OVERVIEW OF THE VENTURE CAPITAL INVESTMENT
PROCESS AND TERM SHEET PROVISIONS
John J. McDonald
Kelley Drye & Warren LLP
3 050 K Stree t, N.W .
W ashin gton , D .C . 200 07
( 202) 342 -8 805
his article provides entrepreneurs with a user–friendly overview of the venture
capital investment process and summarizes the investment terms typically
included in term sheets for venture capital investments. While not a
comprehensive review of all of the considerations involved in accepting venture
capital financing, it should provide entrepreneurs with a good idea of what to expect from
the process and a “leg up” concerning the investment terms that will be negotiated by the
venture capitalist and the entrepreneur.
Investment Process and Concerns of the Parties. The VC investment process involves a
series of steps by the company and the VC, with the VC being satisfied with each step
being required for the process to continue onward. The process can occur in as little as
one to two months but typically takes three to six months. It is not uncommon for an
attractive company to engage in this process simultaneously with more than one VC up
to the time that the company “gives exclusivity” to one of the VCs. Although this article
is focused on a start–up company’s first round of institutional equity financing (typically
referred to as its “Series A” round), many of the considerations discussed in this article
will be true for subsequent equity financing rounds, with the main difference being that
the subsequent financings will involve a three–way negotiation process between the
company, the existing investors and the proposed new investors, as the new investment
will need to be integrated into the company’s existing capitalization structure and
The Timeline. The timeline for the VC investment process typically consists of the
Presentation of the company’s business plan to the VC, typically through a
referring intermediary such as business person, attorney or accountant trusted by
the VC, but sometimes through direct contact at a venture fair or similar event.
Introductory meeting between the VC and company executives.
Initial business due diligence by the VC. The VC will analyze the company’s
market and projections and visit the company offices to meet its employees.
Intensive business due diligence by the VC, consisting of discussions between the
VC and customers and suppliers of the company and thorough analysis of the
company’s technology by the VC’s experts.
The VC pitches the proposed investment to his or her partners or investment
committee and obtains their approval to proceed to term sheet.
The VC prepares and presents a term sheet for proposed investment to the
company. The parties then negotiate the provisions of the term sheet, the term
sheet is signed, the exclusivity period starts and the company ceases negotiations
with any other VCs.
Legal due diligence, consisting of analysis by the VC’s attorneys of the company’s
organizational documents, customer and supplier contracts and other legal
documents, including confirmation by the VC’s attorneys of validity of the
company’s intellectual property filings.
Using the agreed–upon provisions from the signed term sheet as the guide, the
VC’s attorneys prepare and present to the company’s attorneys drafts of the
definitive investment documents (i.e., stock purchase agreement, investor rights
agreement, stockholders agreement and certificate of incorporation). Regardless of
how detailed the term sheet is, issues will inevitably come up concerning matters
that were not addressed in the term sheet or that arise as a result of the VC’s
continuing due diligence process. Negotiation by the parties then follows,
resulting in final investment documents.
Closing of transaction – the investment documents are signed and the funds are
wired by the VC to the company.
Entrepreneurs’ Main Concerns with VC Financing. In considering and negotiating VC
investments into their companies, some of the main concerns of entrepreneurs include:
Dilution of their ownership stakes in the company from the VC investment,
resulting in inadequate financial return to entrepreneurs upon a sale of the
company or other liquidity event.
Loss of management control over day–to–day operations of the company.
Obtaining sufficient funding to be able to achieve business objectives, balanced
against not wanting to sell “too much” of the company at the present (low)
Security of the entrepreneurs’ employment with the company in the future and
compensation if they are terminated without cause.
Having a sufficiently large stock option pool available to be able to attract and
incentivize future additions to the company’s management team.
Repurchase of the entrepreneurs’ ownership stakes in the company upon
employment termination (whether voluntary or involuntary).
Anticipated future capital requirements resulting in further dilution of
entrepreneurs’ ownership stakes in the company.
