The last stretch of an entrepreneur’s fundraising process can have the greatest influence on her experience leading her company. What do founders need to know to close the deal?
First, O’Melveny Partner Jeeho Lee encourages them to get into the right mindset and acknowledge the agency they have in the process. Negotiation starts with knowledge and she crafted her Project Entrepreneur class to equip founders with the essential insights they need to understand, articulate and secure optimal terms for their investment.
Here, she offers a detailed legal primer to evaluate your term sheets and partner with aligned investors. She begins with the key legal steps to set up your company, how to understand your cap table and the various types of financings. Next, she explains how to approach the definitive terms you’ll encounter in your term sheet and what each means for the future. There are multiple ways to reach a beneficial outcome and Lee shares tactics to negotiate terms that will set you and your company up for success.
Part I: Establish Your Legal Foundation
Efficiency is important to investors and a streamlined closing process begins ahead of your capital raise. Lee shares three steps to consider early in your company’s life cycle.
Protect your IP. Full ownership of your IP is one of the primary matters an investor will diligence. Ensure that you are addressing the six main types – trademarks and domain names, patents, copyrights, trade secrets, contractor and employee agreements – at your company.
Incorporate as the right entity. Lee discussed three choices of entity: LLC, Delaware C Corporation, and Delaware S Corporation. Founders who are looking to raise venture capital should be registered as a Delaware C Corp and will be asked to convert if they are not. VCs prefer consistency and this is the most common entity they see. Lee assures it is simple to change your entity if needed. (Delaware S-Corps are not viable for VC investments.)
Companies that are not seeking to raise VC may choose to register as an LLC, as their company will not be subject to double taxation; Though, the dividends equity holders receive will be.
Establish your company. Corporate housekeeping matters. Invest upfront. Founders should ensure all formal paperwork is filed with their state. This is critical to “start the clock for economic basis in the stock,” create a bank account, enter contracts, give employees equity grants, and more.
➺ Key Insight: Lee recommends considering an 83(b) tax filing. It allows you to pay taxes on your equity based on today’s valuation, rather than when your equity vests in the future and will likely be higher. Founders and employees should file within 30 days of receiving an equity grant that has a vesting tie to it. Be mindful of this step. Lee has seen founders reach successful liquidation events and need to pay millions in taxes as a result of not filing.
Part II: Understand Your Cap Table
Your cap table reflects who owns the different securities in your company and their percent ownership. Common securities include the following:
- Common Stock is kept for founders, employees, and may be reserved for friends and family.
- Convertible Preferred Stock is for investors.
- Incentive Plan Reserve, which is common stock, is allocated for existing and future employees.
- Warrants are generally for venture debt, strategic partners, or noteholders.
- Convertible Notes and other equity based securities, such as SAFE agreements.
Lee highlights two key insights that will be relevant when reviewing your term sheets.
- Incentive Plan Reserve will come up in your negotiations. She advises founders to save 10 – 20% for employees. Investors may push back if you have a team in place. Whether you’re in the early or late stages, negotiate by expressing that you need to build your team and have means to incentivize people to join.
- Stock vesting conditions, for employees and especially founders, will be negotiated in term sheets and investor rights agreements. “It is market and expected by VCs that you will have a double trigger for acceleration on your stock options. In order for you to become fully vested and receive all of your equity in a liquidity event, there needs to be the first trigger of that change of control or liquidity happening. The second trigger is that you have been forced to leave your company.” (Note: market terms indicate the industry standard.)
➺ Key insight: Calculate your Pro Forma any time you plan to give out equity. Lee strongly encourages making this a habit to determine what your cap table will look like inclusive of respective deals. This exercise is relevant to both term sheets as well as advisor agreements and will enable you to discern the percent ownership each party will acquire and how it impacts your cap table as a whole.
Part III: Choose the Right Type of Financing
Founders and investors may choose from a variety of financing types that include different features and near and long-term implications. Lee explains three here: Convertible Bridge Notes, SAFE Agreements, and Preferred Stock Financings, ahead of detailing the key terms for preferred stock investments.
Convertible Bridge Notes
Convertible notes are a form of debt that convert into equity. “They are not priced and conversion is generally based on a discount on the next round or a pre-agreed valuation cap,” Lee explains. They have an interest rate that may range from the Fed Rate up to 8%.
Convertible notes are not preferred by investors as they make it difficult to determine ownership percentages. Founders don’t need to entirely avoid them, but should be cognizant of the nuances and future impact.
