Negotiating the Preferred Stock Term Sheet


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This slide show outlines and discusses the key elements of a preferred stock term sheet, and shows the range of negotiability of those terms in the best and worst of times.

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Negotiating the Preferred Stock Term Sheet

  1. 1. Negotiating The Term Sheet Presented by Bart Greenberg Manatt, Phelps & Phillips, LLP TCVN Breakfast Workshop Series August 7 and 14, 2008
  2. 2. Certain Preliminary Matters
  3. 3. Market Conditions Impact Terms <ul><li>Shortage of willing investors leads to aggressive terms </li></ul><ul><li>Desire by Investors to “correct” prior valuation errors (i.e., overvaluations) and pull up returns on whole portfolio may lead to more aggressive terms </li></ul><ul><li>Desire by Investors to avoid future errors may lead to more aggressive terms, such as by imposing self-adjusting valuations, guaranteed returns, downside protection, more bridge financings </li></ul>
  4. 4. Prior Rounds Impact Terms <ul><li>Severe down round/cramdown (leads to most aggressive terms) </li></ul><ul><li>Flat round (could be considered a “win” in unfavorable market conditions) </li></ul><ul><li>Up round (best chance to get reasonable or favorable terms) </li></ul>
  5. 5. Defining the Terms of the Preferred Stock
  6. 6. Closings <ul><li>When will the Investors go “at-risk”? </li></ul><ul><ul><li>Lump Sum at Closing </li></ul></ul><ul><ul><li>Staging of Investment </li></ul></ul><ul><ul><ul><li>Passage of Time </li></ul></ul></ul><ul><ul><ul><li>Milestones </li></ul></ul></ul>Considerations
  7. 7. Closings Pre-Bubble <ul><li>Single Tranche Investment </li></ul>Post-Bubble <ul><li>Single Tranche Investment </li></ul><ul><li>More Extreme: Milestone-Based Tranches </li></ul>
  8. 8. Dividends <ul><li>Priority of Payment </li></ul><ul><ul><li>Common </li></ul></ul><ul><ul><li>Other Preferred </li></ul></ul><ul><li>Dividend/Coupon Rate </li></ul><ul><li>Cumulative vs. </li></ul><ul><li>Non-Cumulative </li></ul><ul><li>Form of Payment </li></ul><ul><ul><li>Cash “coupon” </li></ul></ul><ul><ul><li>Payment-in-Kind Securities (PIKs) </li></ul></ul>Considerations
  9. 9. Dividends Pre-Bubble <ul><li>Non-mandatory, non-cumulative </li></ul><ul><li>8% per year </li></ul>Post-Bubble <ul><li>Mandatory, cumulative 8% per year </li></ul><ul><li>More Extreme : Mandatory, cumulative, </li></ul><ul><li>payable in kind up to 15% per year </li></ul>
  10. 10. Dividends <ul><li>“ Annual $_____ per share dividend on the Series ___ Preferred Stock, payable when and if declared by Board, prior to any dividends paid to the Common Stock; dividends are [not] cumulative. No dividends will be declared or paid on the Common Stock unless and until a like dividend has been declared and paid on the Series ___ Preferred Stock.” </li></ul>Example
  11. 11. Liquidation Preference <ul><li>Should the holder have a “preferred” return before other equity holders? </li></ul><ul><li>When should the preference apply ( e.g. , non-conversion contexts such as a merger or upon liquidation)? </li></ul><ul><li>Key Characteristics: </li></ul><ul><ul><li>Priority of Distribution </li></ul></ul><ul><ul><li>Amount of Preference </li></ul></ul><ul><ul><li>Participation Rights </li></ul></ul>Considerations
  12. 12. Liquidation Preference More favorable to preferred holders More favorable to common holders Multiple of cost to PS; then pro rata participation Cost + AROI to PS; then pro rata participation Cost + AROI to PS; then pro rata up to multiple of PS cost; or else convert Cost + AROI to PS; cost + AROI to CS; then pro rata participation Cost + AROI to PS; negotiated amount to CS; then pro rata participation Cost + AROI to PS; same amount per share to CS; then pro rata participation Cost + annual ROI (“AROI”) or else convert Return cost only, or else convert H G F E D C B A