Intangible aspects of the VC investment in the company, including “credentialing”
effect of receiving funding from a well–known VC, access to industry contacts
through referrals from the VC, and access to future rounds of capital from the VC
VC’s Main Concerns with Start–Up Company Investments. In negotiating VC
investments into start–up companies, some of the main concerns of VCs include:
Current and projected valuation of the company and its impact on the VC’s ability
to obtain an adequate risk–adjusted return on the investment.
Credibility of projections and other information supplied by company
Current and future market for the company’s products or services, the strength of
its competitors and the presence of effective barriers to entry (including verified IP
Stage of development of the company and resulting level of execution risk and
likelihood of additional funding being necessary to get to cashflow break–even or
another significant business milestone.
Alignment between the proposed investment and the investment objectives and
criteria of the VC firm, along with the historical experience of the VC firm
(whether good or bad) in making investments in similar companies.
Experience and ability of present management team and the company’s ability to
recruit others to fill any missing skill/experience sets.
The VC’s ability to manage risk through controls on management’s strategy and
decision making process and protect its downside through liquidation preferences,
additional board seats, anti–dilution adjustments and other measures if the
company’s development doesn’t proceed as planned and additional funding is
The VC’s ability to preserve its upside potential through preferred stock
conversion rights and participation in future funding rounds through contractual
The VC’s ability to exit the investment, either through a sale of the company or a
public offering of the company’s stock.
Negotiating the Term Sheet. To facilitate negotiation of the terms and conditions of a VC
investment, the parties typically prepare a term sheet listing the main terms of such
investment, which can vary in scope from only covering investment amount, valuation
and a few other terms, to going into significant detail concerning most of the terms and
conditions of the investment. A “narrow” term sheet can help get the process started
quickly, but will result in heavier negotiation of the definitive investment documents. A
“comprehensive” term sheet will “front load” the negotiation process, making it more
likely that the deal falls apart early on, but once the term sheet is signed, finalizing the
definitive investment documents is a relatively quick and easy process. VCs typically
have their own approach to term sheets and entrepreneurs are seldom able to negotiate
significant deviations from that approach.
As noted above, once the parties agree on the final term sheet, the definitive
investment documents will be prepared, using the investment terms agreed upon
in the term sheet. The remainder of this article summarizes the investment terms
that are sometimes included in the term sheet and are always addressed in the
definitive investment documents.
Since there are variations in VC investment terms – some of which are favorable
to the VC and others of which are favorable to the company – and VCs will usually
“tilt” the term sheet provisions to their advantage, entrepreneurs are well advised
to develop a thorough understanding of the landscape before the negotiation
process starts and engage counsel that is experienced in VC financings to assist
with negotiation of the term sheet and definitive investment documents.
Although term sheets are, technically speaking, not legal binding, bringing in
counsel to assist with term sheet negotiations is usually money well spent, as VCs
may be unwilling or unable to deviate from the term sheet provisions when
preparing the definitive investment documents because they obtained approval
from their investment committees based on the term sheet. As a result, requests
from entrepreneurs to deviate from a signed term sheet are usually not well
received, even if the entrepreneur later determines (with the advice of counsel)
that he or she cannot allow the investment to be made on the basis of the
provisions in the term sheet.
Valuation and Amount of Investment. Valuation of the company determines what
percentage of the company’s equity the VC receives for its money – the higher the
valuation, the lower the percentage, and vice versa. The greater the percentage that the
VC receives, the less will be left for the entrepreneurs. Typically referred to as the “pre–
money valuation”, this is usually a hotly contested issue between the entrepreneurs (who
want a high valuation to be placed on the company) and the VC (who wants the reverse).
VCs usually formulate a proposed valuation for a company using their experience
with similar companies and information learned about the company through the
due diligence process, based on factors including the strength of the management
team, market size and potential market penetration, and the sustainable
advantage of the company’s product/service offerings. Specific methods for
calculating valuation include comparable company valuation (i.e., start with the
value of comparable public companies and values of companies sold in public M&A
transactions and discount appropriately) and discounted cashflow analysis (i.e.,
project the company’s future cash flows and discount those cashflows back to the
present using net present value calculations), but picking a number is usually
more art than science, in practice.
