Understanding Preferred Instrument Term Sheets in Early Stage Funding
Structuring early stage investments as preferred instruments, such as preferred stock, is significantly more complex than working with convertible notes; understanding preferred instrument term sheets in early stage funding is essential knowledge. This post will introduce some of the commonly encountered terms and provisions in finance deals involving preferred instruments.
The top of the term sheet will usually list the most fundamental details of the transaction, which may be under a section header calling it the offering section. These details include the name of the issuer, the founders’ names, the closing date, the type of securities being offered, and the pre-money valuation. Based on the valuation, the amount of the offering will be indicated, along with the corresponding number of shares and price per share. The offering section is short and straightforward, and it typically does not include much else.
The next section is much longer in comparison. It addresses the specific terms and conditions of the preferred instrument (often preferred stock). This section establishes the rights of the parties with regard to a range of matters, from capitalization and dividends to voting rights and information rights.
Capitalization provisions may reference an attached table describing the required capital structure of the company. Purchase price adjustments may be automatically triggered if any agreed changes are not made to the company’s capital structure after closing. The dividends provision will ordinarily stipulate the dividend type and percentage, when the dividend is to be paid, and whether the investors will participate in common stock dividends in addition to preferred stock dividends.
Liquidation provisions will address what happens in the event the company winds up or liquidates. Normally, the holders of series A preferred stock will be entitled by the provision to receive a per share amount equal to the purchase price plus unpaid declared dividends at preference to the holders of common stock. The remaining language in the liquidation provision will vary depending on the type of preferred stock being issued: participating or non-participating.
The difference between the participating and non-participating preferred stockis that participating preferred stock receives its preferential return first, before non-participating, and also shares with the common stock on a common equivalent basis in any remaining deal proceeds, while non-participating preferred stock does not. If a sale or liquidation occurs at or below the aggregate investment amount of the preferred class, this difference is irrelevant because there will be no proceeds available for distribution to the common class. In a successful outcome, however, the distinction can significantly impact the allocation of deal proceeds.
Preferred stock conversion provisions will describe conversion rights, including automatic conversion to common stock that occurs upon conditions such as the closing of an underwritten public offering of shares of common stock. Such provisions will fix a multiplier applied to the purchase price that is adjusted for stock splits, dividends, or similar events.
Antidilution provisions constitute another major portion of the term sheet. The series A preferred stock will usually be subject to some sort of weighted average adjustment to counteract dilution from the issuance of additional securities. Some issuances will be explicitly excluded from the antidilution mechanism, including, for example, non-cash shares issued in connection with a merger or acquisition approved by the board of directors. Similarly to the conversion provisions, the antidilution conversion price may be proportionally adjusted for splits, dividends, recapitalizations, and other events.
The remaining provisions deal with voting rights, information rights, right of first refusal, and protection mechanisms designed to preserve the initial rights of the series A investors. Registration rights might also appear in later financing rounds, but would be untimely for a series A round.
For a consultation regarding your individual business issues, please contact San Diego Corporate Law today!