“Indemnification: The bylaws and / or other charter documents of the Company shall limit board member’s liability and exposure to damages to the broadest extent permitted by applicable law.  The Company will indemnify board members and will indemnify each Investor for any claims brought against the Investors by any third party (including any other shareholder of the Company) as a result of this financing.”

Given all the shareholder litigation in recent years, there is almost no chance that a company will get funded without indemnifying its directors.  The first sentence is simply a contractual obligation between the company and its board.  The second sentence – which is occasionally negotiable – indicates the desire for the company to purchase formal liability insurance.  One can usually negotiate away insurance in a Series A deal, but for any follow-on financing, the major practice today is to procure director and officer (D&O) insurance.

“Assignment: Each of the Investors shall be entitled to transfer all or part of its shares of Series A Preferred purchased by it to one or more affiliated partnerships or funds managed by it or any or their respective directors, officers or partners, provided such transferee agrees in writing to be subject to the terms of the Stock Purchase Agreement and related agreements as if it were a purchaser thereunder.”

The next clause – assignment – looks as follows:

The assignment provision allows venture funds to transfer between funds and make distributions to their limited partners (their investors). This is something companies must normally live with and is a term that is rarely availed upon by investors.

Neither of these terms should be controversial. The company should be willing to indemnify its directors and will likely need to purchase D&O insurance in order to attract outside board members. The assignment clause simply gives VC firms flexibility over transfers which they require to be able to run their business and – as long as the VC is willing to require that any transferee agrees to be subject to the various financing agreements – the company should be willing to provide for this (although entrepreneurs should be careful not to let the loophole of “assignment without transfer of the obligation under the agreements” occur.)

Jason and I are planning to finish strong with some serious stuff in our term sheet series, but we figured we’d put one more term in that has us sniggling whenever we see it (a “sniggle” is a combination “sneer-giggle” – sort of like how I reacted toKidman / Ferrell in Bewitched last night). The last sniggle term is as follows:

“Initial Public Offering Shares Purchase:  In the event that the Company shall consummate a Qualified IPO, the Company shall use its best efforts to cause the managing underwriter or underwriters of such IPO to offer to [investors] the right to purchase at least (5%) of any shares issued under a “friends and family” or “directed shares” program in connection with such Qualified IPO. Notwithstanding the foregoing, all action taken pursuant to this Section shall be made in accordance with all federal and state securities laws, including, without limitation, Rule 134 of the Securities Act of 1933, as amended, and all applicable rules and regulations promulgated by the National Association of Securities Dealers, Inc. and other such self-regulating organizations.”

We firmly put this in the “nice problem to have” category.  This term really blossomed in the late 1990’s when anything that was VC funded was positioned as a company that would shortly go public. However, most investment bankers will push back on this term if the IPO is going to be a success as they want to get stock into the hands institutional investors (e.g. “their clients”).  If the VCs get this push back, they are usually so giddy with joy that the company is going public that they don’t argue with the bankers.  Ironically, if the VC doesn’t get this push back (or even worse, get a call near the end of the IPO road show) where the bankers are asking the VC to buy shares in the offering, the VC usually panics (because it means it’s no longer a hot deal) and does whatever he can not to have to buy into the offering.

Sniggle.  Our recommendation – don’t worry about this one or spend lawyer time on it.

I had good intentions earlier this week to try to crank out the balance of the term sheet series, but it turned into a busy week.  Since I’m still muddling through the set of terms that either don’t matter much and/or are hard to negotiate away (e.g. chose you battles wisely), I didn’t expect anyone would be waiting on the edge of their seats for these.  However, for completeness, it’s worth going through the stuff that shows up on the last few pages of a standard VC term sheet.  Jason and I aren’t quite done, but with this post, we are one (tedious) step closer.

Almost every term sheet we’ve ever seen has a “Restrictions on Sales” clause in it that looks something like:

“Restrictions on Sales:  The Company’s Bylaws shall contain a right of first refusal on all transfers of Common Stock, subject to normal exceptions. If the Company elects not to exercise its right, the Company shall assign its right to the Investors.”

Management / founders rarely argue against this as it helps control the shareholder base of the company which usually benefits all the existing shareholders (except possibly the one who wants to bail out of their private stock.)  However, we’ve found that the lawyers will often spend time arguing how to implement this particular clause.  Some lawyers feel that putting this provision in the bylaws is the wrong way to go and prefer to include such a provision in each of the company’s option agreements, plans and stock sales.  Personally, we find it much easier to include in the bylaws.

Next up is the ubiquitous proprietary information and inventions agreement clause.

