You seek investors? Prepare adequately

When seeking an investment in a seed round in particular, three important distinct chapters are to be considered:

1. Economic terms

2. Control terms

3. Other terms

Each such chapter comprises a number of elements to be addressed. Below are those to be considered and addressed to prepare adequately and formalize what is to be presented and discussed with potential investors.

Economic Terms

Price

The price per share should be based on fully diluted pre-money valuation and a fully diluted post-money valuation duly established. This is the basis for the percentage the investor will get in terms of shares on a fully diluted basis meaning also on an as converted basis.

Other questions to be considered are: will there be an employee stock option plan in place? If so, what will be the percentage of shares reserved thereunder? It should be noted that the larger the pool in terms of percentage of shares allocated thereunder up front enables the investor to limit his/her dilution.

Liquidation Preference

Another important point to be discussed is if a liquidity event (sale of the assets or shares) occurs, how are the proceeds to be distributed. The return to the investor before any other classes of shares which should be requested is an amount equal to x times the original purchase price for said shares plus declared and unpaid dividends.

It should also be determined if the class of shares of the investor will also be participating and if so if they shall rank thereafter on any distribution made pari passu with the other stockholders (could be capped until a certain multiple return is reached).

If they don’t participate after their liquidation preference, they are called “simple preferred” or “non-participating preferred”. This is how the investor determines event by event to either convert or benefit from its liquidation preference. But the holders of preferred stock should always be able to convert into common shares if it benefits them and be treated like the other shareholders of common stock.

Pay to Play

Also to be addressed is if we want a “Pay to Play” situation and force investor to continue investing in a qualified financing (to be defined) if there is a next round of capital raise in the company. This is important and used by the investor to maintain its percentage of shareholdings and enable the company to grow without having to go back to market.

Anti Dilution

This right should/could probably be granted to protect the investor if the company issues stock at a lower valuation than in previous financing rounds. It is certainly also an important issue to be decided early on.

Control Terms

The following are some of the other main aspects to be discussed and settled in the context of an equity or quasi-equity investment.

Board of Directors

It would be normal and to be considered, to reserve a board seat for the investor.

Protective provisions (consent of investor is required)

The company should, furthermore, consider offering the investor be protected against:

• change of the terms of stock owned by the investor;
• authorize the creation of more stock;
• issued stock senior or equal to the shares held by the investor;
• buy back any common stock;
• change the certificate of incorporation or bylaws;
• pay or declare a dividend;
• borrow money (a specific cap could/should be mentioned) ;or
• declare bankruptcy without the investor’s approval.

Drag along

It should be an obligation for the investor to have to sell its participation if the majority of common stock holders chose to sell their shares.

Conversion

At all times the investor will most probably require its preferred shares be convertible, with a right to convert 1:1 (into common stock) and would certainly provide for automatic conversion in the context of an initial public offering of the company.

Other Terms

Last but not least, the following are also typically addressed at the onset of the investor’s strategy, the company needing to be prepared to discuss and arrive at an understanding:

Dividends

The shares of the investor would give right to non-cumulative dividends in preference to other classes at a specific percentage of the original purchase price of said shares paid by the investor per annum plus a right by investors to participate pro-rata with the holders of common stock on any dividends paid to holders of common stock on an as-if converted basis.

Redemption Rights

The company could consider offering the investor an exit for example after five years. Payable in instalments at the original purchase price plus declared and unpaid dividends. This could be a guaranteed exit path for the investor if the company is not sold or does not proceed with an initial public offering.

Information rights

Should be proposed to the investor as they almost always require same.

Right of first refusal

Should also usually be proposed to the investor.

Needless to say, instead of waiting to see what potential investors could propose, we recommend the company and founders putting forth their preferred terms based on the afore mentioned and prepare to be efficient and attractive to potential investors!