  13. 13. Liquidation Preference Pre-Bubble <ul><li>1X purchase price, plus participation </li></ul><ul><li>rights up to 3X </li></ul>Post-Bubble <ul><li>1X to 3X with some participation rights </li></ul><ul><li>(the lower the X, the greater the </li></ul><ul><li>participation rights) </li></ul><ul><li>Participation Rights are sometimes </li></ul><ul><li>subject to a management carve out </li></ul><ul><li>More extreme : 3X purchase price, plus </li></ul><ul><li>participation rights with no cap </li></ul>
  14. 14. The “Waterfall” <ul><ul><li>Third: Distribution to holders of common stock (with possible participation by holders of preferred stock) </li></ul></ul><ul><ul><li>Second: Distribution to holders </li></ul></ul><ul><ul><li>of preferred stock </li></ul></ul>First: Creditors Satisfied
  15. 15. The “Waterfall” ( an illustration ) * Original investment of $4,100,000 Amount Available for Distribution: $15,000,000   First Second Third Total Creditors 0 0 0 $0.00 Series A* 0 $4,100,000 $4,100,000 $8,200,000 Common Stock (including option pool) 0 0 $6,800,000 $6,800,000         $15,000,000     First Second Third Total Creditors 0 0 0 $0.00 Series A* 0 $12,300,000 $1,350,000 $13,650,000 Common Stock (including option pool) 0 0 $1,350,000 $1,350,000         $15,000,000   Term Sheet: 1x preference for Series A, 1x participation) Term Sheet: 3x preference for Series A, full participation
  16. 16. Liquidation Preference <ul><li>“ First pay the original purchase price [plus premium] plus accrued dividends (if any) on each share of Series ___ Preferred Stock. Thereafter, Series ___ Preferred Stock participates with Common Stock on an as-converted basis.” </li></ul>Example 1: Full Participation
  17. 17. Liquidation Preference “ First pay the original purchase price plus accrued dividends (if any) on each share of Series ___ Preferred Stock. Thereafter, Series ___ Preferred Stock participates with Common Stock on an as-converted basis until the holders of Series ___ Preferred Stock receive an aggregate of [ _ ]X original purchase price.” Example 2: Cap on Participation Rights
  18. 18. Liquidation Preference “ First pay the original purchase price [plus premium?] plus accrued dividends on each share of Series ___ Preferred Stock. The balance to holders of Common Stock.” Example 3: Non-Participating
  19. 19. Redemption <ul><li>Who can trigger? </li></ul><ul><ul><li>Percentage of preferred holders/individually </li></ul></ul><ul><ul><li>Company (rare) </li></ul></ul><ul><li>Priority among other holders </li></ul><ul><li>Staging of Redemption </li></ul><ul><li>Device to force conversion </li></ul><ul><li>Form of Payment </li></ul><ul><li>Legal Restrictions </li></ul>Considerations
  20. 20. Redemption Pre-Bubble <ul><li>Not Common </li></ul>Post-Bubble <ul><li>At option of holders after 5 years at </li></ul><ul><li>purchase price plus accrued dividends </li></ul>
  21. 21. Redemption “ Series ___ Preferred Stock redeemable at the election of holders [of 66-2/3rds] of the outstanding Series ___ Preferred Stock] on or after ____________ at a price equal to the original purchase price [plus accrued dividends] [plus ___% per year] or as soon thereafter as legally permissible.” Example 1: Lump Sum
  22. 22. Redemption “ [ See Example 1 ], to the extent of 1/3 of the shares of Series ___ Preferred Stock on the [____], [____] and [____] anniversary dates of the Closing or as soon thereafter as legally permissible[, but in no event will more than 1/3 of the outstanding shares of Series ___ Preferred Stock (plus 1/3 of the aggregate accrued dividends) be redeemed in any 12 month period.]” Example 2: Three Tranches
  23. 23. Conversion Rights <ul><li>The number of shares of common stock, if any, into which preferred stock converts: preferred stock share price (fixed) Conversion Price </li></ul><ul><li>Typically Based on Certain Triggering Events </li></ul><ul><ul><li>Election by percentage of holders of preferred stock </li></ul></ul><ul><ul><li>IPO </li></ul></ul>Considerations