Ownership and valuation is typically calculated on a “fully–diluted” basis,
meaning that all securities that can be converted into or exercised for shares of
common stock (including convertible notes, preferred stock, options and warrants)
are counted. A fixed amount of shares reserved for future issuance to employees,
directors and consultants under the company’s stock option plan (often referred to
as the “option pool”) is typically included in the calculation and thus dilutes the
The dollar amount of the investment is usually planned to get the company to its
next stage of development (i.e., completion of prototype; beta testing; obtaining
“reference” paying customers; growing the customer base to cashflow break–even,
etc.). Some companies are hesitant to accept more funding at the current (low)
valuation than they absolutely need. Others get as much as they can, reasoning
that doing so will free them from spending time fundraising and give them
flexibility in timing their next round of financing.
Sometimes, to enhance control over expenditure of funds by the company and limit
their downside risk, a VC will want to split its investment into multiple
“tranches”, each of which is conditioned upon the company achieving specified
developmental milestones. Usually some of these milestones are subjective
enough to eliminate any real obligation on the VC to complete the subsequent
tranche investments if it becomes disenchanted with the company. As a result,
multiple–tranche venture investments are usually resisted by companies, as they
typically lock in the present (low) valuation of the company without contractually
obligating the venture capital investor to actually make the subsequent tranche
Another way in which VCs try to limit their risk is to offer to lead a venture
financing round of a specified size, as long as the company is able to find other VCs
acceptable to the lead VC to participate in the financing and thereby “fill out” the
round. A more company–favorable approach to this issue is for the company to
establish a planned round size, conduct an “initial closing” involving the VC who is
ready to invest, and agree to seek other VCs to fill out the round in one or more
subsequent closings. VCs sometimes resist multiple closing financing rounds
because the subsequent closing VCs will have reduced risk, since the company will
have received and deployed the cash from the initial closing, but will invest at the
same valuation as was used for the initial closing.
Structure of the Investment (LLCs vs. Corporations and Use of Preferred Stock).
Most VCs will not invest in any company other than a Delaware corporation that
has elected to be taxed as a “C” corporation (rather than an “S” corporation).
Delaware corporations are preferred because there are a substantial amount of
judicial decisions interpreting Delaware corporate law provisions, which enhances
predictability in the event of a dispute between the company and the VC.
“C” corporation tax status is important to VCs because there are tax consequences
to VC funds investing in pass–through entities such as LLCs or “S” corporations.
As a result, to the extent that a start-up company is organized as, for example, a
Maryland LLC, it will usually be a closing condition for the VC investment that
the company have reorganized as a Delaware “C” corporation. Similarly, “S”
corporations will be required to revoke their “S” elections and be taxed as “C”
VC investments are almost always structured as a purchase by the VC from the
company of shares of the company’s newly–created convertible preferred stock, the
terms of which will be negotiated by the VC and the company. Preferred stock has
priority over common stock if the company is sold or liquidated and also usually
receives dividends before any dividends are paid on the common stock (liquidation
preferences and dividends are discussed in more detail below). Use of the term
“convertible” means that the shares of preferred stock may be exchanged for
shares of common stock (conversion is discussed in more detail below).
The preferential rights of the preferred stock over common stock justifies a higher
price for preferred stock, as compared to the common stock into which it can be
converted. This differential is useful because it enables a company to sell shares of
preferred stock to VCs at higher prices, while granting stock options and issuing
shares of common stock to company management at lower prices. It is important
to keep in mind, however, that the company’s method of valuing stock options and
common stock issued to company employees must comply with applicable tax law
provisions, with potentially significant adverse tax consequences to both the
company and the recipients of the stock option and common stock grants resulting
from violation of such provisions.
Dividends. VCs invest in start–up companies for capital appreciation potential, not to
receive periodic dividends, and start–up companies rarely (if ever) actually issue any
dividends. However, the preferred stock issued to VCs in venture financings will
typically provide for “accruing” dividends as a way of compensating the VC for tying up
its funds in the investment for extended periods of time.
