I’m going to keep tonight’s term sheet post short and sweet, especially since I’m still reeling from the horrifyingly bad War of the World movie I just saw.  Jason and I are almost done with the term sheet series (yeah, we know we keep promising that) but – like the Spielberg tragicomedy I just watched, it’s not over until it’s over (sorry – that cliche just snuck its way in – I was helpless against it – the aliens made me do it.)

Occasionally a term sheet will have – buried near the back – a short clause concerning “founders activities.”  It usually looks something like:

“Founders Activities: Each of the Founders shall devote 100% of his professional time to the Company.  Any other professional activities will require the approval of the Board of Directors.”

This should be no surprise to a founder that your friendly neighborhood VC wants you to be spending 100% (actually 120%) of your time and attention on your company.  If this paragraph sneaks its way into the term sheet, the VC has either been recently burned or is suspicious and / or concerned that one or more of the founders may be working on something besides the company in question.

Of course, this is a classic no-win situation for a founder.  If you are actually working on something else at the same time and don’t disclose it, you are violating the terms of the agreement (and – breaching trust before you get started – not a good thing as it’ll eventually come to light.)  If you do disclose it – or push back on this clause (hence signaling that you are working on something else), you’ll reinforce the concern that the VC has.  So – tread carefully here.  Our recommendation – unless of course you are working on something else – is simply to agree to this (why wouldn’t you, unless you don’t believe in the thing you are asking the VC to fund?)

In situations where I’ve worked with a founder that already has other obligations or commitments, I’ve always appreciated him being up front with me early in the process.  I’ve usually been able to work these situations out in a way that causes everyone to be happy and – in the cases where I can’t get there – I’m glad that the issue came up early so that I didn’t waste my time or the enterpreneurs’ time.

While there are situations where VCs get comfortable with entrepreneurs working on multiple companies simultaneously (usually with very experienced entrepreneurs or in situations where the VC and the entrepreneur have worked together in the past), they are the exception, not the norm.

As Jason and I continue to wind our way through a typical VC term sheet, we thought we’d tackle the infamous “drag-along agreement.” This is one of those terms that has recently increased in importance to VCs due to the all the financing and exit dynamics that occurred during the downturn of 2001 – 2003. A typical drag-along agreement is short and sweet and looks as follows:

“Drag-Along Agreement: The [holders of the Common Stock] or [Founders] and Series A Preferred shall enter into a drag-along agreement whereby if a majority of the holders of Series A Preferred agree to a sale or liquidation of the Company, the holders of the remaining Series A Preferred and Common Stock shall consent to and raise no objections to such sale.”

As transactions started occurring that were at or below the preferred liquidation preferences, entrepreneurs and founders – not surprisingly – started to resist doing these transactions since they often weren’t getting anything in the deal. While there are several mechanisms to address sharing consideration below the liquidation preferences (e.g. the “carve out” – which we’ll talk more extensively about some other time), the fundamental issue is that if a transaction occurs below the liquidation preferences, it’s likely that some or all of the VCs are losing money on the transaction. The VC point of view on this varies widely (and is often dependent on the situation) – some VCs can deal with this and are happy to provide some consideration to management to get a deal done; others are stubborn in their view that since they lost money, management shouldn’t receive anything.

However, in all of these situations, the VCs would much rather control their ability to compel other shareholders to support the transaction being considered. As more of these situations appeared, the major holders of common stock (even when they were in the minority of ownership) began refusing to vote for the proposed transaction unless the holders of preferred waived part of their liquidation preferences in favor of the common. Needless to say, this “hold out technique” did not go over well in the venture community and, as a result, the drag-along became more prevalent.

I’ve heard founders and early shareholders say a variety of things with regard to a drag-along, but the most inane is “it’s not fair – I want to be able to vote my stock however I want to.” Remember that this term is one of a basket of terms that are part of an overall negotiation associated with injecting money into your company. There are tradeoffs in any negotiation and nothing is standard – so “fair” is an irrelevant concept – if you don’t like the terms, don’t do the deal.