“Proprietary Information and Inventions Agreement:  Each current and former officer, employee and consultant of the Company shall enter into an acceptable proprietary information and inventions agreement.”

This paragraph benefits both the company and investors and is simply a mechanism that investors use to get the company to  legally stand behind the representation that it owns its intellectual property.  Many pre-Series A companies have issues surrounding this, especially if the company hasn’t had great legal representation prior to its first venture round.  We’ve also run into plenty of situations (including several of ours – oops!) where companies are loose about this between financings and – while a financing is a good time to clean this up – it’s often annoying to previously hired employees who are now told “hey – you need to sign this since we need it for the venture financing.”  It’s even more important in the sale of a company, as the buyer will always insist on clear ownership of the IP.  Our best advice here is that companies should build these agreements into their hiring process from the very beginning (with the advice from a good law firm) so that there are never any issues around this, as VCs will always insist on it.

Finally, a co-sale agreement is pretty standard fare as well.

“Co-Sale Agreement:  The shares of the Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange their stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis.  This right of co-sale shall not apply to and shall terminate upon a Qualified IPO.”

If you are a founder, you are probably asking why we did not include the co-sale section in the “really matter section.”  The chance of keeping this provision out of a financing is close to zero, so we don’t think it’s worth the battle to fight it.  Notice that this only matters while the company is private – if the company goes public, this clause no longer applies.

“Voting Rights: The Series A Preferred will vote together with the Common Stock and not as a separate class except as specifically provided herein or as otherwise required by law.  The Common Stock may be increased or decreased by the vote of holders of a majority of the Common Stock and Series A Preferred voting together on an as if converted basis, and without a separate class vote.  Each share of Series A Preferred shall have a number of votes equal to the number of shares of Common Stock then issuable upon conversion of such share of Series A Preferred.”

Most of the time voting rights are simply an “FYI” section as all the heavy rights are contained in other sections such as the protective provisions.

Today’s “term that doesn’t matter much” from our term sheet series is the Right of First Refusal. When we say “it doesn’t matter much”, we really mean “don’t bother trying to negotiate it away – the VCs will insist on it.” Following is the standard language:

“Right of First Refusal: Investors who purchase at least (____) shares of Series A Preferred (a “Major Investor”) shall have the right in the event the Company proposes to offer equity securities to any person (other than the shares (i) reserved as employee shares described under “Employee Pool” below, (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their right of first refusal) to purchase [X times] their pro rata portion of such shares. Any securities not subscribed for by an eligible Investor may be reallocated among the other eligible Investors. Such right of first refusal will terminate upon a Qualified IPO. For purposes of this right of first refusal, an Investor’s pro rata right shall be equal to the ratio of (a) the number of shares of common stock (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) held by such Investor immediately prior to the issuance of such equity securities to (b) the total number of share of common stock outstanding (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) immediately prior to the issuance of such equity securities.”

There are two things to pay attention to in this term that can be negotiated. First, the share threshold that defines a “Major Investor” can be defined. It’s often convenient – especially if you have a large number of small investors – not to have to give this right to them. However, since in future rounds, you are typically interested in getting as much participation as you can, it’s not worth struggling with this too much.

A more important thing to look for is to see if there is a a multiple on the purchase rights (e.g. the “X times” listed above). This is an excessive ask – especially early in the financing life cycle of a company – and can almost always be negotiated to 1x.

As with “other terms that don’t matter much”, you shouldn’t let your lawyer over engineer these. If you feel the need to negotiate, focus on the share threshold and the multiple on the purchase rights.

When Jason and I last wrote about term sheets, Jack was still trying to save the world (surprise – he did) and we dealt with a meaty and important issue – vesting. For completeness (and because all good “series” deserve to be finished off), we’re tackling the terms that rarely matter in the next couple of posts.  Today we’re starting with Information Rights and Registration Rights.

You might ask, “If these terms rarely matter, why bother?” Well – you’ll end up having to deal with them in a VC term sheet, so you might as well (a) be exposed to them and (b) hear that they don’t matter much. Of course, from a VC perspective, “doesn’t matter much” means “Mr. Entrepreneur, please don’t pay much attention to these terms – just accept them as is.” Specifically, if one of these terms is being hotly negotiated by an investor or company, that time (and lawyer money) is most likely being wasted.

First up is Information Rights – the typical clause follows:

“Information Rights: So long as an Investor continues to hold shares of Series A Preferred or Common Stock issued upon conversion of the Series A Preferred, the Company shall deliver to the Investor the Company’s annual budget, as well as audited annual and unaudited quarterly financial statements. Furthermore, as soon as reasonably possible, the Company shall furnish a report to each Investor comparing each annual budget to such financial statements. Each Investor shall also be entitled to standard inspection and visitation rights. These provisions shall terminate upon a Qualified IPO.”

