Negotiating term sheets, types of stock, and protective provisions

Welcome to the first edition of Above Board. Thanks so much for subscribing.

This Q&A features Jim Armstrong, Managing Director of Composite Ventures and Forbes Midas List investor. He explains different types of stock, the importance of protective provisions (and how to negotiate them), the need for company legal counsel, and more.

If you like what you read, please feel free to forward this to a friend or colleague / share the link for them to subscribe. Any feedback, feel free to hit reply!

Let’s jump in.

AB: Thanks for joining, Jim. To get started, can you explain what the difference is between preferred and common stock?

JA: A company has different types of stock, namely preferred and common stock. Investors always get preferred stock. Employees at a company, including founders, get common stock. Preferred stock and common stock are incredibly different vehicles: preferred stock is very powerful, while common stock is protected by basic law at the state level regarding what's wrong and right. 

Preferred stock has every bell and whistle in the world: 80% of these revolve around governance, while 20% concern economic liquidation preferences, pro rata rights, and anti dilution. These can range from valuation price per share, ability to resell, and so on.

As for terms, there's five or six that stand out to most people, but there's one set of provisions in each term sheet called negative control provisions or protective provisions, which were really designed to be, as their name implies, protective. 

AB: Why are protective provisions so powerful?

JA: There might be 100 million shares of common stock and only one share of preferred stock. But, the preferred stock— owned by investors— has protective provisions which state you can't do a series of activities— A, B, C, D, or F— without the preferred shareholder’s permission. These provisions relate to the most important potential future actions for a company, such as selling it, change of control, creating securities senior to those they own, whether you can raise venture debt in the future, prohibiting the creation of future option pools, etc. 

In essence, even though a founder may have only given up one 1 millionth of their company, that single share of preferred stock controls anything growth oriented or exit oriented you want to do with your company in the future. Most investors use protective provisions openly and honestly, but not all. And a founder/CEO certainly needs to be aware of them.

If you wanted to raise money on a term sheet without protective provisions, you would limit your investors to a very, very small and sophisticated group.

AB: Can founders negotiate protective provisions?

JA: Short answer: yes, via carve outs. For example, the protective provisions may state that the company cannot increase an option pool without the permission of the preferred shareholders, unless it's less than 6% per year. Another example: the company may not engage in a change of control unless it results in four times or more back to the investors on their money.

Protective provisions are usually the heaviest point of negotiation regarding term sheets and it comes down to leverage. You need to do due diligence on the investor who's going to be on your board because they are the person who represents those shares. More importantly, you want to get to know the firm and the way they act. You should seek to understand their incentives: I call venture capital ‘the great unlicensed profession’ because you don't need a license, you just need money. This is why it’s so important to understand the incentives of your investors.

Let’s say your new preferred holder says ‘I don't want you being sold to a competitor.’ You could respond and say, ‘I understand that… but let's not put it in the protective provisions. Let's do a side letter where we write down the three competitors and we can put a 36 month expiration date on it.’

Whenever you can get things out of the broad agreement (and instead have it on a side letter), the better. Why? Whatever you give your early investors, you can bet that all follow on investors will start with that as table stakes for what they receive. So, you're setting precedent early on and that's why it's important to get this right from the outset.

AB: How should you think about legal counsel when working on an investment arrangement?

JA: As a company, you should never rely on investor counsel, ever. A company should have its own counsel. A set of legal docs for early stage fundraising takes about a month to wrap up post-term sheet and costs about $45,000 today. The usual practice is that the company pays for that. The company should insist that they (with their legal counsel) draft the documents. A company should not let investors draft the initial set of documents. Then, the investor can review and send back their feedback. This approach will allow you to get more language in the documents that you prefer, as opposed to the investor dominating the language.

AB: How much can a term sheet be negotiated?

JA: Simply put, there's nothing sacred in a term sheet. I’ve seen crazy stuff. Put it this way: I don't even use counsel for term sheets anymore. I did early in my career. Nowadays, I write my own term sheets with provisions that make sense for the deal. The better you are, the more experienced you are at deal making and the more you look at a term sheet as a creative document.

AB: So a company gets into the term sheet negotiation stage with an investor and realizes that the investor is hard to work with (think: they’re negotiating every single term and everything feels like a battle). Should the company turn back and consider other investors?

JA: Rarely have I seen people turn back at that point and that's a mistake. The minute you realize that you're getting into business with people who don't share your values around professionalism, disclosure, transparency, and fairness, it's very difficult because at this point, you've probably told other investors that they lost out on the deal.

But, you should turn back and bite the bullet. Otherwise, you're signing up for several years— maybe a decade— of unhappiness and feeling demotivated.

AB: Thanks for reading. In our next edition, we’ll be discussing liquidation preferences. Until then, take care and please feel free to share Above Board with those who you think may find it helpful.