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Checklist - Alternate Term Sheet Provisions

This document provides alternative provisions that can be included in a term sheet for an investment. It outlines alternative terms for dividends, liquidation preference, redemption, registration rights, pre-emptive rights, automatic conversion, anti-dilution, management options, and stock restriction agreements. The provisions give flexibility depending on whether the company is seeking investment or investing in others. Legal review of any included provisions is recommended.

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53 views

Checklist - Alternate Term Sheet Provisions

This document provides alternative provisions that can be included in a term sheet for an investment. It outlines alternative terms for dividends, liquidation preference, redemption, registration rights, pre-emptive rights, automatic conversion, anti-dilution, management options, and stock restriction agreements. The provisions give flexibility depending on whether the company is seeking investment or investing in others. Legal review of any included provisions is recommended.

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KnownUnknowns-X
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHECKLIST

ALTERNATIVE TERM SHEET PROVISIONS

Following are alternative provisions you can use to modify a term sheet depending on whether your
company is investing or is seeking capital. Consider the explanations of each provision before integrating
it in your Term Sheet Agreement. And don’t forget to ask your lawyer to review it!

DIVIDEND

The directors need not pay a dividend unless they wish to pay dividends on Common Stock in the same
year. In a scenario more favorable to investors, dividends may be participating (i.e., preferred
stockholders to receive additional dividends ratably with common stockholders once all preferences have
been satisfied) and/or cumulative (i.e., unpaid dividends will be added to the liquidation amount and the
redemption price of the preferred stock and all accrued dividends for past as well as the current year must
be paid prior to payment of dividends on common stock

LIQUIDATION PREFERENCE

Alternatively, terms may be structured so that preferred stockholders may get back only their original
investment or they may retain their original investment plus all accrued but unpaid dividends for every
years or they may share the remainder ratably on an as-converted basis with common stockholders only
after their preferences and all common stock liquidation amounts have been paid. In subsequent
financings, new series of preferred stock may have a superior position on liquidation or be on a pari passu
footing with this series with respect to liquidation. Liquidation may be defined in the term sheet to include
acquisition of the Company or its merger into another entity, with the classification of such event as a
liquidation or not at the investors' option at time of the merger.

REDEMPTION

While going public or an acquisition usually connote a clear "success’, the investor must also consider the
case in which the Company only achieves moderate success and management is content to keep things
going as a private Company. According to these terms, the company must redeem at a specified amount
which provides investors with some guaranteed return on their investment. Alternatives include: (a) a
provision stating that the Company may not call the Preferred Stock for redemption nor may the investors
require the Company to redeem their stock and (b) optional redemption after a certain date by either the
Company or the investors. If the Company may call the Preferred Stock at its option, it could potentially
call once the common price exceeds the redemption price and force the investor to take a mediocre
repayment on his investment or convert to common and lose his preferred position in the Company.

REGISTRATION RIGHTS

In order to have a public offering the Company must file a registration statement with the SEC. Because
the investor can not be assured of controlling the Board of Directors of the Company (after all that is what
the entrepreneur fears will happen), the investor usually negotiates for "demand registration rights" under
which the Company contractually agrees to file a registration statement on the demand of the investor.
The number of "demands" is negotiated, with the Company saying that one is enough and the investor
arguing for two or more.
Conceptually the granting of demand registration rights is a big deal for the Company because of the time
and cost involved if those rights are invoked – it can easily cost $200,000 or more to file a registration
statement. In reality, it is a rare case when registration is demanded against the desires of management –
after all management has to go on the "road show" and make a good presentation to the mutual fund
managers and brokers who will be buying the stock.

In addition, the investor usually receives "piggyback" registration rights under which the investor’s shares
are included in any "primary registration" statement (where the company is selling its own stock) or in any
"secondary registration" where the Company is filing a registration statement to permit others to sell.

PRE-EMPTIVE RIGHTS

This right is typically granted to investors to ensure that the Company does not negotiate new financings
with new players without offering to deal with the present investors. Sometimes investors are required to
take "all or none" of the new financing.

AUTOMATIC CONVERSION

Because the control and others terms of a venture capital preferred are not consistent with public market
securities, the Preferred Stock has to “disappear” (i.e., be converted into Common Stock) at the Initial
Public Offering.

ANTI-DILUTION

Antidilution adjustments increase the amount of stock received by an investor if the Company issues
additional stock at prices which are lower than that paid by the investor. Because there is no readily
ascertainable independent market price for the stock, investors believe that they should be protected
against having overpaid. Another rationale is that the entrepreneur should pay if he does not increase the
value of the Company by the next round of financing. However, from the entrepreneur's side a decrease
in the value of the Company could result from events beyond the entrepreneur's control- e.g. a stock
market crash or a change in the law. Having said this, antidilution adjustments are almost always present
in one form or another.

Note that the formulae used in these provisions decrease the conversion price of the Preferred Stock
resulting in more shares of common stock per share of Preferred Stock upon conversion. The weighted
average antidilution formula considers the total number of shares being issued as well as the per share
price; contract this to the full rachet antidilution formula which automatically reduces the conversion price
to the price at which a new issued is sold, even if only a small number of shares are issued.

MANAGEMENT OPTIONS

Investors usually factor the option pool size into their valuation of the Company and assume that the full
amount of the option pool is taken into account in determining the “pre-money” valuation of the Company.

STOCK RESTRICTION AGREEMENT

Investors will want to ensure that the present management of the Company has an incentive to remain
there; rewarding continued work at the Company by appreciation in the value of stock and discouraging
the individual's leaving by the buy-back provisions detailed above are effective mechanisms to encourage
long-term commitment.

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