Information rights are generally something companies are stuck with in order to get investment capital. The only variation one sees is putting a threshold on the number of shares held (some finite number vs. “any”) for investors to continue to enjoy these rights.

Registration Rights are more tedious and tend to take up a page or more of the term sheet.  The typical clause(s) follows:

“Registration Rights: Demand Rights: If Investors holding more than 50% of the outstanding shares of Series A Preferred, including Common Stock issued on conversion of Series A Preferred (“Registrable Securities”), or a lesser percentage if the anticipated aggregate offering price to the public is not less than $5,000,000, request that the Company file a Registration Statement, the Company will use its best efforts to cause such shares to be registered; provided, however, that the Company shall not be obligated to effect any such registration prior to the [third]anniversary of the Closing. The Company shall have the right to delay such registration under certain circumstances for one period not in excess of ninety (90) days in any twelve (12) month period.

The Company shall not be obligated to effect more than two (2) registrations under these demand right provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty (180) day period commencing with the date of the Company’s initial public offering, or (ii) if it delivers notice to the holders of the Registrable Securities within thirty (30) days of any registration request of its intent to file a registration statement for such initial public offering within ninety (90) days.

Company Registration: The Investors shall be entitled to “piggy-back” registration rights on all registrations of the Company or on any demand registrations of any other investor subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered pro rata in view of market conditions. If the Investors are so limited, however, no party shall sell shares in such registration other than the Company or the Investor, if any, invoking the demand registration. Unless the registration is with respect to the Company’s initial public offering, in no event shall the shares to be sold by the Investors be reduced below 30% of the total amount of securities included in the registration. No shareholder of the Company shall be granted piggyback registration rights which would reduce the number of shares includable by the holders of the Registrable Securities in such registration without the consent of the holders of at least a majority of the Registrable Securities.

S-3 Rights: Investors shall be entitled to unlimited demand registrations on Form S-3 (if available to the Company) so long as such registered offerings are not less than $1,000,000.

Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one special counsel of the selling shareholders not to exceed $25,000).

Transfer of Rights: The registration rights may be transferred to (i) any partner, member or retired partner or member or affiliated fund of any holder which is a partnership, (ii) any member or former member of any holder which is a limited liability company, (iii) any family member or trust for the benefit of any individual holder, or (iv) any transferee satisfies the criteria to be a Major Investor (as defined below); provided the Company is given written notice thereof.

Lock-Up Provision: Each Investor agrees that it will not sell its shares for a period to be specified by the managing underwriter (but not to exceed 180 days) following the effective date of the Company’s initial public offering; provided that all officers, directors, and other 1% shareholders are similarly bound. Such lock-up agreement shall provide that any discretionary waiver or termination of the restrictions of such agreements by the Company or representatives of underwriters shall apply to Major Investors, pro rata, based on the number of shares held.

Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to registration rights as are reasonable, including cross-indemnification, the period of time in which the Registration Statement shall be kept effective, and underwriting arrangements. The Company shall not require the opinion of Investor’s counsel before authorizing the transfer of stock or the removal of Rule 144 legends for routine sales under Rule 144 or for distribution to partners or members of Investors.”

Registration rights are also something the company will have to offer to investors. What is most interesting about this section is that lawyers seem genetically incapable of leaving this section untouched and always end up “negotiating something.” Perhaps because this provision is so long in length, they feel the need to keep their pens warm while reading. We find it humorous (so long as we aren’t the ones paying the legal fees), because in the end, the modifications are generally innocuous and besides, if you ever get to the point where registration rights come into play (e.g. an IPO), the investment bankers of the company are going to have a major hand in deciding how the deal is going to be structured, regardless of the contract the company entered into years before when it did an early private financing.

While lots of VCs posture during term sheet negotiations by saying “that is non-negotiable”, terms rarely are (as you’ve likely inferred from previous posts on term sheets be me and Jason.) Occasionally, a term will actually be non-negotiable. In all the VC deals we’ve ever seen, the preferred has the right – at any time – to convert its stake into common. Following is the standard language:

“Conversion: The holders of the Series A Preferred shall have the right to convert the Series A Preferred, at any time, into shares of Common Stock. The initial conversion rate shall be 1:1, subject to adjustment as provided below.”

This allows the buyer of preferred to convert to common should he determine on a liquidation that he is better off getting paid on a pro rata common basis rather than accepting the liquidation preference and participating amount. It can also be used in certain extreme circumstances whereby the preferred wants to control a vote of the common on a certain issue. Do note, however, that once converted, there is no provision for “re-converting” back to preferred.