If you are faced with a drag-along, your ownership position will determine whether or not this is a relevant issue for you. An M&A transaction does not require unanimous consent of shareholders (these rules vary by jurisdiction, although the two most common situations are either majority of each class (California) or majority of all shares on an as converted basis (Delaware)), although most acquirers will want 85% to 90% of shareholders to consent to a transaction. So – if you own 1% of a company, while the VCs would like you to sign up to a drag-along, it doesn’t matter that much (unless there are 30 of you that own 1%.) Again – make sure you know what you are fighting for in the negotiation – don’t put disproportionate energy against terms that don’t matter.

When a company is faced with a drag along in a VC financing proposal, the most common compromise position is to try to get the drag along to pertain to following the majority of the common stock, not the preferred. This way – if you own common – you are only dragged along when a majority of the common consents to the transaction. This is a graceful position for a very small investor to take (e.g. I’ll play ball if a majority of the common plays ball) and one that I’ve always been willing to take when I’ve owned common in a company (e.g. I’m not going to stand in the way of something a majority of folks that have rights equal to me want to do.) Of course, preferred investors can always convert some of their holding to common to generate a majority, but this also results in a benefit to the common as it lowers the overall liquidation preference.

As Jason and I continue to work our way through a typical venture capital term sheet, we encounter another key control term – the “protective provisions.” Protective provisions are effectively veto rights that investors have on certain actions by the company. Not surprisingly, these provisions protect the VC (unfortunately, not from himself.)

The protective provisions are often hotly negotiated. Entrepreneurs would like to see few or no protective provisions in their documents. VCs – in contrast – would like to have some veto-level control over a subset of actions the company could take, especially when it impacts the VC’s economic position.

A typical protective provision clause looks as follows:

“Protective Provisions: For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or though any merger, recapitalization or similar event, that (i) alters or changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services), (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the Company’s Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of the Company’s Board of Directors, or (viii) results in the payment or declaration of any dividend on any shares of Common or Preferred Stock, or (ix) issuance of debt in excess of $100,000.”

Subsection (ix) is often the first thing that gets changed by raising the debt threshold to something higher, as long as the company is a real operating business rather than an early stage startup. Another easily accepted change is to add a minimum threshold of preferred shares outstanding for the protective provisions to apply, keeping the protective provisions from “lingering on forever” when the capital structure is changed – either through a positive or negative event.

Many company counsels will ask for “materiality qualifiers” (e.g. that the word “material” or “materially” be inserted in front of subsections (i), (ii) and (vi), above.) We always decline this request, not to be stubborn (ok – sometimes to be stubborn), but because we don’t really know what “material” means (if you ask a judge, or read any case law, they will not help you either) and we believe that specificity is more important that debating reasonableness. Remember – these are protective provisions – they don’t “eliminate” the ability to do these things – they simply require consent of the investors. As long as things are “not material” from the VC’s point of view, the consent to do these things will be granted. We’d always rather be clear up front what the rules of engagement are, rather than having a debate over “what material means” in the middle of a situation where these protective provisions might come into play.

When future financing rounds occur (e.g. Series B – a new “class” of preferred stock), there is always a discussion as to how the protective provisions will work with regard to the new financing. There are two cases: (a) the Series B gets its own protective provisions or (b) the Series B investors vote alongside the original investors as a single class. Entrepreneurs almost always will want a single vote for all the investors (case b), as the separate investor class protective provision vote means the company now has two classes of potential veto constituents to deal with. Normally new investors will ask for a separate vote, as their interests may diverge from those of the original investors due to different pricing, different risk profiles, and a false need for overall control. However, many experienced investors will align with the entrepreneur’s point of view of not wanting separate class votes as they do not want the potential headaches of another equity class vetoing an important company action. If your Series B investors are the same as your Series A investors, this is an irrelevant discussion, and it should be easy for everyone to default to case b. If you have new investors in the Series B, be wary of inappropriate veto rights for small investors (e.g. consent percentage required is 90% instead of a majority (50.1%), so a new investor who only owns 10.1% of the financing can effectively assert control over the protective provisions through his vote.)