Accrual of preferred stock dividends works like interest accruing on debt – a stated
percentage of the purchase price of the preferred stock (e.g., 8%) will accrue every
year until paid. Although dividends will accrue every year, they are usually only
paid “when, as and if” declared by the company’s board of directors. More
importantly, as discussed in more detail below, accrued dividends on preferred
stock are used in computing the amount of “liquidation preference” paid to the
holders of the preferred stock upon a sale or liquidation of the company, as well as
the redemption amount paid to the preferred stock holders upon redemption of
their preferred stock by the company.
VC investment documents usually specify that no dividends can be paid on
common stock unless the accrued and unpaid dividends on the preferred stock
have been paid first. Where a company has multiple series of preferred stock
outstanding (i.e., Series A, Series B, etc.), each series of preferred stock will either
be “senior” to (i.e., gets paid before), “junior” to (i.e., gets paid after), or “pari
passu” with (i.e., gets paid at the same time as) the other series of preferred stock
for purposes of payment of dividends.
Liquidation Preference. When a venture–backed company is sold or liquidated, the
preferred stockholders will receive a specified amount (the “liquidation preference”
amount) before any sale or liquidation proceeds are distributed to the common
The liquidation preference amount is usually equal to the original purchase price
of the preferred stock plus any accrued but unpaid dividends on the preferred
stock. Since the preferred stock is usually only held by the VC investors and the
common stock is usually only held by company management, this means that,
upon a sale of the company, the VC investors will get their money back, plus
accrued dividends, before company management receive any sale proceeds and, if
the company is sold for less than the VC investment amount plus accrued
dividends, company management will receive nothing in connection with the sale.
Although not very common, sometimes VCs are able to negotiate liquidation
preferences that are a stated multiple of the original purchase price plus accrued
dividends (i.e., “2X” or “3X”), which make it less likely that management receives
anything for its common stock upon a sale of the company or liquidation.
A “participating preferred” or “double dip” preferred stock provision enables the
preferred stock holder to receive not only the liquidation preference amount
discussed above, but also to share (on an as–converted basis) with the common
stockholders in any remaining amount be distributed to the common stockholders
after the deduction of the liquidation preference amount from the sale proceeds.
By adding the (VC) preferred stockholders to the pool of (management) common
stockholders, participation provisions reduce the amount of sale proceeds realized
by management and other common stockholders upon a sale of the company. For
this reason, sometimes the preferred stock participation aspect will be “capped”,
with the cap typically formulated as the preferred stockholders participating with
the common stockholders only until the preferred stockholders have received
liquidation preference plus participation payments equal to some multiple (two is
typical) of their original investment. Alternatively, sometimes the preferred
stockholders can choose to either receive their liquidation preference amount or
participate with the common stockholders upon a sale of the company or
liquidation, but not receive both types of payments.
Most venture–backed companies obtain venture financing in a number of separate
financings occurring one after the other, which are usually denominated as “Series
A”, “Series B”, “Series C” and so on, referring to the type of preferred stock sold by
the company in each such financing. As is the case for preferred stock dividends,
when a company has multiple series of preferred stock outstanding, there will be
an established ranking of such preferred stock whereby, for purposes of payment
of the liquidation preference amount, each series of preferred stock will either be
“senior” to, “junior” to, or “pari passu” with the other series of preferred stock.
Preferred stock seniority is typically one of the most significant issues in
negotiating a Series B or other later–stage VC investment.
Conversion Rights. As noted above, the preferred stock purchased by the VCs is usually
convertible into shares of common stock.
From the perspective of the VCs, the advantage to convertible preferred stock, as
compared to common stock, is that it has the “upside” benefit of being convertible
into common stock if the company does well and the common stock increases
dramatically in value, but also has “downside protection” through the liquidation
preference (discussed above) and restrictive covenants (discussed below).
