In this second part of Osborne Clarke’s look at term sheets, Mathias Loertscher and Robert Wood explain some additional technical terms, including founder vesting, anti-dilution ratchets, and “drag and tag” provisions, as well as the sections of the term sheet that are legally binding.
Vesting allows founders to earn their equity over time. A VC investor will often ask early stage business founders to “vest” (or “reverse vest” or “re-vest”) part of their equity when its VC investment is first made.
If the founder’s equity is subject to vesting, this means that any “unvested” shares may be bought back by the company or be converted into worthless deferred shares (with no rights) if the founder leaves the company before their shares vest.
Vesting frequently occurs on a “cliff” basis, meaning that a defined portion vests straight away or on an anniversary of the investment, and then switches to a more linear monthly basis (e.g. over the next 1 to 2 years). Vesting can also occur on achievement of certain specific milestones, and is often accelerated – in whole or in part – on an exit or if the founder is wrongfully terminated without cause. Ideally, full vesting should be entirely within the founder’s control.
Founder vesting is a matter of negotiation as an investor may be willing to recognise the contribution a founder has already made to the development of a business. Factors which will be taken into consideration are:
■how mature the business is;
- whether it is generating revenues;
- whether the founder has put money into the business; and
- whether the founder has already gone through a vesting process already (although, it does not preclude an investor from asking the founder to “re-vest” part of their equity again).
For founders, vesting can seem harsh and unfair, but a new investor will see it as important way of ensuring the founder is fully committed to the business after the investment, particularly on deals with a hopeful valuation. Like all things, it’s a question of balance.
Good Leaver/Bad Leaver
If any employee (including a founder) leaves a company before an exit, a VC investor will want to ensure their equity is made available to incentivise a replacement (without diluting the other shareholders. Additionally, the investor will want to ensure they don’t benefit from any future value growth from the shares.
A term sheet therefore contains reference to compulsory transfer provisions, often referred to as “good leaver / bad leaver” clauses. The consequences of these provisions will differ depending on whether the individual is:
- a “good leaver” – An employee, director or consultant who leaves in circumstances where they are generally not culpable e.g. death, permanent incapacity or where they are wrongfully terminated; or
- a “bad leaver” – An employee who leaves in circumstances where they have done something wrong e.g. gross misconduct, criminal offences or other termination with cause.
Voluntary resignation can be either good or bad depending on when the person resigns.
A good leaver will generally be required to transfer their shares at fair market value when they leave. In other words, they receive the value that they helped to build up to that point. A bad leaver is always required to transfer their shares at nominal value.
The shares are bought back by the company, transferred to a nominated third party by the board (e.g. an employee benefit trust) or offered to the other shareholders. Bad leaver shares may automatically convert into worthless deferred shares. This can be helpful, as it is hard to transfer shares to employees below market value without creating tax problems.
Any unvested shares are treated as worthless, regardless of the circumstances in which the founder leaves the company. If the founder is a bad leaver, their vested shares will tend to be bought back by the company (or converted into worthless deferred shares) at nominal value. Occasionally this is limited to only the most extreme bad leaver circumstances.
If the founder is a good leaver there may be some negotiation around the vested shares. They may be subject to transfer at fair market value, retained by the founder or a mixture of the two (with the proportions changing over time so that the number of vested shares retained increases the longer they’ve been with the company).
Be very wary of any reference to “customary” leaver provisions as the implications of different approaches can be significant for a founder and other employee shareholders. Always take legal advice before you agree any leaver provisions at the term sheet stage.
The term sheet will often refer to an “anti-dilution ratchet” right for the VC investor. This offers protection for an investor in the event of a future fundraising at a valuation which is lower than the valuation at which the investor is investing (or, as it is commonly referred to, a “down round”).
An anti-dilution ratchet gives the investor the right to receive extra shares (for which they pay nothing or very little) so that the average price per share paid by the investor is adjusted to take into account the down round. In other words, it protects the investor from having overpaid for its shares on the previous round.
