Understanding the Control Terms of the Term Sheet

In the previous blog, we covered the economic terms of the term sheet. Continuing with our attempt to demystify the term sheet, we cover the control terms in this blog.

Control terms refer to how much control the VCs or investors get to exercise control over the startup. It matters to them because they’re not at the helm of the daily affairs of the company and want to stay aware of any material decisions that might affect their investments. Also, some control provisions are necessary to prevent VCs from running afoul of the fiduciary duties they owe both to the investors (their limited partners) and to the company.

While VCs often have less than 50 per cent control of the company, there are a variety of control terms that effectively give them control of many activities of the company.

Board of Directors

The process of electing the board of directors is one of the most important control mechanisms of the company. The board of directors is the most powerful element of a company’s management structure and almost always has the power to fire the CEO. The board has to approve many important actions that the company takes, including budgets, option plans, mergers, IPOs, new offices, significant expenditures, financings, and hiring of C-level executives. Entrepreneurs should think carefully about the proper balance among investors, startup, founders, and outside representatives on the board.

In early-stage companies, there will be typically three-five members. The three-person board will mostly consist of:

1.     Founder/CEO

2.     VC

3.     An outside board member, or perhaps another founder And, a five-person board will typically consist of:

1.     Founder

2.     CEO

3.     VC

4.     A second VC

5.     An outside board member

A mature company will typically see more members (seven to nine) who are outside board members.

Protective Provisions

The next key control term you will find in a term sheet is protective provisions. These are veto rights that investors have on certain actions by the company.

Typical protective provisions may be that a company can’t-

·       Change the terms of the stock owned by the VC

·       Authorize the creation of more stock

·       Issue stock senior or equal to the VC’s

·       Buy back any common stock

·       Sell the company

·       Change the certificate of incorporation or bylaws

·       Change the size of the board of directors

·       Pay or declare a dividend

·       Borrow money

·       Declare bankruptcy without the VC’s approval

·       License away the intellectual property of the company, effectively selling the company without the VC’s consent

·       Consumate an initial coin offering or similar financings or

·       Create a token-based interest in the company

Founders often try and push back on some of these if they are in a strong negotiating provision. Further, founders should acquire a minimum holding of preferred shares to ensure protective provisions remain in place. A high-voting threshold is also something founders should watch out for. Often, founders are able to negotiate a single vote for all investors, i.e, for Series A, B and so on. The overall consent percentage should not be higher than 66 2/3 per cent to avoid a scenario where a shareholder holding a small percentage has veto rights.

Drag-along provisions

Equip the investors with rights to compel the founders and other shareholders to vote in favour of the sale, merger or other “deemed liquidation” of the company. Drag-along provisions act as protection for the investors in case they want to sell the company, especially if they seek to exit their investment and sell the company for a price less than the amount of their liquidation preference. Founders can negotiate on the drag-along provisions and push them back.

Investors often insist on including drag-along rights as they make exits easier for the founder. They are beneficial to investors in multiple ways.

• It may be a hard process to convince each and every small shareholder, in such a scenario, drag-along provisions enable the interest party to buy 100 per cent of the company. Without drag-along rights, preferred shareholders would only be able to sell their stakes. And since in most cases, the acquiring companies want to buy 100 per cent, the deal may fall apart if the small shareholders dissent.

• Even if the investors hold a majority, drag-along rights can help avoid contentious and time-consuming “freeze-out” merger situations where the minority shareholders are pressured to sell their stocks.

• When the sale price is below the liquidation preferences, the founders and the common shareholders have a rough deal. Having drag-along rights would allow the preferred shareholders to sell the company.

In the second version of drag-along, if a founder leaves, his stock will be dragged along by all other classes of stock. In other words, the departing founder will not be able to exercise his voting power anymore.

Conversion

Conversion is one of the non-negotiable terms of the term sheet. In most VC deals, the preferred shareholders have the unfettered right to convert their stake into common stock.

This allows the preferred shareholders to convert to common if they see a higher benefit of getting paid on an as-converted basis rather than accepting the liquidation preference and the participation amount. Conversion can also be used when the preferred shareholders want to control a vote of the common on a certain issue. Its important to note that once converted, there is no provision to convert back to preferred.

In an IPO of a venture-backed company, the investment bankers would want to see everyone convert to common stock. Earlier it used to be a rare event for a venture-backed company to go public with multiple classes of stock, although this happens more frequently today.

Other Terms

Aside from these economic terms and control terms that we have covered in two blogs, there are a couple of other terms too which are a crucial part of a term sheet. These include dividends, redemption rights, conditions precedent to financing, information rights, etc. We’ll leave these for another day.