The first round of fundraising is run through private individuals like friends and family members (called "love money") or individual professional investors (business angels), who not only inject fresh money, but also often bring in their expertise and their network.
The company founders then proceed with a new, larger round of financing to expand the company in its initial market. This is called Series A, and is carried out with professional collective investors, the VCs (venture capitalists). VCs make a temporary investment (with a minimum 5-year horizon) and will receive a return when the company is finally sold (or floated on the stock market).
After discussions about the valuation (which determines the share in the capital held by the investor after entry), founders and VCs negotiate a document defining the terms and conditions of the entry into the capital, called term sheet. Its legal nature is clear: It is a starting point for negotiations, not a legally binding document (except concerning certain terms, such as the exclusivity granted to the signing investor).
The final understanding of the parties will be materialized by the subsequent conclusion of actual agreements: The subscription agreement, which sets the VC's actual commitment to invest in the company, and the shareholders' agreement, governing the relations between the founders and the investors after the fundraising. The actual transaction (issuance of shares and payment of the subscription price by the investors) is carried out some time (closing) after the subscription agreement has been signed. The shareholders' agreement will also be signed at closing.
The main terms of a Series A term sheet (the "Term Sheet"), which will be included in the subscription agreement and/or shareholders' agreement, can be distinguished according to their purpose:
- The terms about the issuance of the securities to be allotted to the investor (1)
- The terms relating the transfer of shares (2).
- The terms aiming to protect the investor from further dilution in the company in which they invest (the "Company") in the event of a new round of financing (3).
- The terms relating to the shares held by the directors in case of termination of their operational functions(4).
- The terms relating the governance of the Company (5).
1. The terms concerning the issuance of securities to the investor
The investor generally wishes to be allocated so-called preference shares (the "A Shares"). Under French Law, there are two categories of shares: (i) Ordinary shares to which are attached the traditional rights that the French Commercial Code attaches to shares (such as the right to profits, voting rights…and (ii) preference shares which grant special advantages (to be described in the articles of association).
In the latter case, shareholders grant special rights for only some of them, who will therefore hold a special class of shares, and not ordinary shares.
Several rights are generally attached to the A Shares, which only the investor is allotted, and not the other shareholders (a). There is also a guarantee for the investor of the amount of their investment, via a so-called ratchet mechanism (b).
a. The rights attached to the A Shares
The A shares generally has a right to a preferential or priority dividend, or to "political" rights (such as a right to enhanced information, included mutatis mutandis in the shareholders' agreement, in addition to the preference attached to the A Shares).
Two preferential rights are particularly discussed, insofar as they affect the exit of the investor, through which she liquidates her investment: The liquidation preference and, to a lesser degree, the conversion into ordinary shares.
(i) liquidation preference right: Through this right, the holders of A share to a higher proportion of the total price in the event of a change of control (i.e sale of more than 50 % of the voting rights) of the Company (or transactions similar to such a sale, such as, in particular, a merger or a global sale of the Company's assets).
In the event of a change of control of the Company (or a transaction treated as such by the Term Sheet), the sale price would be allocated among the shareholders as following:
- The investor would be allocated the greater of (i) the portion of the price he or she would have received if all of their shares had been converted into ordinary shares and (ii) the amount of their initial investment.
- The balance of the transfer price would be allocated among the common shareholders.
This way, the investor are guaranteed against a loss of the amount of their investment.
It may happen that the investor, in addition to the preferential repayment of their investment, also requests that the surplus of the transfer price be shared among all shareholders including the holders of A Shares. However, this type of preferential liquidation should not be recommended to the founders, as it is too favorable for a Series A investor.
(ii) Conversion of A Shares into ordinary shares: The conversion of A Shares into ordinary shares, presented as a right attached to the A Share, (with, consequently, disappearance of the particular rights attached to them) will generally take place in two cases:
- At the option of the holder, at their own discretion: Generally, in this case, for one A Share, one ordinary share will be allotted.
