes in preferred and Changes in preferred only

friendly VC financing merger/sale of assets only

Information rights Unaudited annual and Unaudited annual and Unaudited annual

quarterly quarterly

Registration rights None None None

Right of first offer on new Yes Yes Yes

financings

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Right of first refusal and Assignment of company Silent Silent

co-sale agreement right of first refusal to

investors

Drag-along Yes for Series Seed No No

holders and founders.

Triggered upon (i) majority

of common, (ii) majority of

Series Sees, and (iii)

board approval.

Future rights Yes No Yes

Legal opinion None None None

Legal fees $10K to investor counsel None None

What would you change about the documents?

I’m still pondering and will update this post later after I speak to some early-stage investors.

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