A more interesting term is the automatic conversion, especially since it has several components that are negotiable.

“Automatic Conversion: All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price, upon the closing of a firmly underwritten public offering of shares of Common Stock of the Company at a per share price not less than [three] times the Original Purchase Price (as adjusted for stock splits, dividends and the like) per share and for a total offering of not less than [$15] million (before deduction of underwriters commissions and expenses) (a “Qualified IPO”). All, or a portion of, each share of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price in the event that the holders of at least a majority of the outstanding Series A Preferred consent to such conversion.”

In an IPO of a venture-backed company, the investment bankers will want to see everyone convert into common stock at the time of the IPO (it is extremely rare for a venture backed company to go public with multiple classes of stock – it happens – but it’s rare). The thresholds of the automatic conversion are critical to negotiate – as the entrepreneur; you want them lower to insure more flexibility while your investors will want them higher to give them more control over the timing and terms of an IPO.

Regardless of the actual thresholds, one thing of crucial importance is to never allow investors to negotiate different automatic conversion terms for different series of preferred stock. There are many horror stories of companies on the brink of going public and having one class of preferred stockholders that have a threshold above what the proposed offering would consummate and therefore these stockholders have an effective veto right on the offering. We strongly recommend that – at each financing – you equalize the automatic conversion threshold among all series of stock.

If you are avid followers of the TV series 24 (as Jason and I are), you’ll recognize that the next item in our term sheet series – Redemption at Option of Investors – has similar characteristics to the regular exchange Jack has with CTU:

CTU Director (any of them – Driscoll, Tony, Ryan, George, Michelle): “Jack – stand down – don’t go in there without backup.”

Jack: (Gruffly, in a hoarse voice) “I gotta go in – there’s no time to wait – if I don’t go, the world will end and my (current babe, hostage, daughter, partner) will die.”

CTU Director: (Mildly panicked) “Jack – wait – it’s too dangerous – I command you – wait.”

Jack: (Insolently) “I gotta go.” (Jack hangs up the phone).

Cut to clock ticking and commercial or teaser for scenes from next week.

Think of the discussion around redemption rights as this scene – utterly predictable and ultimately benign. Jack always goes in. Jack always stops the bad stuff – for the time being. Jack (or the bad guys) always creates a new problem. The CTU director always forgets that Jack disobeyed a direct order shortly after Jack is successful with his latest task.

You are Jack. Your investor is the CTU director. If you ask your CTU director “have you ever actually ever triggered redemption rights?” you will normally get some nervous fidgeting (“wait – it’s too dangerous”), a sheepish “no” followed by a confident “but we have to have them or we won’t do the deal!” (“I command you – wait.”)

Redemption rights usually look something like:

“Redemption at Option of Investors: At the election of the holders of at least majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.”

There is some rationale for redemption rights. First, there is the “fear” (on the VCs part) that a company will become successful enough to be an on-going business, but not quite successful enough to go public or be acquired. In this case, redemption rights were invented to allow the investor a guaranteed exit path. However, any company that is around for a while as a going concern that is not an attractive IPO or acquisition candidate will not generally have the cash to pay out redemption rights.

The second reason for redemption rights pertains to the life span of venture funds. The average venture fund has a 10 years life span to conduct its business. If a VC makes an investment in year 5 of the fund, it might be important for that fund manager to secure redemption rights in order to have a liquidity path before his fund must wind down. As with the previous case, whether or not the company has the ability to pay is another matter.

Often, companies will claim that redemption rights create a liability on their balance sheet and can make certain business optics more difficult. In the past few years, accountants have begun to argue more strongly that redeemable preferred stock is a liability on the balance sheet, not an equity feature. Unless the redeemable preferred stock is mandatorily redeemable, this is not the case and most experienced accountants will be able to recognize the difference.

There is one form of redemption that we have seen in the past few years and we view as overreaching – the adverse change redemption. We recommend you never agree to the following which has recently crept into terms sheets.

“Adverse Change Redemption: Should the Company experience a material adverse change to its prospects, business or financial position, the holders of at least majority of the Series A Preferred shall have the option to commit the Company to immediately redeem the outstanding Series A Preferred. Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.”

This is just too vague, too punitive, and shifts an inappropriate amount of control to the investors based on an arbitrary judgment. If this term is being proposed and you are getting pushback on eliminating it, make sure you are speaking to a professional investor and not a loan shark.

In our experience – just like Jack’s behavior – redemption rights are well understood by the market and should not create a problem, except in a theoretical argument between lawyers or accountants.