- upon occurrence of certain events (most often the listing of the company on the stock exchange): The conversion will be automatic, generally on the same 1:1 basis as in the case of conversion by option.
b. The issuance of other securities than shares in order to protect the investor against a decrease in valuation
Generally speaking, in order to protect the investor against a decrease in the valuation of the Company, the Term Sheet frequently provides for a so-called ratchet mechanism, via the allocation of warrants issued simultaneously with the A Shares (the "Ratchet BSA") which, like any other warrant, give the right to subscribe to a future issue of shares, by exercising them, if the conditions laid down by the parties are met.
The Ratchet BSA guarantee the initial investors against a financial dilution of their participation, resulting from a loss of value of their shares, consecutive to an overvaluation of the Company at the time of their entry into the capital.
In this case, the investor has the right to be allocated, via the exercise of the Ratchet BSA, a certain number of additional A Shares free of charge as soon as a new investor enters the Company at a lower valuation than the owner of the A Shares. The global value of his investment is maintained by the increase in the number of his A Shares, following the exercise of the Ratchet Warrants, and calculated according to the type of ratchet.
There are three types of ratchet:
- full ratchet: in this case, the price per share of the fundraising round will be aligned with that of the following round and the investor will receive several additional A Shares, as a consequence of the exercise of the BSA Ratchet, the number of which will be calculated in such a way that his investment, per share, is equal to the price of the share in the following round. This ratchet mechanism is the most favorable to the investor.
- weighted average ratchet: in this case, the initial investor's cost price per share will be adjusted so that it is equal to the average of the prices per share of rounds A and B weighted by the number of shares issued. Depending on whether a fully diluted basis is taken into account (after simulating the exercise of all financial instruments giving access to capital, such as stock options for example) or not, the weighted average ratchet will be broad-based or narrow-based.
Although less radical than the full ratchet, the narrow-based weighted average ratchet is more favorable to the investor than the broad-based weighted average ratchet. Indeed, in the denominator of the formula for calculating the number of new shares to be allotted by exercise of the Ratchet BSA, the total number of shares of the Company is generally included.
Consequently, if one takes into account the shares that would theoretically be issued upon exercise of stock options (broad-based), the denominator will be higher and therefore the average price of the shares lower, and the number of A Shares to be allocated by way of exercise of the Ratchet warrants to the initial investor lower.
2. Terms relating to the transfer of shares.
In a Series A round, the investor frequently requests three types of terms:
1- A right of first refusal terms: this term provides, in the event of a transfer of its shares by a shareholder to a third party, the right for the other shareholders to acquire them in priority at the same price and conditions as those offered by the third party. If the beneficiaries of the first refusal right do not exercise it, the shareholder in question regains the right to sell freely to the third party.
2- Tag along terms (full and proportional). In this case, one or more shareholders wishing to transfer control of the company to a third party undertake to acquire or to make acquired by this third party all the shares held by the investor, under the same conditions, in particular with regard to price (total or full drag along right).
Shareholders who transfer part of their shares to a third party, but not control, may undertake to acquire or have acquired by the said third party, the shares held by the investor, in the same proportions (proportional tag along).
3- An obligation to sell jointly (drag along): In this case, in the event of a proposal for the acquisition by a third party of substantially all of the capital (generally more than 95 percent) accepted by (i) one or more shareholders representing a reinforced majority of the capital (in practice two thirds or three quarters) and/or (ii) by a reinforced majority of the owners of A Shares, all shareholders will be pushed to sell their shares to the third party.
3. Terms aiming to protect the investor from further dilution in the Company in the event of a new round of financing.
As we have seen, the ratchet term guarantees the investor against a financial dilution of his holding, resulting from a loss of value of the shares held, following an overvaluation of the Company at the time of their subscription (see above).
The so-called "anti-dilution" or “pre-emptive rights” clause allows the investor to subscribe for new shares in the event of a new round of financing with another investor, and thus to maintain its stake at the same level.
Of course, when exercising the right conferred by this clause, the investor will have to pay for the new shares allocated to him at the same price as those subscribed by the new investor.
