In today’s venture financing environment, knowledge of the venture financing process is vital to ensuring fair business practice between entrepreneurs and investors. Many times, deal terms are often agreed to by entrepreneurs without a clear and concise understanding of what the terms actually mean to their company.
One of the most common remarks we get about our Intelligence is “I didn’t know deal terms of private company financings were available.” Some people are merely not aware that this amount of light can be revealed about a company’s specific deal terms. We now track approximately 15 specific deal terms of the venture financings, as discovered by our analysts when pouring over a company’s regulatory filings. In addition, the documents that supply our analysts with this data are made available to our subscribers to validate the information being provided.
In this week’s buzz, we are looking at a couple of terms that, given the current state of venture funding, should be more prevalent in deal’s to come and what those terms mean should you see them in a term sheet.
What is the difference between Participating Preferred stock and Conventional Convertible Preferred stock?
- Participating Preferred stock allows the holder to receive their liquidation preference, and then they are allowed to participate again (on an as converted to common basis) in receiving any remaining assets, usually along side the Common stock.
- Conventional Convertible allows a holder to receive their liquidation preference, and they do NOT have the right to participate (on an as converted basis) in any remaining assets.
At what point does the participation cease for the Participating Preferred stock?
That depends on the “Participation Cap”. If the “Participation Cap” is 0, then there is no maximum participation amount. If the “Participation Cap” is set (ex: 2x the original issue price) then the holders can participate until the “Cap” is met.
What is Pay-to-Play?
- Pay-to-Play is just is just what it says. If this provision is implemented, then it can require existing investors to participate in subsequent investment rounds, especially a Down Round. Where Pay to Play provisions exist, an investor’s failure to purchase its pro-rata portion of a subsequent investment round will result in conversion of that investor’s Preferred Stock into Common Stock or another less valuable series of Preferred Stock (Shadow Preferred). Other consequences could be the loss of anti-dilution protection and/or the loss of participation in future rounds.
What are Antidilution provisions?
Antidilution provisions are contractual measures that allow investors to keep a constant share of a firm’s equity in light of subsequent equity issues. These may give investors preemptive rights to purchase new stock at the offering price.
Why should either side of a deal go in blind? If you are a seasoned investor then you can rely on previous deals…or can you? Today’s deals are not the same as deals done two years ago. The same applies to entrepreneurs. Can an entrepreneur that has previously started a company and raised capital for that company, rely solely on his/her prior experience?
Investors are looking for entrepreneurs that are dedicated to their craft, entrepreneurs that have done their homework and can show their work. Some of the prominent participants in the industry, whether they are lawyers, CFOs, or entrepreneurs, are scratching their heads trying to figure out if they will see an increase in the use of certain terms. Historically, the West Coast money has been more “company friendly” as compared to the East Coast. Those days are still here to a certain extent, but it seems that more than before, the focus is on the stage (Early vs Later Stage) of the company rather than on the location. From what we have seen, West Coast deals are still fairing slightly better for the entrepreneur/portfolio company than the rest of the regions, but not by the leaps and bounds that they use to. With all of the valuations getting cut, the down rounds increasing, and investors seeking more quality investments, there maybe changes in the use of Deal Terms that will be around for a while. A couple of the Deal Terms that we may see more of are Participating Preferred stock and the use of Pay-to-Play provisions.
What is Redemption?
Redemption is the right or obligation of a company to repurchase its own shares.
Redemption Rights force the company to purchase shares (a “put”) and more infrequently the company’s right to force the investor to sell their shares (a “call”).
What are Cumulative Dividends?
Cumulative Dividends are payments to shareholders made with respect to an investor’s Preferred Stock. Generally, holders of Preferred Shares are contractually entitled to receive dividends prior to holders of Common Stock. Dividends can accumulate at a fixed rate (for example 8%) or simply be payable as and when determined by a company’s Board of Directors in such amount as determined by the board. Because venture backed companies typically need to conserve cash, the use of Cumulative Dividends is customary with the result that the Liquidation Preference increases by an amount equal to the Cumulative Dividends.
What is the difference between Full Ratchet and Weighted Average Antidilution?
Full Ratchet Antidilution is the sale of a single share, at a price less than what the favored investors paid, reducing the conversion price of the favored investors’ convertible preferred stock “to the penny”. For example, from $1.00 to 50 cents, regardless of the number of lower priced shares sold.
Weighted Average protection is when the investor’s conversion price is reduced, and thus the number of common shares received on conversion increased. In the case of a down round, it takes into account both: (a) the reduced price and, (b) how many shares (or rights) are issued in the dilutive financing.
As mentioned, these are just a couple of deal terms found in a venture deal, but ones that carry a tremendous amount of weight in the negotiation process. For those of you wanting to know the actual deal terms for specific companies, we invite you to access our collection of over 15,000 companies in the VC Experts Intelligence database.
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