Convertible preferred stock is typically convertible into common stock at any time,
at the option of the holder, although VCs will typically only convert into common
upon an exit transaction (and then only if doing so will give them greater proceeds
that they would receive as preferred stockholders). The initial conversion ratio is
usually 1:1 and is subject to adjustment in connection with subsequent dilutive
stock issuances, as discussed below. Conversion may also happen automatically in
response to certain events, such as when the company goes public at a valuation
that provides a sufficient return to the VCs (e.g., a “Qualifying IPO”, which is an
initial public offering in which common stock is sold for a per–share price of more
than a stated multiple of the per–share preferred stock price).
Where there are multiple investors holding shares of a given series of preferred
stock (e.g., Series A Preferred Stock), sometimes a provision is included making
the consent of the holders of majority of stock in the series sufficient to force
conversion of all the preferred stock in the series into common stock.
Anti–Dilution Protection. Preferred stock terms usually include “anti–dilution”
provisions, which are designed to protect the existing investors from the dilutive effect of
future issuances by the company of securities at a lower valuation than the valuation at
which the existing investors’ investment was done. Such investments are considered to
be “dilutive” because the later investors receive stock representing a greater percentage
of the company for less money, on a per–share basis, than was paid by the current
Anti–dilution provisions apply to issuances of stock as well as issuances of
promissory notes, options and warrants that are convertible into or exercisable for
shares of stock. Anti–dilution protection is implemented by adjusting the ratio at
which the current investors’ shares of preferred stock are convertible into shares of
common stock (which, as discussed above, is usually initially set at 1:1), so that the
preferred stock becomes convertible into more shares of common stock if the
company does a subsequent dilutive issuance, effectively counteracting the effect
of that dilutive issuance.
Anti–dilution adjustment provisions can be either “full ratchet” or “weighted
average”. “Full ratchet” anti–dilution provisions adjust the preferred stock
conversion ratio in response to the dilutive issuance without taking into account
the amount of stock sold in the dilutive issuance (i.e., the adjustment is the same
whether the company sells 100 shares or 10,000,000 shares in the dilutive
issuance). “Weighted average” anti–dilution provisions, which adjust the
preferred stock conversion ratio in a manner that is sensitive to the number of
shares being sold in the dilutive issuance, are usually viewed as being more fair,
since they more accurately counteract the actual dilution resulting from the
dilutive issuance. Weighted average anti–dilution provisions can be either
“narrow–based” or “broad–based”, with narrow–based provisions resulting a
greater anti–dilution adjustment for a given dilutive issuance (which benefits the
VC preferred stockholders), as compared to broad–based provisions. Broad–based,
weighted average anti–dilution adjustment provisions are most typical (and most
company–favorable), narrow–based weighted average anti–dilution adjustment
provisions are less typical and full–ratchet anti–dilution adjustment provisions are
least typical (and most VC–favorable).
Anti–dilution provisions usually have “carve–outs”, resulting in no adjustment to
the preferred stock conversion ratio, for issuances of stock options and restricted
stock pursuant to the company’s stock option plan, issuance of warrants to lenders
and landlords, and issuances of stock by the company in connection with corporate
acquisitions and other strategic transactions. Sometimes there are numerical caps
on the amount of shares that may be issued under the carve–outs. The term sheet
will typically state that there will be “customary” carve–outs from the anti–
dilution adjustment and the actual list gets negotiated when the definitive
investment documents are prepared.
Voting Rights. Preferred stock issued in VC financings typically entitles its holder to
vote (on an as–converted basis) with the holders of common stock in matters submitted to
the vote of the company’s stockholders. In addition, preferred stockholders usually
receive certain special voting rights.
The special preferred stock voting rights usually include the right to elect one or
more of the members of the company’s board of directors. Although VC board
representation is customary, the precise composition of the board is usually a
negotiated deal term, with a five person board, consisting of the CEO, another
company executive or other company-friendly person, two VC representatives and
one independent director, being a somewhat typical configuration for a Series A
VC investors typically require the company to obtain their consent before taking
certain capitalization–related actions, such as amending the certificate of
incorporation, redeeming or paying dividends on any company stock, or creating
any new series of preferred stock that is senior to, or pari passu (equal rank) with,
the existing series of preferred stock. Because any such restriction on the
company creating a new series of preferred stock effectively gives the VC investors
a veto right on any future equity financings of the company, such restrictions are
sometimes resisted by entrepreneurs, some of whom are able to get the VCs to
limit the consent right to issuances of senior preferred stock, thereby allowing the
company to issue junior or (more importantly) pari passu preferred stock. This is
an important distinction, as new VC investors are typically unwilling to make
their money junior to that of existing investors but may be willing to invest on pari
passu basis with the existing investors.