Maturity Dates, which range between six to 18 months, are one Lee advises to be cautious of. “There is a dissonance when there is a maturity date. You can give a convertible note to someone who doesn’t understand that they are supposed to be investing for the upside. Then, when that note becomes due, they expect you to pay them back. It’s something to think about because they have all the leverage.” This is uncommon with investors who are looking to receive equity and will likely agree to an extension. However, may be requested by angel investors who want to ensure they get their money back.
SAFE Agreements are a type of equity that give investors the right to obtain preferred equity in your next round. They are a standard form with established mid-market terms. Price is commonly the only negotiation; Though, founders looking for specific terms can include side letters with specifications. (The purpose of SAFE agreements is speed and efficiency. Those looking to add multiple side letters may consider doing a priced round.)
➺ Key insight: Avoid stacking pre-priced financing agreements. “The risk of stacking convertible notes and SAFE agreements is that there is a lot of unclarity around who owns what percentage of the company. So, when a VC comes in or in your next round, it’s very hard to discern what you actually own and what those notes are going to convert to. Keep things as simple and as clean as possible.”
Lee assures that founders who already have notes and SAFEs on their cap tables can solve for greater clarity. “Say you’ve issued two convertible notes and now, you want to issue SAFEs. You can easily ask your convertible note holders if they are willing to convert the terms to a SAFE, whilst being cautious of re-trading on pricing terms. It’s very rare that anything is set in stone. Don’t ever feel like you are boxed in.”
Preferred Stock Financings
Preferred stock financings are an equity security that allows an investor to convert into your preferred stock and are the security commonly used in VC deals. They include legal terms to protect investors in the event of unexpected situations or negative financial circumstances for the company.
Preferred stock financings are priced and used from a company’s Series Seed round to their Series A and beyond. As Series Seed financings are smaller, they generally include fewer terms; primarily preemptive rights, information rights, and liquidation preferences. Particular future investors may receive MFN provisions, such as rights of first refusal or co-sale rights. Founders will encounter registration rights, anti-dilution, board seats, and protective provisions in their Series A term sheets.
Part IV: Learn the key terms
Education is the foundation of a founder’s ability to negotiate. It’s essential to gain a clear understanding of the key terms to articulate what is important to you. Lee views them as levers and classifies them in three categories: economic, control, and liquidity.
- Economic: liquidation preference, dividends, conversion rights, and anti-dilution protection
- Control: voting rights, board of directors, preemptive rights, and rights of first refusal
- Liquidity: registration rights and redemption rights
Prior to defining each term, she shares four guiding principles to navigate the process.
- Know your levers. “You should think about each lever holistically, and how they impact your company, but you should also think about them individually. What terms are important to you and which are less so? Start to familiarize yourself with all of the different ways you can push and pull in a negotiation.”
- Beware of precedent. “VCs often won’t have a good reason as to why they don’t want to give on a certain term. All they will say is: If I give this to you, I’m going to have to give it to the next founder. It’s the reality of business negotiations.”
- Think a round ahead. “Similarly, keep in mind that anything you agree to, especially in earlier rounds, is going to be expected by future investors. When you see a particular term you’re not comfortable with, ask yourself: What does this mean for me in my next round? As you’re making your final decision, know that you’re likely going to have to live with it not just for this subset of investors but for your next capital raise as well.”
- Optimize for ease. “Investors are obsessed with speed, process, and efficiency. They want things to be simple, especially in the earlier rounds. They don’t want to spend a lot of time, and neither do you, negotiating very bespoke terms.”
Liquidation Preference dictates an investor’s right to receive their money in the event your company is sold or dissolved. It is standard for investors to get back the money they invested and to do so ahead of common stockholders.
Lee advises founders to beware of investors who negotiate a non-participating liquidation preference (1X non-participating liquidation preference). They are uncommon, but give investors the rights to the remaining common stock after your stockholders, creditors, and debt holders have been paid.
Dividends accrue when a company has additional capital that is allocated to the preferred stockholders, prior to the common stockholders. They are rare as capital is intended to be reinvested in the company.
In the event they are expected, Lee advises founders to ensure an accompanying clause in their term sheet. “The term sheet shouldn’t say you will pay a 6 – 7% dividend. It should say you will pay a 6 – 7% dividend if/when declared. The if/when declared language covers that you agree that if the board ever decides to pay a dividend, you will pay them a dividend of the agreed upon percentage of what they invested. The key is if the board has decided. You don’t want to accidentally agree to pay dividends in your term sheet or definitive documents, even if the board doesn’t think it is appropriate.”
Conversion and Anti-dilution
Conversion is how an investor converts their stock. Preferred stock converts into common stock with two features: optional and mandatory.
Optional conversion gives investors the ability to convert their stock whenever they’d like. It is unlikely, as preferred stock has more rights, protections, and equal or greater economic value than common, but is a way for investors to protect themselves.