  24. 24. Antidilution Adjustments <ul><li>Way to “fix” earlier valuation errors on conversion ( i.e . allocate most or all of risk of down round to common stock) </li></ul><ul><li>Three Types of Adjustments </li></ul><ul><ul><li>“ Full Ratchet” </li></ul></ul><ul><ul><li>“ Narrow-Based” Weighted Average </li></ul></ul><ul><ul><li>“ Broad-Based” Weighted Average </li></ul></ul><ul><li>Specified Exceptions </li></ul>Considerations
  25. 25. Antidilution Adjustments Pre-Bubble <ul><li>Standard broad-based weighted </li></ul><ul><li>average adjustment </li></ul>Post-Bubble <ul><li>Narrow-based weighted average </li></ul><ul><li>adjustment </li></ul><ul><li>More extreme : Full ratchet adjustment </li></ul><ul><li>for a period; then narrow or broad- </li></ul><ul><li>based weighted average </li></ul>
  26. 26. Antidilution ( an illustration ) Scenario: Adjustments (Upon Series B) <ul><li>Series A Conversion Ratio Prior to Series B = 1:1 </li></ul><ul><li>Upon Series B, Series A Conversion Ratio adjusted as follows: </li></ul>Common Stock Outstanding 1,000,000 shares Series A Preferred 1,000,000 shares at $1.00 (or $1,000,000) Series B Preferred 1,000,000 shares at 75¢ (or $750,000) Type of Adjustment Conversion Ratio Full Ratchet 1:1.333 Narrow-Based 1:1.143 Broad-Based 1:1.091
  27. 27. Antidilution Adjustments “ Conversion ratio for Series ___ Preferred Stock adjusted on [ratchet/[broad or narrow] weighted average] basis in the event of a dilutive issuance [so long as investor purchases full pro rata share of dilutive issuance (“pay to play”).]” Example 1: With Pay to Play
  28. 28. Antidilution Adjustments “ Dilutive issuance” shall not include: (i) up to ______ shares of Common Stock issued pursuant to a stock option plan approved [unanimously/by a majority] of the Board of Directors; (ii) Common Stock issued upon conversion of the Preferred Stock; (iii) stock issued in any IPO in which the Preferred Stock is converted into Common Stock; or (iv) stock issued in connection with mergers or acquisitions approved [unanimously/by a majority] of the Board of Directors.” Example 2: Specified Exceptions
  29. 29. Protective Provisions Considerations <ul><li>Control Provisions </li></ul><ul><ul><li>Board Seats </li></ul></ul><ul><ul><li>Voting Agreements </li></ul></ul><ul><ul><li>Other Protections </li></ul></ul>
  30. 30. Protective Provisions Pre-Bubble <ul><li>Investor approval of: senior securities, </li></ul><ul><li>sale of company, payment of dividends, </li></ul><ul><li>liquidation, change of rights </li></ul><ul><li>Investor approval of senior or pari passu </li></ul><ul><li>securities, sale of company, payment of </li></ul><ul><li>dividends, change of rights, change of </li></ul><ul><li>business, incurrence of debt over </li></ul><ul><li>specified limit, annual budgets and </li></ul><ul><li>variances, acquisitions of other </li></ul><ul><li>businesses, grant of exclusive rights in </li></ul><ul><li>technology, appointment or termination </li></ul><ul><li>of CEO </li></ul>Post-Bubble
  31. 31. Protective Provisions “ Votes on an as-converted basis, but also has [class/series] vote as provided by law and on (i) the creation of any senior [or pari passu] security, [(ii) payment of dividends on [Common Stock/on any class of Stock]],[(iii) any redemptions or repurchases of Common Stock or Preferred Stock [except for purchases at cost upon termination of employment], (iv) any liquidation, dissolution or winding up of the Company; (v) any merger, acquisition, recapitalization, reorganization or sale of all or substantially all of the assets of the Company, (vi) an Example
  32. 32. Protective Provisions <ul><li>increase or decrease in the number of authorized shares of Series [ _ ] Preferred Stock or Common Stock, (vii) any [adverse] change to the rights, preferences and privileges of the Series [ _ ] Preferred, [(viii) an increase or decrease in the size of the Board], [(ix) [material] amendments or repeal of any provision of the Company’s Charter or Bylaws]; [(x) the issuance of any additional shares of capital stock (or options) to the Company’s founders,] and [(xi)] authorization of any amount of indebtedness in excess of $____.]” </li></ul>Example (cont.)
