Rights & Preferences, What to Expect from a VC

Your company has grown to the point that you are no longer in need of “friends and family money” or angel financing.  You are now seeking venture capital funding that will help move your company further down the growth spectrum; but, you are not sure what to expect in terms of the rights and preferences that a venture capitalist may require for its investment in your company.  This article will briefly highlight some of the more common rights and preferences that a venture capitalist will expect for an investment in your company and that you will see outlined when you are presented a term sheet by the venture capitalist.

Antidilution Rights

Antidilution rights protect the venture capitalist against the issuance of securities by your company at a later date for a price less than what was paid by the venture capitalist.  If the venture capitalist purchased preferred stock in your company and is afforded antidilution protection, the term sheet will generally specify a formula for adjusting the conversion ratio to take into consideration any fluctuation in the share price upon the issuance of new securities.

Conversion Rights

If the venture capitalist is purchasing preferred stock, generally there will be conversion rights attached to those shares.  Conversion rights can either be mandatory or optional.  If the preferred stock is subject to mandatory conversion rights, the term sheet will specify what those events are and will provide a formula for the conversion of the preferred shares into common shares.

Drag Along, Tag Along, First Refusal, Co-Sale and Preemptive Rights

Generally, a venture capitalist will require the shares of stock it purchases to have any one or all of the following rights: the right of the venture capitalist to compel minority shareholders to participate in a stock sale (drag along); the right of a minority shareholder venture capitalist to sell its shares with the majority shareholders (tag along); the right of the venture capitalist to be first offered securities to be sold by other shareholders or your company (first refusal);  the right of the venture capitalist to sell its securities along with any securities sold by other shareholders or your company (co-sale); and the right of the venture capitalist to acquire any newly issues securities issued by your company to the extent required to maintain the relative percentage ownership on an as-converted basis (preemptive).

Registration Rights

Registration rights entitle the venture capitalist to force your company to register shares of common stock issuable upon conversion of preferred stock with the Securities and Exchange Commission.

Voting Rights

Most commonly, the venture capitalist receives the number of votes equal to the number of shares of common stock into which its securities may convert upon a conversion trigger event.  The term sheet will generally describe whether the preferred stock purchased by the venture capitalist has “class” or “protective” voting rights or whether the venture capitalist has special rights to take control of your company upon the occurrence of certain events of default. The venture capitalist will often have the right to elect (or otherwise appoint for election by the company’s shareholders) one or more members of the board of directors of your company.

Information Rights

If the venture capitalist is a minority shareholder, the venture capitalist will typically desire the right, which should be specified in the term sheet, to receive monthly and/or quarterly financial statements, an annual audited financial statement, and an annual budget, as well as the ability to have interim access to the books and records of your company.

Dividend Preference

Many times a venture capitalist will be entitled to special dividends or other preferential returns on the securities it purchases.  The term sheet will also set forth whether such dividends will accumulate to the extent not paid and whether the holders of common stock or any other junior securities may receive dividends or other distributions if accumulated dividends owing to the venture capitalist are not paid.

Liquidation Preference

For the risks associated with investing in an early stage company, venture capitalists may require a premium on the investment.  Liquidation preference refers to the right of a venture capitalist to receive a return prior and in preference to other shareholders on liquidation or sale of your company.

These are just a few of the common rights and preferences that you can expect to see contained in the initial term sheet you receive from a venture capitalist.  The term sheet is designed to highlight the most important business terms of the equity sale and will almost always provide that the definitive agreements will contain such other customary terms and conditions as may be appropriate.  It is important for you to understand what every each provision of the term sheet means to your company and its capital structure.  Seek out counsel and advice early in the process so that you can be better prepared during the negotiation of the terms and conditions of the venture capitalists investment into your company.