Sometimes, VCs will impose restrictions on the company’s ability to take certain
operational actions without their consent such as incurring debt (other than trade
payables), hiring or firing members of senior management, changing the
company’s business or entering into related party contracts, which can be
implemented through requiring the approval of the VC (in its capacity as a
stockholder in the company) or by requiring approval of the VC’s appointees on the
company’s board of directors. While including some restrictive covenants is
customary, an overly burdensome covenant package can act as an impediment to
operation of the business and should be resisted by the company.
Pre–Emptive Rights. VC investors usually receive a contractual right to participate in
future equity financings of the company through “pre–emptive” rights, in which they get
to maintain their percentage interest in the company by purchasing their pro rata
portion of any company stock (or notes, options, warrants or other securities convertible
into or exercisable for stock) that is sold in any equity financing done by the company
subsequent to the VC’s investment.
The term sheet will typically state that there will be “customary” carve–outs from
the pre–emptive rights provisions and the actual list gets negotiated when the
definitive investment documents are prepared.
The list of company securities issuances that are “carved–out” from pre–emptive
rights typically includes issuances of restricted stock and stock options pursuant to
the company’s stock option plan, issuance of warrants to lenders and landlords,
and issuances of stock in connection with corporate acquisitions and other
strategic transactions (which often mirror the list of carve–outs from the anti–
dilution provisions discussed above).
Pay–to–Play. When making an investment in a start–up company, many (if not most)
VCs plan on making not only the initial Series A investment, but also making “follow on”
investments in later financing rounds. Where more than one VC is participating in a
financing round, sometimes the lead VC will want to include provisions in the
investment documents to help ensure that the other VCs will continue to support the
company in future investment rounds, which are referred to as “pay to play” provisions.
Pay–to–play provisions typically punish any existing preferred stock investor that
fails to fully exercise its pre–emptive rights to purchase its pro rata portion of the
securities sold in a new financing transaction by adversely changing the terms of
the non–participating investor’s investment in the company. The adverse change
can be forced conversion of all of the non–participating investor’s preferred stock
into common stock or elimination of anti–dilution protection from the non–
participating investor’s preferred stock, among other things.
Because pay–to–play provisions encourage existing investors to participate in
future financing rounds, they could be considered to be pro–company. However,
since some strategic investors and smaller VCs have institutional prohibitions on
investing in pay–to–play companies, companies that agree to include pay–to–play
provisions should keep in mind that doing so will reduce the pool of possible
investors for subsequent financing rounds.
Redemption Rights. VC investors sometimes require a redemption feature on the
preferred stock, which requires the company to buy back the preferred stock from the
VCs on or after a specified time period after the closing of the VC financing (usually 5 to
The redemption price is usually the “liquidation preference” amount (i.e., original
purchase price plus accrued and unpaid dividends) discussed above, but is
sometimes equal to the greater of the liquidation preference amount or the fair
market value of the preferred stock as of the time of redemption (which is usually
based mostly on the then–current value of the common stock into which the
preferred stock is convertible).
VCs usually argue that they need redemption rights due to the finite life of each
investment partnership managed by their firms (which are generally six to ten
years). More candid VCs will admit that they are disinclined to invest in “lifestyle
companies”, in which management makes a steady living but no exit for the
investors is forthcoming, and redemption provisions are a way of moving a
company to an exit event.
