Select Provisions of Venture Capital Contracts
In the previous posts I have been discussing some ways entrepreneurs and startups can protect themselves when signing a deal with VC or Angels. In this article I will discuss some provisions the wary founder should be cautious of when looking over a VC contract.
In the robust VC market of the late 1990s many of the below provisions were of little effect, because the appreciation trajectories of company valuations were positive and subsequent rounds of investment at higher valuations lessened the provisions value or rendered them moot.
Additionally, liquidations were achieved at such a high valuation that company founders, management, and employees had sufficient profits to share even after the preferences were paid to investors. However, after the bubble burst in the early 2000’s many VCs began insisting on and exercising these provisions.
a. Anti-Dilution Provisions
Anti-dilution provisions dilute the share value of common stock rather than diluting preferred stock. These provisions act as a 'price protector' for the VC; the preferred shareholders are granted a reduction in their conversion price, resulting in more common shares being issued and the common shareholders suffering a price reduction. Anti-dilution provisions and the ratcheting agreements therein are one of the most hotly debated provisions in venture capital contracts.
b. Initial Liquidation Preferences
Initial liquidation preferences provide that, in the event of a sale of the company, the holders of preferred stock receive a specified amount—usually equal the amount initially invested—per share prior to any payments to the holders of common stock.
The term 'liquidation' is usually applicable at the time of sale. If the proceeds from the sale are less than or equal to the preferred shareholders' initial liquidation preferences, the common shareholders get nothing.
c. Participation Rights
Participation rights allow a preferred shareholder to share the proceeds of a sale on a pro rata basis with the common shareholders as though the preferred shares are common shares. The preferences may take on a cumulative effect, as later rounds of investors usually negotiate and require liquidation preferences with participation rights and this in turn whittles down the profits available to the common shareholders.
d. Mandatory Redemption Provisions
Mandatory redemption provisions provide that if a company has not gone public after a certain number of years, the preferred holders are entitled to require portfolio companies to redeem their preferred shares for cash, which the portfolio company must buy-back from the venture capitalist out of cash that is available. Mandatory redemption provisions are incorporated into the deal so that venture capitalist can exit a venture if the holding company becomes part of the living dead. This provision, however, is often unexercised or ineffective if exercised because typically if the VCs want to exercise this provision the portfolio company has no funds with which to pay.
These topics have been written on many times since Brad Feld's seminal blog on the topic. I have to admit, this blog series inspired my Law Review subject paper and my passion for VC contracts and building a more sustainable industry. Make sure you familiarize yourself with all the the available research prior to signing a funding contract with many strings attached.
This article was written by Curtis Roberts, the founder of The Founder's Attorney.
If you have any questions or suggestions he can be reached at firstname.lastname@example.org.
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This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.