  33. 33. Defining the Terms of the Stock Purchase Agreement
  34. 34. Representation and Warranties Considerations <ul><li>Scope/Coverage </li></ul><ul><li>By the Company </li></ul><ul><li>By the Founders ( e.g. , technology) </li></ul>
  35. 35. Conditions to Closing <ul><li>Satisfactory Completion of Due Diligence </li></ul><ul><li>Exemption or Qualification of Shares under Applicable Securities Laws </li></ul><ul><li>Filing of Amendment to Charter to Establish Rights and Preferences of the Preferred Stock </li></ul><ul><li>Opinion of Counsel to the Company </li></ul>Considerations
  36. 36. Employee Matters <ul><li>Employment Agreements with Founders </li></ul><ul><li>Obligation for All Employees/Consultants to Enter into Company’s Standard Inventions and Proprietary Information Agreement </li></ul>Considerations
  37. 37. Expenses <ul><li>Company Typically Pays Reasonable Fees and Expenses of Investors’ Counsel </li></ul><ul><li>Consider Cap on Obligation </li></ul>Considerations
  38. 38. Defining the Terms of the Investors’ Rights Agreement
  39. 39. Registration Rights Considerations <ul><li>Types of Registration Rights </li></ul><ul><ul><li>Demand Rights </li></ul></ul><ul><ul><li>Piggyback Rights </li></ul></ul><ul><ul><li>S3 Rights </li></ul></ul><ul><li>Termination of Rights </li></ul><ul><li>Limitation on Subsequent Rights </li></ul><ul><ul><li>Absolute prohibition </li></ul></ul><ul><ul><li>Permitted if Subordinate </li></ul></ul><ul><li>Allocation of Expenses </li></ul>
  40. 40. Registration Rights “ Beginning on the earlier of [3-5] years from Closing, or [three/six] months after the Company’s IPO, [1-2] demand registrations [for underwritten public offerings] upon initiation by holders of at least [30]% of outstanding Series ___ Preferred Stock (or Common Stock issuable upon conversion of the Series ___ Preferred Stock or any combination thereof) for aggregate proceeds in excess of $_______.” Example 1: Demand Rights
  41. 41. Registration Rights “ Investors in Series __ Preferred Stock will have [unlimited] piggyback registration rights subject to pro rata cutback at the underwriter’s discretion. Full cutback upon the IPO; [30% minimum inclusion thereafter]. Investors will not be subject to cutback unless all other selling shareholders are excluded from registration.” Example 2: Piggyback Rights
  42. 42. Registration Rights “ [Unlimited] S-3 Registrations of at least $500,000 each [upon initiation by holders of at least [20%] of the outstanding Series ___ Preferred Stock (or Common Stock issuable upon conversion of the Series ___ Preferred Stock or any combination thereof)]. [No more than two S-3 Registrations in any 12 month period.]” Example 3: S3 Rights
  43. 43. Registration Rights “ Registration rights terminate [(i) [3-7] years after the IPO;] or (ii) when [the Company is publicly traded and] all shares can be sold [in any 90-day period] under Rule 144, whichever occurs first.][, provided that this clause (ii) shall not apply to any 5% holder deemed to be an affiliate of the Company.]” Example 4: Termination
  44. 44. Market Stand-Off Considerations <ul><li>Time of Lock-Up </li></ul><ul><li>Who Controls Decision </li></ul><ul><ul><li>Investors </li></ul></ul><ul><ul><li>Underwriter </li></ul></ul><ul><li>Equal Application </li></ul><ul><li>Obligation to Execute Underwriter’s Form of Lock-Up Agreement </li></ul>
  45. 45. Market Stand-Off “ Prior to the Closing, all shareholders shall agree that in connection with the IPO not to sell any shares of Preferred Stock or Common Stock issuable upon conversion thereof for a period of up to [180] days following the IPO [(provided directors and officers of the Company and [5]% shareholders agree to the same lock-up. Such shareholders also shall agree to sign the underwriter’s standard lock-up agreement reflecting the foregoing.” Example
