How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (14 page)

After a year, the company is sold for $20 million. The investor gets the $10 million back plus 30% of the remaining amount, or $3 million. The remaining $7 million goes to the rest of the shareholders.

As you can see, a participation clause can take a big bite from a transaction. As much as possible, try to eliminate it from the term sheet.

If this is not possible, try to get a cap. For example, you may agree that the amount of the liquidation preference and the participation may not exceed 2X the initial investment.

In the Series A stage, it’s easy to get a sense of the impact of the liquidation preference and participation. But with Series B and subsequent rounds, the math can become complicated, because there will likely be multiple preferences and participations. Thus it’s a good idea to have a spreadsheet to test the myriad alternatives. You do this by using a
capitalization table
(or
cap table
for short). It lists all the shareholders in a company and makes it easy to see how changes will impact the equity percentages. Your attorney should provide such a table.

All C-Corps have a board of directors, which can range from three to ten members or so. They often meet every month or two to review the company’s progress and weigh-in on strategic decisions.

But the board is more than a source of advice. It also has lots of power. Consider that it can appoint and fire the CEO. This is why VCs negotiate hard to get as much power as possible over the board seats.

Zuckerberg saw this as something to avoid at all costs. To realize his vision of a global powerhouse—which would involve holding back on advertising deals, saying no to mega-buyout offers from companies like Yahoo, and deferring an IPO—he knew that he had to maintain control of the board.

Zuckerberg also had the advantage of getting valuable advice from Sean Parker on the matter. Parker was kicked out of the company he founded, Plaxo, because he didn’t have enough control over the board. And he also got kicked out of Napster!

To avoid this result at Facebook, Parker recommended that Zuckerberg set up the corporate governance to give him power to name three out of the five board seats. The other two went to Peter Thiel, who was known to be founder friendly, and Jim Breyer, a partner at Accel.

It wasn’t until June 2008 that Zuckerberg made a move to elect an outside board member: Marc Andreessen. Back in the mid-1990s, Andreessen ignited the Internet revolution with the Netscape browser. Zuckerberg instantly confided in Andreessen because he had first-hand experience of the challenges of being a 20-something wunderkind.

Then, in March 2009, Zuckerberg brought on another key board member: Donald Graham, CEO of
The Washington Post
. They became good friends and shared a deep sense of the importance of creating a company that is built to last.

The lesson is not to rush things. Doing so only adds to the complexity and, even worse, to a loss of control. Spend time getting to know potential board members and developing a feel for their philosophies on major issues.

Some VCs may request an observer seat for board meetings. It’s tempting to agree, because you won’t lose any power. But you should still say “No.” For the most part, an observer only adds to the distractions at board meetings.

In terms of compensation, a board member usually receives stock options instead of cash, as well as reimbursement for travel and out-of-pocket expenses. But be careful. The reimbursements must be
reasonable
. You don’t want to pay for the gas in a VC’s jet!

A
down round
is horrible. This happens when the next series of funding is at a lower valuation. Existing shareholders usually take a hit, and employees and founders also feel lots of pain. It can be so bad that key people decide to leave, putting the venture in jeopardy.

A VC anticipates this possibility and puts in place protections known as
anti-dilution clauses
. The problem is that the founders and employees don’t get these protections.

Even though this seems unfair, it doesn’t matter. Anti-dilution clauses are standard features in a term sheet.

But there are ways to lessen the pain. To understand how, you need to know about the different types of anti-dilution clauses.

The most severe is the
full ratchet
, which triggers the issuance of new shares to an existing investor and reduces the price of the prior financing to the same price as the current round. The result is that the founders see massive dilution. If this occurs, it’s best for a founder to leave. The down round will
already have created a major loss in confidence, and the investors probably want you to leave anyway.

The other type of anti-dilution clause is the
weighted average approach
. It involves a convoluted equation that blends a lower price and new shares issued. Basically, it lessens the severity of the dilution’s impact for the founders. The level depends on the formula, which has two flavors: broad-based and narrow-based. The math is beyond the scope of this book. But as a general rule, the broad-based approach is best for entrepreneurs. It still has a sting but is tolerable.

For the most part, you want existing investors to participate in future rounds because it’s a telling sign of their confidence in the company. It also helps to promote continuity. It cannot be stressed too much that your investors are key partners in your company’s success.

To encourage future investments, you can include a play-to-play provision in the term sheet. If the investor doesn’t invest, preferred stock converts into common stock. This means the investor loses key advantages, such as the liquidation preference and the anti-dilution clause.

You probably won’t see a pay-to-play provision in the initial term sheet. It’s up to you to bring it up and highlight how it’s important to the deal. You can say something like, “Aren’t you interested in the long-term prospects of the company? Why not invest in the future rounds?”

If there is still pushback, you need to reconsider the investor. Will they be there when times are tough?

A pay-to-play provision may not be appropriate for angels, though. They are using their personal funds and may not want to feel obligated to keep funding the company. Out of deference, you may want to leave such a provision out of the term sheet for the angel round.

A drag-along provision requires founders and other key shareholders to vote in favor of a major corporate transaction, such as a sale or merger. It can make for a self-fulfilling prophesy. For example, suppose XYZ invests $10 million in ABC and has a 3X liquidation preference. Microsoft comes along and offers $20 million for the company. The VC wants to get a quick return for their portfolio—because their other investments have been lagging—and agrees to
the deal. If there are drag-along rights, everyone else must do so as well. But the problem is that all the other shareholders will get nothing.

