Terms to Avoid in Early Financing Rounds
Companies with limited financing alternatives may be forced to grant burdensome and restrictive rights to investors to obtain funding. However, in early-stage rounds (especially those being funded by friends and family), I have seen companies grant such rights to investors who would have invested without them. Set forth below are some financing terms and structures which early stage companies should consider not offering, at least, in their initial negotiations with investors:
- Common Stock v. Preferred Stock. Preferred Stock provides investors with various preferences senior to the holders of common stock. For example, typically preferred stock includes a distribution preference, which means that preferred stockholders get paid prior to other stockholders upon a liquidity event. In addition, the holders of a class of preferred stock generally must approve future classes of preferred stock that have senior rights. Such rights are detrimental to a company’s existing stockholders and could impede future fundraising efforts. Therefore, companies should always try offering common stock, before offering a preferred class of stock.
- Preferential Returns on Preferred Stock. If a company offers preferred stock, it should avoid offering unreasonable preferences. Some provisions to avoid include, (1) cumulative dividends, which accumulate quarterly or annually, and are required to be paid prior to any distributions on junior equity securities, (2) participation rights, which provide holders with the rights of common stockholders, in addition to their rights as preferred stockholders, and often result in preferential distributions in excess of 1x their investment, and (3) liquidation preferences that provide preferred stockholders with preferential distributions in excess of 1x their investment.
- Preemptive Rights. Preemptive rights provide investors with the right to purchase a pro-rata share of any future sale of securities. Preemptive rights impose a burden on management in future fundraisers, and the inadvertent failure to offer preemptive rights or the failure to correctly follow the notice procedures could expose the company to liability if the value of the company increases. Therefore, try to avoid granting preemptive rights, and if granted, try to limit them to a short period of time or a set number of subsequent offerings.
- Financial Reporting. Companies should try to avoid the obligation to provide investors with periodic financial statements and/or operational reports. While companies should be transparent and openly and continually communicate with their investors, it is better not to be contractually obligated to do so. If investors demand financial statements or periodic reports, (a) limit the reporting requirement to annual, rather than quarterly or monthly, and (b) avoid mandatory audited or reviewed financial statements, which impose substantial additional costs on the company.
- Registration Rights. Demand registration rights enable investors to require a company to register a class of shares with the SEC, whereas piggyback registration rights merely entitle investors to include their shares in a registration initiated by the company. While piggyback registration rights are not particularly burdensome because the company is simply required to include shares in an already existing registration statement, demand registration rights could be very costly and burdensome. Therefore, companies should try to avoid granting registration rights, and if they do, try to limit them to piggyback rights.
- Majority Consent to Amendments and Waivers. As a condition to closing future financings or taking other corporate actions, a company may need to obtain certain consents or waivers from early investors, including, but not limited to, renegotiating the rights of such investors, or obtaining their consent to issue senior securities. Therefore, always include a provision in the investment documents that provides the holders of a majority of such securities with the right to agree to amendments, waivers and consents on behalf of all of the holders of such securities.
- Voting Control. Ensure the founders maintain voting control and have enough ownership to maintain control after future contemplated financings. Issuing the founders’ so-called super-voting stock (i.e., 10 votes per share), is one mechanism to maintain such control. Another common method is a voting agreement that ensures that the founders maintain the right to appoint a majority of the directors to the board.
- Operational Restrictions. Try to avoid provisions requiring investor approval of operational decisions, such as salary increases, hiring, future equity financings, bank loans, or expenditures in excess of a specified amount. I have seen several companies become operationally handcuffed by such contractual restrictions, especially where investors become unreasonable or disgruntled.
- Non-Dilutable Shares. In rare cases, I have seen companies grant early investors non-dilutable shares, which means that such investors have the right to maintain their percentage interest in the company in perpetuity, without investing any additional capital. Non-dilutable shares make it virtually impossible to raise additional capital. Never grant non-dilutable shares.
- Anti-Dilution Rights. Anti-dilution rights protect investors from dilution in down rounds (i.e., future equity issuances at a lower valuation), by requiring the company to issue additional shares to the protected investors upon the closing of a down round. In the case of convertible securities, it results in an automatic decrease of the exercise or conversion price in a down round. With so-called “full ratchet” anti-dilution protection, if a company subsequently issues shares at a lower price, the effective price per share paid by the investors holding such rights automatically adjusts down to the lower price. As a result, such investors automatically get topped up based on the lower share price, and if such investors hold convertible securities, the conversion or exercise price is automatically adjusted down to the price paid by the new investors. A typical and more equitable anti-dilution provision, known as “weighted average” anti-dilution, employs a formula that takes into account the number of new shares being issued and the extent to which the new issue price is lower than the issue price of the protected securities. Try to avoid granting any anti-dilution protection, especially “full ratchet” anti-dilution protection.
The information contained in this article is strictly for educational purposes and is not intended to be legal or tax advice or to be relied upon by anyone without doing their own research, and consulting with legal and tax advisors.