  46. 46. Right of First Offer Considerations <ul><li>Who Owns the Right? </li></ul><ul><ul><li>All holders of preferred stock </li></ul></ul><ul><ul><li>Holders of at least [____] percentage of preferred stock </li></ul></ul><ul><li>Determination of Percentage </li></ul>
  47. 47. Right of First Offer Pre-Bubble <ul><li>Right to maintain pro-rata ownership in </li></ul><ul><li>later financings </li></ul>Post-Bubble <ul><li>Right to maintain pro-rata ownership in </li></ul><ul><li>later financings </li></ul><ul><li>More extreme : Right to invest 2X pro- </li></ul><ul><li>rata ownership in later financings </li></ul>
  48. 48. Right of First Offer “ The Investors shall have a pro rata right, based on their percentage equity ownership of [Preferred Stock] [Common Stock, on a fully diluted basis], to participate in subsequent financings of the Company (excluding [ See List of Specified Exceptions to Antidilution Adjustments ]. Such right will terminate immediately prior to a Qualified Public Offering.” Example
  49. 49. Financial Information Considerations <ul><li>Financial Statements </li></ul><ul><ul><li>[Audited] annual statements </li></ul></ul><ul><ul><li>Unaudited monthly/quarterly statements </li></ul></ul><ul><li>[1-5] Year Projections </li></ul><ul><li>Other Material Information </li></ul>
  50. 50. Board of Directors Considerations <ul><li>Determination of Authorized Number of Directors </li></ul><ul><li>Voting Agreement Among Shareholders </li></ul><ul><ul><li>Class Votes </li></ul></ul><ul><ul><li>Specific Identification </li></ul></ul><ul><li>Independent Members of Board </li></ul><ul><li>Use of an Advisory Board </li></ul><ul><li>Board Observation Rights </li></ul>
  51. 51. Board of Directors “ [The Company’s Articles of Incorporation shall provide that the] Board shall consist of ____ members, with the holders of a majority of Series ___ Preferred Stock entitled to elect ____ member(s) [and the holders of a majority of the Common Stock entitled to elect ____ member(s)]. [The Company and the Investors intend to select ____ outside director(s) with relevant industry experience as soon as possible after Closing.] Board composition at Closing shall be _______, [with vacancy].” Example
  52. 52. Defining Terms of Other Agreements
  53. 53. Restrictions on Transferability <ul><li>Rights of First Refusal </li></ul><ul><li>Co-Sale Rights </li></ul><ul><li>Drag-Along Rights </li></ul>
  54. 54. Rights of First Refusal Pre-Bubble <ul><li>Right to purchase any shares proposed </li></ul><ul><li>to be sold by employees </li></ul>Post-Bubble <ul><li>Right to purchase any shares proposed </li></ul><ul><li>to be sold by employees </li></ul><ul><li>More extreme : right to purchase any </li></ul><ul><li>shares proposed to be sold by any </li></ul><ul><li>shareholder </li></ul>
  55. 55. Rights of First Refusal “ Any [vested] Common Stock acquired by [employees] [founders] [shareholders] shall be subject to a right of first refusal of [the Company] [the Investors] to repurchase any stock, at the bona fide offer price.” Example
  56. 56. Co-Sale Rights Pre-Bubble <ul><li>Right to sell alongside any founder that </li></ul><ul><li>sells shares </li></ul>Post-Bubble <ul><li>Right to sell alongside any founder </li></ul><ul><li>that sells shares </li></ul><ul><li>More extreme : Right to sell alongside </li></ul><ul><li>any shareholder that sells shares </li></ul>
