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Navigating Your Series A Term Sheet
You’ve just gotten through an exhausting fundraise, congratulations are in order, and now you have an unsigned Series A term sheet in your hand. What’s next? It’s often assumed that you will know what you’re…
You’ve just gotten through an exhausting fundraise, congratulations are in order, and now you have an unsigned Series A term sheet in your hand. What’s next? It’s often assumed that you will know what you’re looking at when handed a Series A term sheet, but if you’re a first-time founder, that usually isn’t the case.
To help you navigate your Series A term sheet we’ve briefly summarized common fields and terms and what you should be looking for under each one. The fields below are largely based off of Y-Combinators post and Series A Term Sheet template, “A Standard and Clean Series A Term Sheet.” As a note, this is not legal advise and we suggest consulting with your lawyer while reviewing your term sheet.
Liquidation preference is simply the order in which stakeholders are paid out in case of a company liquidation (e.g. company sale). Liquidation preference is important to your investors because it gives some security (well, as much security as there is at the Series A) to the risk of their investment. If you see more than 1x, which means the investor would get back more than they first invested, that should raise a red flag.
To learn more about liquidation preferences check out this article, “Liquidation Preference: Everything You Need to Know.”
In the eyes of an early stage investor, dividends are not a main point of focus. As Brad Feld puts it, “For early stage investments, dividends generally do not provide “venture returns” – they are simply modest juice in a deal.” Dividends will typically be from 5-15% depending on the investor. Series A investors are looking to generate huge returns so a mere 5-15% on an investment is simply a little added “juice.”
There are 2 types of dividends; cumulative and non-cumulative. YC warns against cumulative dividends; “the investor compounds its liquidation preference every year by X%, which increases the economic hurdle that has to be cleared before founders and employees see any value.”
Conversion to Common Stock
Common practice will automatically convert preferred stock into common stock in the case of an IPO or acquisition. Generally, Series A investors will have the right to convert their preferred stock to common stock at any time. As Brad Feld puts it, “This allows the buyer of preferred stock to convert to common stock should he determine on a liquidation that he is better off getting paid on a pro rata common basis rather than accepting the liquidation preference and participating amount.”
On a Series A term sheet, the voting rights simply states the voting rights of the investor. Generally, your Series A investors will likely receive the same number of votes as the number of common shares they could convert to at any given time. In the Y Combinator example, as with most term sheets, this section can include some technical jargon that is not easy to understand.
The most important vetoes that a Series A investor usually receives is the veto of financing and the veto of a sale of the company.
One of the more important sections when navigating your Series A term sheet is the board structure. Ultimately, the board structure designates who has control of the board and the company. How your Series A investors want to structure the board should be a sign of how they perceive you and your company.
The most “founder-friendly” structure is 2-1. A scenario in which 2 seats are given to the common majority (e.g. the founders who control a majority of the common stock) and 1 given to the investors. This allows founders to maintain control of their company.
On the flip side, there is a 2-2-1 structure (2 founders, 2 investors, 1 outside member). In this scenario, it is possible for the founders to lose control of the company. While a common structure, be sure that the board structure is in line with conversations while fundraising. As Jason Kwon of YC puts it, “So when an investor says that they’re committed to partnering with you for the long-term – or that they’re betting everything on you – but then tells you something else with the terms that they insist on, believe the terms.”
As defined by the Morgan Lewis law firm, “Drag along is the right to obligate other stockholders to sell their securities along with securities sold by the investor.” Drag along rights give investors confidence that founders and the common majority will not block the sale of a company. While there is no way around drag along rights, some people will suggest that founders negotiate for a higher “trigger point” (e.g. ⅔ votes as opposed to 51%).
You can learn more about drag along clauses in this post, Demystifying the VC term sheet: Drag-along provisions.
While there are countless other aspects and negotiations tactics when navigating your Series A term sheet, we’ve found the ones above to be most difficult to understand and offer an opportunity to negotiate. Always be sure to consult with your lawyer before signing your term sheet.
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