In other words, founders should negotiate this hard. Keep in mind that Zuckerberg didn’t have a drag-along clause in his financings.

If you cannot knock out the clause completely, there are some ways to soften it. One is to require majority approval from the common stock holders. If investors complain, say that the preferred stock holders have the option to convert to common stock.

Another helpful clause is to require a minimum valuation on the deal. It could be something like 2X the liquidation preference.

Now let’s look at clauses that are not essential. Although you should put up some resistance to them, you need not spend too much effort on it. Save your time for the clauses already discussed.

This clause involves the conversion of preferred stock into common stock. One approach is an optional conversion right, which gives a preferred stock holder the discretion of whether to convert their stock. Often this is done when maximizing the value from a liquidation preference.

Huh? To understand this, let’s take an example. Suppose ABC invests $10 million in XYZ and gets 20%. The preferred stock has a 1X liquidation preference, but there is no participation.

After a few years, XYZ sells out to Facebook for $100 million. ABC gets only $10 million with the liquidation. Thus, a better option is to convert the preferred stock to get 20% in common stock, which amounts to $20 million (this is known as
on a converted basis
).

In some cases, there is a mandatory conversion right. This means a conversion takes place as a result of a certain event, which is typically an IPO. It’s much cleaner for a public company to have only common stock.

A mandatory conversion has a threshold amount, which is the minimum that needs to be raised in the public offering. For a startup, it’s important to set this threshold as low as possible. For example, if there is a conversation at $100 million, this may give an investor leverage to negotiate better terms or more equity. But if the amount was instead $20 million, the conversion would be automatic because most IPOs exceed this amount. In fact, if the amount is
less than $50 million, you should not have much of a problem with the mandatory conversion clause.

Some companies are known as the “living dead,” which means they have little growth potential. VCs don’t have much opportunity to see outsized gains in such cases.

Yet they may want to get their money back. This can be done with a
redemption right
(or a
put
), which allows an investor to require a company to repurchase shares after a fixed period of time. Despite this, the redemption right may be useless because the company may not have enough cash on hand to buy back the shares.

If you cannot eliminate the redemption right in a term sheet, you should push back on the time limit—say, providing for five years or more. You should also not tie it to a “material adverse change” clause (this is when a major event happens, such as an earthquake or a terrorist incident). It’s important to limit the redemption right to the initial investment amount, which doesn’t include any dividends.

A
dividend
is a distribution of cash from a company to its investors. It seems strange for a startup to have such a clause; dividends are supposed to come out of a company’s profits, which probably don’t exist for a startup.

Some dividends are
cumulative
. This means that if a dividend isn’t paid, it accumulates in a reserve account. No other investor gets a payment until these dividends are paid off. You should definitely fight against cumulative dividends.

A
non-cumulative
dividend means a board must declare a dividend. If not, then there is no payment for the year. And yes, this is much better.

From a legal standpoint, a term sheet is non-binding. Both parties can walk away from the deal at any point, without consequence.

Yet this isn’t likely to happen. In the investing world, reputation is vitally important. A VC doesn’t want to be known for leaving a company at the altar. At the same time, an entrepreneur doesn’t want to be considered flaky. After all, they most likely need to keep raising money.

There are some provisions in a term sheet that a VC wants to make binding. One is the
no shop
clause. This forbids a founder from actively seeking out another term sheet after an agreement is reached.

The VC may try to set this at 90 days or more. But you should have a period no longer than 30 days.

These are veto rights for investors. It doesn’t matter what the board says. A vote from the shareholders doesn’t matter either. A protective provision always trumps everything else.

Certain standard provisions probably can’t be negotiated away, such as the following:

• Sale of the company
  
• Amendments to the certificate of incorporation or the bylaws
  
• Changes in the total number of authorized preferred and common stock
  
• Issuances of new securities that have preferences over existing preferred stock
  
• Redemption of preferred shares or common stock
  
• Payment of a dividend or any cash distribution
  
• Change in the number of directors
  

But there are some you can probably push back on:

• Change in the focus of the business
  
• Hiring or firing of an executive
  
• Engaging in a transaction with an executive or a director
  
• Incurring debt over a certain limit
  

For an early-stage company, this clause definitely is not worth negotiating. It sets forth the rights for the investors when there is a filing of an IPO, which probably won’t happen for four to five years. Facebook didn’t go public until eight years after its founding.

If the investors spend much time on registration rights, it’s a sign that they don’t understand the nuances of early-stage companies. In the end, the investor may not be appropriate for your company. Besides, do you want to eat up legal fees on something that is a non-issue?

Many entrepreneurs have outside business interests. These may include angel investments, side projects, or board seats.

Such activities are not necessarily problems. If anything, they are a good way to gain more experience and expand your contacts.

But some investors may be concerned about a founder’s focus. Is the founder spending too much time on outside activities? Or may there be conflicts of interest?

A “Founder’s Activities” clause sets some general guidelines. As with any negotiation, be up front and honest. If you plan to continue to engage in outside activities, make sure you disclose this to the investor. You don’t want this to be a source of contention in the future, which could hurt the company and your relationship with the investor.

Until recently, this clause didn’t get much attention. But now it has become important because of the emergence of secondary markets like SecondMarket and SharesPost. These are online exchanges that allow investors and employees to sell their shares to outsiders even though the stock is not publicly traded.