Mandatory conversion may occur when a specific event happens, such as an IPO, or it is voted on by a deemed percentage of your investors. In this case, all of your preferred stock, at least in that series, will convert to common stock.
➺ Key Insight: Preserve future optionality. Lee advises founders to include both terms in their term sheets in the case of a sale or IPO, for two key reasons. “Say you’re driving towards an IPO. You want to have the ability to flatten your cap table and for everyone to be common stock because that is what everything is going to be publicly traded as. Investors will want this too,” she says. “Second, you want to be able to require everyone to convert if the majority of your investors agree. It gives you a release valve that if there is a certain event, such as an acquisition offer that doesn’t trigger the liquidation preference, you have the ability to clean your cap table. If you don’t have mandatory conversion and an investor holds 1% of your preferred stock, they can cause a major issue in your deal if the counterparty needs the cap table to be cleaned out.”
Preferred stock generally converts at a 1:1 ratio to common stock but may be adjusted based on circumstances such as stock dividends or stock splits. Lee explains it is fair for investors to include the subject adjustment in their term sheet. For example, if your common stock splits from one share to two, preferred stockholders will also be eligible for that split.
Keep these tips in mind as you approach anti-dilution.
- Give yourself options. “Make sure each of your term sheets has carve outs to these anti-dilution adjustments. For example, if you are trying to buy a software company and want to issue them shares, rather than cash, it’s fair for you to do that without changing the ratio.”
- Agree to fair calculations. “Anti-dilution should be calculated with a broad-based weighted average, meaning that when an adjustment event happens you should be able to spread that adjustment across all of your cap table. This is market. A narrow equation is not as great for the company and existing stockholders. You should have your spidey sense on if someone gives you a term sheet that has a full ratchet – They may not be the best business partner.”
Preferred stock holders gain their voting rights on a converted basis. Thus if the conversion ratio is 1:1, they vote as if they have one share of common stock.
Preferred stock holders will ask to have protective provisions, in addition to those of common stockholders, to wield influence over key occurrences within your business.
Lee breaks down the four common areas they’ll ask for provisions and assures they are fair and market.
- Fundamental to equity: “Investors are going to want provisions on things that are fundamental to the equity. For example, if you are going to issue any securities that are senior to the preferred stock, they’re going to want approval or veto rights.”
- Leakage: “Investors are investing in you because they believe in and want to grow with you. They understand they need to give you the freedom to run your business the way you deem best, but they don’t want to give you too much freedom. They want to make sure that they can protect the leakage of assets. So, if your board and you decide that you want to redeem stock (buy back your common stock), they want to be able to have a say and veto rights because money is leaving the company.”
- Contractual: “They are going to want protective provisions and veto rights on contractual rights you have agreed upon, such as their say in the size of your board.”
- Operational: “Investors shouldn’t have voting rights over these. Say, you want to change your CEO’s executive compensation or explore an ancillary line to your core business, you should be able to have control over that without needing to get their say. Watch out for operational rights. When you are reviewing your term sheet with your lawyers and advisors, ask: Will any of these protective provisions impact how you can operate your business?”
Board of Directors
The lead investor for your Series A will commonly anticipate a board seat. As you build your board, Lee emphasizes that your director has a fiduciary duty to all stockholders. As a founder, be sure you feel confident you are choosing an investor you trust who is the right fit for the responsibilities.
Preemptive rights give investors the ability to participate in your next fundraising round. “Investors want to ensure they can maintain their overall percentage of ownership in the company,” Lee says. “They want to have a certain level of control and amount of what you all project to be the upside.”
She highlights two key insights:
- Understand an investor’s capacity for long-term involvement. “This is where we start thinking about the levers. If you don’t think an investor has the ability to fund your next round, you should think harder about giving them this right or at least structuring it so that you can offer it to them but aren’t stuck if they aren’t willing to fund it.”
- Protect your decision-making power. “Similar to anti-dilution, there should be carve outs for preemptive rights. Say, you want to use your company’s shares for an acquisition, you should be able to do that without triggering preemptive rights.”
Rights of First Refusal
Rights of first refusal give the company and investors the right to purchase stock that is sold or transferred to a third party. The company has the first right, and investors second. Founders may occasionally negotiate the primary right, prior to the company. (This stock is commonly owned by founders or common stockholders).
Liquidity is critical for VCs as they’re looking for a return on investment and is pertinent when it comes to registration and redemption rights. They aren’t common in early-stage financings but carry weight in the future.
Registration rights enable the investor to require the company to register their shares with the SEC when they go public.