Some investors that feel they have enough control with their board involvement to ensure the company does not take any action contrary to their interests, and as a result will not focus on these protective provisions. During a financing, this is the typical argument used by company counsel to try to convince the VCs to back off of some or all of the protective provisions We think this is a short-sighted approach for the investor, for as a board member, an investor designee has legal duties to work in the best interests of the company. Sometimes the interests of the company and a particular class of shareholders diverge. Therefore, there can be times whereby an individual would legally have to approve something as a board member in the best interests of the company as a whole and not have a protective provision to fall back on as a shareholder. While this dynamic does not necessarily “benefit” the entrepreneur, it’s good governance, as it functionally separates the duties of a board member from that of a shareholder, shining a clearer lens on a area of potential conflict.

While one could make the argument that protective provisions are at the core of the “trust” between a VC and entrepreneur, we think that’s a hollow and inappropriate statement. When an entrepreneur asks “don’t you trust me – why do we need these things?”, the simple answer is that it is not an issue of trust. Rather, we like to eliminate the discussion about who ultimately gets to make which decisions before we do a deal. Eliminating the ambiguity in roles, control, and rules of engagement is an important part of any financing – the protective provisions cut to the heart of some of this.

In our series of posts on Term Sheets, Jason and I thought we’d take on a relatively easy one today. In our previous posts on Price and Liquidation Preferences, we discussed the key economic terms that VCs care about. In this post, we tackle one of the two primary “control terms” that matter to VCs.

VCs care about control provisions in order to keep an eye on their investment as well as – in some cases – comply with certain federal tax statutes that are a result of the types of investors that invest in VC funds. One of the key control mechanisms is the election of the board of directors.

There is no secret science in the board of director election paragraph – it simply spells out how the board of directors will be chosen. The entrepreneur should think carefully about what they believe the the proper balance should be between investor, company, founder and outsider representation should be on the board. There are many existing VC (and entrepreneur) posts concerning the value of a board, the desired composition of the board, and what a board is responsible for. This post doesn’t delve into those issues – we are simply addressing how the board is selected.

A typical term sheet looks as follows:

Board of Directors: The size of the Company’s Board of Directors shall be set at [n]. The Board shall initially be comprised of ____________, as the Investor representative[s] _______________, _________________, and ______________. At each meeting for the election of directors, the holders of the Series A Preferred, voting as a separate class, shall be entitled to elect [x] member[s] of the Company’s Board of Directors which director shall be designated by Investor, the holders of Common Stock, voting as a separate class, shall be entitled to elect [x] member[s], and the remaining directors will be [Option 1: mutually agreed upon by the Common and Preferred, voting together as a single class.] [ or Option 2: chosen by the mutual consent of the Board of Directors].

If a subset of the board is being chosen by more than one constituency (e.g., two directors chosen by the investors, two by founders / common holders and one by “mutual consent”), you should consider what is best: (a) chosen my mutual consent of the board (one person, one vote) or (b) voted upon on the basis of proportional share ownership on a common-as-converted basis.

VCs will often want to include a board observer as part of the agreement either instead of or in addition to an official member of the board. This is typical and usually helpful, as many VC partners have an associate that works with them on their companies. While there’s rarely any contention about who attends a board meeting, most VCs will want the right to have another person from the firm at the board meeting, even if they are non-voting (an “observer”).

Many investors will mandate that one of the common-stockholder chosen board members be the then-serving CEO of the company. This can be tricky if the CEO is the same as one of the key founders – often you’ll see language giving the right to a board seat to one of the founders and a separate board seat to the then CEO – consuming two of the common board seats. Then – if the CEO changes, so does that board seat.

While it is appropriate for board member and observers to be reimbursed for their reasonable out-of-pocket costs for attending board meetings, we rarely see board members receive cash compensation for serving on the board of a private company. Outside board members are usually compensated with stock options – just like key employees – and are often invited to invest money in the company alongside the VCs.