Venture Capital For Dummies by Nicole Gravagna

Author:Nicole Gravagna
Language: eng
Format: epub
Publisher: Wiley
Published: 2013-08-09T00:00:00+00:00

Illustration by Wiley, Composition Services Graphics

Figure 9-1: Liquidation preference. At low valuation VCs take all; at high valuation, the founders do very well.

Board of directors

The board of directors has the right to make big decisions about the fate of the company. The board approves budgets and acts as the boss for the CEO. This part of the term sheet defines who gets representation on the board.

This line item can be more important than the pre-money value of the company but is sometimes overlooked, even though what’s determined here has important implications. If the board is made up entirely of people elected by the investors, then the investors control the company. If the investors don’t get representation on the board, they have no control over the company.

A common board for a small start-up consists of three to five people and includes representation from the investors, the founders, and industry experts.

Protective provisions

Protective provisions allow shareholders to block certain actions in the company, akin to veto power. These provisions require a vote by a subset of shareholders before the company can go forward with a large decision. Here are some standard provisions addressing the major issues of company structure and ownership:

Selling the company assets, merging, or being acquired

Change the number of shares in the company

Redeeming or repurchasing stock shares

Changing the number of board members

Taking on any new significant debt

Changing the dividends for any class of stock

When any of these events are proposed, the people holding the protected stocks get to vote to determine whether the event will actually occur.

Although most protective provisions are reasonable, we have seen past protective provisions that have blocked any new deals from happening with a company. In one case, the investor required that she approve all checks over $1,000, which put an operational stranglehold on the company and was a red flag to investors.

Anti-dilution clauses

Companies that intend to raise multiple rounds of funding have to reassure early investors that future investment rounds won’t dilute their investment. This dilution most often happens in down rounds (the stock is at a lower price than in the previous round) or flat rounds (the stock is at the same price as the previous round). A lower share price can happen because the company’s value decreased. Following are two main ways that a company’s shares would be lower in the current round than in previous rounds:

The company’s value was artificially high due to a misunderstanding of company valuation, investor speculation, or a bubble in the economy.

The company has lost value due to poor performance or poor management.

Two kinds of anti-dilution provisions may show up in your term sheet: weighted average and ratchet-based. These provisions have to do with how the down round is calculated.

Ratchet-based anti-dilution

With full ratchet anti-dilution, an investor who purchased shares in a Series A round receives additional shares if a subsequent round comes in at a lower price. A few problems exist with full-ratchet anti-dilution, most notably that, if the company is

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