There are, however, different varieties of anti-dilution ratchets, some of which are more favourable to the other shareholders:
- A “full ratchet” means that the price of the investor’s shares is reduced to the new, lower price per share. For example, if the investor received 100 shares at £10 per share and the new price per share is £5, the investor will receive a bonus issue of 100 shares on the down round (so that £1,000 investment means a holding of 200 shares at £5 per share).
- A “weighted average ratchet” means that the number of shares being issued on the new round is taken into consideration in determining the extent to which the investor’s share price should be rebased. The idea is that a very small down round should not have the same impact on the other shareholders as a much larger down round.
- A weighted average ratchet can be “narrow based” (only the actual number of shares in issue are taken into account) or “broad based” (both the shares in issue and any outstanding options are taken into account). A broad based weighted average is most favourable to the other shareholders as it results in the least dilution on a down round.
These rights can sometimes be subject to “pay to play” provisions, meaning an investor will only have anti-dilution protection if it participates in the down round to the extent of its pre-emptive rights (sometimes called “following its money”).
If you’re unsure of what kind of anti-dilution right is being sought in a term sheet, ask for it to be stated explicitly as it’s a very important area to get right.
“Drag and Tag”
A term sheet will often make reference to customary “drag and tag” provisions.
A “drag along” provision applies when a majority of shareholders (holding at least 50% of shares between them) have accepted an offer for their shares and they require the other shareholders to sell their shares to the same purchaser on the same terms. In other words, they “drag along” the other shareholders on the sale. A VC investor will want some control over the exercise of the drag along provision so that it cannot be dragged into an exit that it does not approve. As such, the dragging shareholders will usually need investor consent to exercise their rights.
A “tag along” provision allows a minority of shareholders to require that an offer be made for their shares where a majority has accepted an offer which would result in a change of control of the company (again, usually 50% of the shares).
Similar to a tag along right, some companies now have “co sale” rights, where the ability of the majority shareholder to sell a percentage of their shares is conditional upon an offer being made to the other shareholders. This allows them to sell the same percentage of their shares to the same buyer. Co-sale rights can be difficult in practice and should really be seen as an attempt to prevent liquidity / share transfers until an exit.
Legally Binding – Confidentiality, Exclusivity and Fees
Term sheets are largely not legally binding apart from a few provisions. These include:
- Confidentiality – both the proposed investment terms, as well as the existence of the term sheet, are often confidential. As such, make sure that you don’t go around bragging that you have received a term sheet from an investor. You will also want to make sure that the confidentiality provision covers any due diligence information which is disclosed to the investor, or put in place a separate non-disclosure agreement to cover that information.
- Exclusivity – A VC investor will want to know that all conversations with competing investors have been terminated before doing any proper due diligence or instructing lawyers to prepare its documentation. It will require the company to make a binding commitment not to consider any other offers or carry on any other negotiations during the exclusivity period. A company cannot be forced to continue negotiating with the investor, but it can be restricted from negotiating with anyone else.
From the company’s perspective, it is important to keep the exclusivity period as short as possible (no longer than it should reasonably take to complete the deal, say between 2 and 6 weeks) so that if the VC investor chooses not to proceed with the investment for any reason, the company is not prevented from speaking to alternative investors for too long.
An investor may also want a “break fee” as part of the exclusivity arrangement. This is a fee payable by the company in the event that it withdraws from the negotiations or the investor discovers something materially adverse about the company which causes it to withdraw. If you are required to pay this fee, ensure it is capped at a reasonable pre-estimate of the investor’s legal and accounting costs. Your lawyer will be able to help you negotiate this provision.
The term sheet will contain other terms which we have not reviewed in this two-part blog series. These may have significant impact on a founder (such as non-compete and non-solicitation covenants binding the founders), so as with everything else, make sure you understand what you’re signing up to and, if in doubt, seek advice.