The remedies for the failure by a company to redeem its preferred stock when
requested to do so by the VC investors sometimes include additional “penalty rate”
dividends accruing on the preferred stock, the VCs receiving the right to appoint a
majority of the company’s board of directors, and the VCs becoming entitled to
force a liquidation of the company or to “drag–along” the other company
stockholders in a sale of the company (drag–along rights are discussed in more
Where there are multiple VC investors holding shares of a given series of preferred
stock (i.e., Series A Preferred Stock), sometimes the investors require a provision
stating that the consent of the holders of majority of the stock in the series is
sufficient to force redemption of all of the preferred stock in the series.
Right of First Refusal and Co–Sale Rights. VC investors usually seek to ensure that
company stock does not go outside of “friendly hands” by requiring the entrepreneurs and
other significant stockholders to agree to first offer their company stock to the company
and the VC investors, prior to transferring any such stock to a third party. In addition,
as a disincentive for entrepreneurs and other significant stockholders to sell their stock
to third parties, VC investors typically require that the entrepreneurs and other
significant stockholders allow them to participate in any such transfer by requiring the
buyer to also buy a pro rata portion of the VC investors’ company stock (if the third party
purchaser doesn’t want to buy all of the stock, the entrepreneurs or other significant
stockholder usually must reduce the amount of stock that it sells in the sale).
There is a usually a carve–out from right of first refusal and co–sale provisions for
estate planning–related transfers to family members of the stockholder and trusts
established for their benefit.
Sometimes entrepreneurs are able to negotiate a carve–out from right of first
refusal and co–sale provisions for transfers of company stock among the existing
Drag–Along Rights. To help ensure that their exit from the investment goes smoothly,
VC investors sometimes subject minority stockholders (i.e., entrepreneurs, other
management stockholders and any angel or other pre–VC funding equity investors) to a
“drag–along” provision, in which the minority stockholders agree that, if the VCs and
other investors collectively holding a majority of the company’s stock (on an as–converted
basis) decide to sell the company, the minority stockholders will also agree to sell their
stock and take other actions in support of the sale transaction
For the drag–along obligation to apply, usually the price and other terms for the
sale of the minority investors’ stock has to be the same as those for the majority
investors (i.e., no “control premium” is paid to the majority investors).
Entrepreneurs are sometimes able to negotiate the holders of a specified
“supermajority” (rather than just 50.1%) of the company’s stock being required to
initiate a drag–along sale, with the threshold being set high enough to effectively
give a group of minority investors (such as the management stockholders and
some other minority investors), acting together, the ability to block a drag–along
Registration Rights. Another VC exit protection is registration rights, which require the
company to register the common stock received upon conversion of the VC’s preferred
stock with the SEC for sale in a public offering. This can be done either as part of an
SEC–registered offering already planned by the company (called “piggyback” rights) or in
a separate SEC registered offering initiated at the VCs’ request (called “demand” rights),
in each case at the company’s expense.
Although demand registration provisions typically relate to SEC registrations that
are effected after a company does its initial public offering, sometimes demand
registration provisions include an outside date by which the company must
register the VC’s stock with the SEC (usually 5 to 7 years after the investment
closing), which effectively require the company to go public by such date or obtain
a waiver from the VCs. As is the case for the redemption rights discussed above,
VCs typically request these provisions as a means of helping to ensure that they
will be able to exit their investment in a timely manner. However, unlike the
redemption provisions, a company’s ability to go public is driven to a significant
degree by the state of the public securities markets, which are not controlled by
the company or the VC investors and may not be hospitable to an IPO at a
In addition to the inclusion of “forced IPO” demand rights, as discussed above, the
number of demand registration rights that the VCs will receive generally is
sometimes negotiated by the parties, with two being a relatively typical number.
In addition, sometimes VCs will request a “most favored nation” provision,
restricting the company’s ability to grant registration rights to others on more
Vesting of Entrepreneurs’ Stock. VCs sometimes require, as part of the VC financing
transaction, that entrepreneurs subject their company stock to repurchase by the
company upon termination of the entrepreneur’s employment with the company. Over
time after the VC financing, if the entrepreneur stays employed by the company, an
increasing percentage of his or her company stock becomes “vested”. Stock that has not
become vested as of the date on which an entrepreneur leaves the company is considered
Usually termination of an entrepreneur’s employment by the company without
“cause” or by the entrepreneur for “good reason” will result in accelerated vesting
of all of the entrepreneur’s unvested stock.