➺ Key Insight: Be cognizant of how this may influence your choice to go public. “The key negotiating point here is: Can they force you to go public? Do their registration rights get triggered six months after your IPO and they can require you to do additional filing with the SEC and register their shares? Or, is it five years from the date of you signing the registration rights agreement that they can force you to register their shares? That could become a trigger that forces you to go public.”
Redemption rights enable an investor to require you to buy back their shares within a specified time period. They are not standard and Lee urges founders to be vigilant if an investor is requesting them.
“Mandatory redemption is almost like a maturity on a note,” she says. “This goes back to first principles and can become dangerous, because if you give it one of your first investors all your investors are going to want it. All of the sudden, five years from the date of your first closing, you have almost all your stockholders saying: Give me back my money. It typically ends up being a traumatic experience for a company.”
“Someone may argue that the investors want to be able to pressure you to do something,” she adds. “You may be doing really well in year four and they’re asking you why you aren’t selling or going public. They don’t really have a mechanism to force you to do that. Registration rights would give them one.”
Part V: Prepare for the Closing Process
Founders should anticipate a four to six week process from receiving their term sheet to closing their investment. It is possible to accelerate your timeline if you need the capital quickly and investors are willing to collaborate. Similarly, a lack of cooperation may extend the process for months.
The first step is to receive and negotiate your term sheets, where, once again, timeline may vary based on each party’s participation. “So much of this is psychology,” Lee says. “It depends on people’s willingness to come to the table and negotiate and how reasonable and market-driven an investor is.”
While you’re negotiating your term sheet, VCs will do due diligence on your company, including reviewing your cap table.
Once you’ve agreed on terms, your lawyers will begin drafting your documents. In addition to your term sheet, they will draft your: stock purchase agreement, charter, investor rights agreement, voting agreement, and right of first refusal/co-sale agreemenation.
The next phase is legal and IP due diligence. Anticipate 2 to 4 weeks here.
At this point, if you are raising capital from multiple investors, your lead investor will spearhead the process and form a syndicate with other investors.
The last step is securing the appropriate approvals, such as your board and stockholders, prior to closing.
➺ Key Insight: Prepare ahead of time to run an efficient fundraising process. “Founders who have organized data rooms and respond in a timely manner to diligence requests signal to VCs that they have a good organizational setup and their papers are in order. VCs feel uncomfortable with unorganized processes; It’s a silly thing for the other side to lose confidence to the extent that you have the time and capacity to control.”
Part VI: Ace Your Negotiations
A founder’s ability to negotiate is one of the preeminent insights Lee emphasized in her class. “This is a two way street,” she assures. “Walk into the room knowing that you have leverage. Whoever you are seeking funding from, they need you. Their business model is to make money off your investment. Don’t forget that you bring something incredible to the table.”
Preparation is the first step to successful negotiations. Lee strongly encourages founders to learn about the key terms and identify their priorities prior to embarking on the process. They’ll give you a lens to assess your term sheets and discern where you’d like to negotiate.
Once you receive them, consider her questions to evaluate your offers.
- What does the investor bring to the table? (i.e. Industry expertise and relationships, future funding, etc.)
- Do you envision having a good rapport?
- What are the gaps in your organization?
- What do you need to hit your six days, six months, and six years goals?
- What are your non-negotiables?
- What is your risk tolerance?
- What are the liquidation preferences, veto provisions, etc. that the investor is asking for?
Your answers will help reveal which offers you’d like to pursue and where you may need to make adjustments. Keep these tips in mind to streamline your negotiations.
- Do your homework. “Information is power. Know what you want and do your Pro Forma calculation ahead of time. But, also know what they want. What motivates them? You should know what terms they’ve given to other startups.”
- Know your leverage. “Read the room. Identify what leverage you have versus what leverage they have. How hard can you push on this point? What will happen if you don’t compete on this one? What do you think their fallback will be to get back to market check?”
- Create a Plan B. “What is your Plan B? It’s much easier to go into the room and push back on terms if you have a Plan B. Be sure to think about their Plan B as well.”
- Advocate with confidence. “Remember, when you walk into that room, you’re not just negotiating for yourself. You’re negotiating for your team and company.”
Equipped with the knowledge from Lee’s class, consider taking the first step in this process by dedicating time to articulate your ideal investment terms and how you plan to navigate to the best outcome for your business. “Reflect on what is important to you, your company, and what you need,” she adds. “As a founder, you’re busy running your business, but if you can make space for this, it will help minimize stress and add clarity to your negotiations process. We don’t always get everything we want, but we should get a lot of what we want. There are so many ways to land in a place where both your investors and you are happy.”