  57. 57. Co-Sale Rights <ul><li>“ Until the IPO, the Investors also shall have the right to participate on a pro rata basis in transfers of any shares of [Preferred Stock or] Common Stock [held by the Founders or any [major] shareholder], [and a right of first refusal on such transfers, [subordinate to] [prior to] the Company’s right of first refusal. [Any shares not subscribed for by an Investor may be reallocated among the other eligible Investors.]” </li></ul>Example
  58. 58. Drag-Along Rights Pre-Bubble <ul><li>None </li></ul>Post-Bubble <ul><li>None </li></ul><ul><li>More extreme : Right to force </li></ul><ul><li>shareholders to sell company upon </li></ul><ul><li>board and majority shareholder vote </li></ul>
  59. 59. Drag-Along Rights “ So long as the Investors own shares of Series ___ Preferred Stock representing at least [25]% of the Company’s Common Stock on a fully-diluted basis (as determined by ]), the Investors shall have drag-along rights with respect to securities of any of the Founders or principal Common Stock holders in the event of a proposed sale of the Company to a third party (whether structured as a merger, reorganization, asset sale or otherwise).” Example
  60. 60. Founder Vesting Pre-Bubble <ul><li>3- or 4-year vesting with some up-front </li></ul><ul><li>vesting </li></ul>Post-Bubble <ul><li>4-year vesting with no-up front vesting </li></ul><ul><li>More extreme : 5-year vesting and/or </li></ul><ul><li>performance standards </li></ul>
  61. 61. Founder Vesting “ If a Founder voluntarily terminates his or her employment with the Company or is terminated for cause, then the [Company/the Investors] will have the right to repurchase 100% of the Founders’ shares less [1/48]th of those shares for each complete month of service the employee served with the Company.” Example 1: Single Trigger
  62. 62. Founder Vesting “ Upon termination of the employment of the shareholder, with or without cause, the Company may repurchase at cost any shares subject to the repurchase option. The Company’s repurchase option shall lapse by [___ percent (__%)] of the unvested portion in the event such Founder is terminated without Cause or Constructively Terminated as a result of and within six (6) months prior to or twelve (12) months following a Change in Control.” Example 2: Double Trigger
  63. 63. Certain Term Sheet Terms
  64. 64. Capitalization “ The Company’s capital structure before and after the Closing is set forth below [including founder’s shares to be issued prior to the Closing]:” Example
  65. 65. Publicity <ul><li>“ The Company will not discuss the terms of this Term Sheet with any person other than key officers, members of the Board of Directors of the Company or the Company’s accountants or attorneys without the written consent of Investor, except as required by law. In addition, the Company shall not use the Investor’s name in any manner, context or format (including, reference on or links to websites, press releases, etc.) without the prior review and approval of Investor.” </li></ul>Example
  66. 66. No Shop <ul><li>“ From the signing date hereof until 5:00 P.M. Pacific Standard Time on __________, the Company and the Founders agree that they shall not solicit, encourage others to solicit, encourage or accept any offers for the purchase or acquisition of any capital stock of the Company, of all or any substantial part of the assets of the Company, or proposals for any merger or consolidation involving the Company, and they shall not negotiate with or enter into any agreement or understanding with any other person with respect to any such transaction.” </li></ul>Example
  67. 67. Questions?
  68. 68. Negotiating The Term Sheet Thank you! Presented by Bart Greenberg Manatt, Phelps & Phillips, LLP (714) 371-2518 [email_address]