Some stock vesting agreements provide that unvested stock may be repurchased
by the company at the price originally paid by the entrepreneur (which is usually a
de minimus amount) and vested stock may be repurchased by the company at the
fair market value of such stock. Other stock vesting agreements only subject
unvested stock to repurchase by the company (at original purchase price) and
vested stock is not subject to repurchase.
Entrepreneur stock vesting arrangements are often fiercely resisted by
entrepreneurs, who argue that their company stock is their property, which was
accepted in lieu of salary and other employment benefits, and which therefore
should not be subject to forfeiture or other loss if they leave the company. VC
investors that require these types of arrangements usually argue that a large part
of the value in the company stock is being created with their money and
entrepreneurs shouldn’t benefit from increases in the value of the company that
occur after they leave the company.
* * * * *
This article does not constitute legal advice from the author or the law firm of Kelley Drye & Warren LLP.
If you have any questions about the matters discussed in this article, please don’t hesitate to contact
John McDonald at (202) 342-8805 or JMcDonald@KelleyDrye.com.
John McDonald Biography
John McDonald is a member of the Private Equity Group at Kelley Drye & Warren
LLP, resident in the firm’s Washington, D.C. office. John’s practice focuses on
counseling clients on a full range of corporate transactional and general commercial
matters, with particular emphasis on representing early-stage growth companies,
venture capital firms, strategic investors and angel investors in venture capital and
other debt and equity financing transactions.
John also has extensive experience representing private equity investment firms and
their portfolio companies in leveraged buyouts, mergers and acquisitions, divestitures,
recapitalizations, equity and debt financings, joint ventures, executive employment matters and equity
John is active in the local venture capital community. He presently serves as Co-Chairman of the Selection
Committee for the Business Alliance of George Mason University “Grubstake” venture investor breakfast
series and served as a presenting company advisor for the 2003, 2004 and 2005 MAVA Capital Connection
John received his law degree, cum laude, from the Georgetown University Law Center in 1998. While at
Georgetown Law, John served as lead articles editor of The Tax Lawyer and was an intern at the Division
of Enforcement of the New York Stock Exchange and at the Division of Investment Management of the
Securities and Exchange Commission. He received his bachelor of science degree, magna cum laude, from
the State University of New York at Stony Brook in 1994, where he double majored in economics and
business management and was elected to the Phi Beta Kappa national honor society.
Representative Venture Capital Financing Transactions
Company Receiving Series of Investors Represented Party
Telarix, Inc. Series C-1 Edison Venture Fund; Redshift Ventures Telarix, Inc.
Vidsys, Inc. Series B IDG Ventures; Motorola, Inc.; JVAX Investment Vidsys, Inc.
Regent Education, Inc. Series A Edison Venture Fund Edison Ventures
ASIP, Inc. Series C Nokia Venture Partners; Redpoint Ventures; Intel Nokia Venture
Capital; Fina Ventures Partners
Broadmargin, Inc. Series A ABS Capital Partners; Concert Capital Broadmargin, Inc.
Orbcomm, LLC Series A SES Global; Ridgewood Capital Partners; Northwood SES Global
Glycomimetics, Inc. Series A New Enterprise Associates; Alliance Technology Glycomimetics,
enPocket, Inc. Series A Nokia Venture Partners Nokia Venture
Qovia, Inc. Series A Nokia Venture Partners; Anthem Capital; Maryland Nokia Venture
Department of Business and Economic Development Partners
TecSec, Inc. Series B Boeing Corporation TecSec, Inc.
Aspen Aerogels, Inc. Series A Rockport Capital Partners Rockport Capital
Seclarity, Inc. Series A Blumberg Capital Partners; Valley Ventures Blumberg Capital
Sonic Series D HSBC; Murjan Holdings Sonic
Inc. ns, Inc.
Broadwave, Inc. Series A Telesoft Partners Broadwave, Inc.