Negotiating Your “Series A” Financing

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One of your first tasks in financing your technology company is likely to be completing your initial equity financing with outside investors. Typically, these financings are done with a venture capital firm (“VC”), angel investors or “friends and family” and the company will sell Series A Preferred Stock. Some of the primary negotiating points in the Series A Preferred Stock financing term sheet are the following:

     A. Valuation. This is a very difficult matter to ascertain, and, in truth, there is no way to determine a closely held company’s value with any precision. A company is well advised to seek non-legal assistance in determining its starting point for negotiation of valuation in order to be able to negotiate this point effectively.

     B. Dividends. The term sheet will typically provide that dividends will be paid on the Series A Preferred Stock “when, as and if” declared by the Board. In truth, dividends are rarely paid.

     C. Liquidation Preference. The term sheet will almost always provide that if the company is liquidated, after all the debts have been paid, the holders of the Series A Preferred Stock will get the amount that they invested back (together with accrued but unpaid dividends) before any payments are made to the holders of the Common Stock.

     D. Conversion Rights. In certain instances, the investors will want to convert their preferred stock to common stock (such as on a sale of the company). The Series A Preferred Stock is typically convertible initially on a 1:1 basis, subject to anti-dilution protection if the company later issues shares at a lower valuation.

     E. Registration Rights. The term sheet will almost always provide for “registration rights” – the right to participate in or demand registration of the shares with the Securities and Exchange Commission.

     F. Right of First Offer; Preemptive Rights. The term sheet often gives the investors the right to invest in the company’s future financings in preference to other investors the company may want to bring in as shareholders (a “Right of First Offer’). The investor will also want the right (called a “Preemptive Right”), if shares are issued in an investment, and the Right of First Offer is not exercised, to acquire the number of shares necessary to maintain its percentage ownership in the company, at the same price as the new investor is paying.

     G. Voting Rights of Series A Preferred. Typically, the Series A Preferred Stock will carry a number of votes equal to the number of shares of Common Stock issuable on conversion, and the Series A Preferred Stock and Common Stock will vote together as a class (except in certain instances described under “Protective Provisions”).

     H. Protective Provisions. There are certain instances in which the consent of the Series A Shareholders is required before the company may take a particular action, including a sale of all or substantially all of the company’s assets, an increase in the size of the board of directors, or a change in the terms of the company’s charter or bylaws. The investors will also want to approve increases in executive salaries, annual budgets, and other major matters relating to the business of the company.

     I. Rights Relating to the Founders. The term sheet will often require that the founders agree to have their shares vest over some period of time, and that the founders agree to sign non-competition agreements which will extend for one to two years following the term of their employment with the company.

     J. Anti-Dilution Protection. Investors will want protection if the company issues shares at a lower price per share than the investors are paying. These provisions are built into the rate at which the Preferred Stock is convertible into Common Stock.

     K. Board Seats. The investors will typically want at least one seat (often two seats) on the board of directors, and want to add at least one independent director to the board.

     L. Payment of Fees. The term sheet will require that the company pay the investor’s legal fees. The company should be able to negotiate a cap on this amount.

     M. No Shop. The term sheet will usually require that the company agree not to discuss alternative investments with any other investor for a period of about 30-60 days after the term sheet is signed.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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