4. Terms relating to the shares held by the directors in case of termination of their operational functions.
When an executive, who also owns shares in the Company, leaves his operational functions, she theoretically keeps her shares. She has two positions: That of an executive, which she leaves, and that of a shareholder, which she cannot lose by the mere fact of ceasing to be an executive.
Therefore, in order to resolve this situation, the shareholders' agreements signed when an investor acquires a stake in the company contain so-called management claw-back clause, which provides for the repurchase of the executive's shares in the event of their departure from the company.
The price and/or number of shares to be repurchased will differ depending on the cause of the termination of operational functions.
If the executive resigns or is dismissed for gross misconduct (showing intent to harm), all of her shares may be bought back at a lower price than their real value, or even their nominal value (bad leaver clause). The purpose is to sanction the executive who harms the company by leaving. All other causes of departure from operational functions are called good leaver.
Management claw-back clauses are often accompanied by a so-called reverse vesting mechanism.
If during a certain period after closing, an officer of the Company resigns or commits misconduct (which will have to be restricted to cases of gross misconduct, in accordance with the practice in such matters), the shares (which, through a legal fiction called reverse vesting, he will be deemed to acquire each month after the expiration) will have to be sold at their nominal value (bad leaver clause).
Conversely, if the executive leaves the Company for any reasons other than those making a case of bad leaver, all or part of their shares may be bought back at a value calculated based on a method fixed by the shareholders' agreement (good leaver clause). The purpose here is not to sanction the executive, but simply to allow them to sell her shares at the fair financial conditions.
The investor generally requests that the shares held by an executive be repurchased at an price calculated on the basis of the market value of the shares held by the executive on the date of their departure, or sometimes at a price calculated on the basis of the valuation of the last round of financing prior to termination.
5. The terms relating to the governance of the Company.
These are the term providing enhanced information for the benefit of the investor (a) and the term governing the functioning of the collegial consultative body set up to guide the decisions of the directors (b).
- The reinforced information term
This type of terms grants the investor the possibility to receive, in addition to the legal information to which any shareholder is entitled, a right to the communication of temporary accounting situations and/or periodic, monthly or quarterly financial and/or cash flow statements, financing tables and/or projected budgets; business plans or activity reports of the Company.
This can be materially burdensome for a young company, so the investor will be careful to remain reasonable, especially since the managers bring more value in their operational functions than in administrative reporting tasks.
2. The term governing the operation of the collegiate body
In order to be represented on the statutory collegial body (the "Board") that assists the executive (but without any other power than advisory), the investor usually asks to appoint a candidate (the "Investor Board Member").
The investor also suggests certain limited decisions (such as, for example, approval of the annual budget, incurring unbudgeted expenses, formation of a subsidiary, acquisition of another company…) to be approved by the Board, acting by majority vote (including the favorable vote of the Investor Board Member).
In practice, this allows the investor Board Member, and therefore indirectly the Investor, to block the adoption of these decisions. Reminding here the Board is only an advisory body responsible for guiding the decisions of the Chairman, who in a simplified joint stock company (the most common legal form of startups in France) has the sole power to bind the company, but if they were to override the Board's veto, they would incur liability.
In order to allow some flexibility , it is appropriate to define precisely the decisions requiring the approval of the Investor Board Member and in particular to provide for thresholds in certain cases (e.g. the obligation to obtain the approval of the Investor Board Member in the event of the sale of an asset exceeding a certain amount, but not in all cases).
Many inexperienced founders are tempted to sign the Term Sheet as provided by the investors, without discussing the terms. This may put them in an uncomfortable position when the final subscription agreement is negotiated. The investors are looking to secure the highest capital gain and, under these conditions, will provide for the most advantageous exit conditions, reducing those of the founders. Of course, the Term Sheet is not binding. Nevertheless, it is sometimes difficult to go back on the agreed terms. It is therefore necessary to ensure that the terms of the Term Sheet comply with the standards practiced in Series A financing.
By Dr. Renee Kaddouch, Ph.D. - Legal Sherpa at 7Mountains.