editione1.0.2
Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Preferred stock rounds are the most common type of fixed price round for angel investments—in fact, when investors and founders refer to a fixed price round or a priced round, they usually mean a preferred stock financing, although common stock fixed price rounds are possible. Preferred stock is equity that has specified preferences relative to common stock and potentially to other classes of preferred stock. Those preferences are negotiated as part of the term sheet and documented in the definitive documents of the stock sale.
The most common preferences conferred to preferred stockholders are:
a liquidation preference
a dividend preference
purchase price anti-dilution protection
protective provisions (these are provisions that require the separate vote or approval of the preferred stockholders to do certain things—such as sell the company, sell all or substantially all of the assets of the company, any amendment to the terms of the preferred stock, issue preferred that is on a parity with or senior to the preferred stock, et cetera).
The above rights, if they are part of the deal, will have to be reflected in the company’s charter document filed with the Secretary of State of the state in which the company is incorporated. The company’s articles of incorporation or certificate of incorporation are typically amended to include these negotiated provisions immediately prior to the closing of the financing.
Preferred stock is convertible into common stock. Usually, preferred stock starts out as convertible to common stock on a 1:1 basis. This means that each share of preferred stock is convertible into one share of common stock. The preferred stock term sheet may contain additional details on conversion.
Preferred stock rounds are usually larger than convertible debt or convertible equity rounds; $500K at the low end, and up to tens of millions. Over the life of a startup, it may raise multiple rounds of preferred stock. The first round of preferred stock may be referred to as a Series Seed Preferred Stock if it is a relatively small round (less than $2M). If it is a larger round, it will typically be labeled Series A Preferred Stock. Subsequent rounds are referred to as Series B, Series C, and so on. Each round usually contains preferences that are senior to those of the prior rounds; in some cases, the lead investor may insist on revisions to the rights of prior rounds. It is a classic example of the Golden Rule—the holder of the gold makes the rules.
A fixed price financing (or fixed price round or priced round) is a type of financing where the investors buy a fixed number of shares at a set price (in a common stock or preferred stock round), as opposed to rounds in which the number of shares and the price of those shares will be determined later (such as convertible note or convertible equity rounds). The most common type of fixed price round are preferred stock deals, which often represent rounds larger than convertible rounds, greater than $500K for example, which justifies the legal cost of documenting the round.
By definition, in a fixed price financing a price must be set or fixed for the security being sold (preferred stock, or less frequently, common stock) by the company. There are a number of factors that come into play when determining the price, and some of those factors are a function of negotiation. In order to provide a full understanding of how this works, in Part IV we’ll dig into pre-money valuation, post-money valuation, stock option pools, and dilution generally.
We talked about some of the advantages of convertible notes in the prior section. Convertible rounds are built on the assumption that the company will raise another round in the future that will fix the price of the non-priced round. But if no subsequent round is planned, then a non-priced round is not a good fit, and a fixed price financing is called for.
Investors may prefer fixed price financing over convertible debt so they can lock in the valuation of the company earlier (while it is presumably lower) and receive the rights and preferences associated with preferred stock. Some investors are also wary of convertible debt or convertible equity rounds because they don’t want to have to wait to become a shareholder, or because they believe (or they believe founders believe) that convertible debt creates a conflict of interest between the founders and the investors.
If a company raises capital through one or more convertible debt or convertible equity rounds, eventually they will want to do a preferred stock financing to convert that debt to shares (equity). Convertible securities typically need a qualifying (minimum size) priced round to convert into stock. Angels really like preferred stock financings because, as you will see below, they are able to attach a wide variety of preferences to the stock—that is, privileges and control provisions for the preferred stockholder.
founderEntrepreneurs have a mixed perspective on preferred stock, depending on the particulars of the preferences. On the plus side, raising a preferred stock round means they are raising a significant amount of money, and that is likely what they need to keep going and growing.
The downsides for the entrepreneur are:
The benefits of the preferences that accrue to investors in a preferred stock round come generally at the expense of the entrepreneur and the pre-existing stockholders. Convertible note and convertible equity holders usually convert into the same class of stock (the preferred) that is creating the qualified financing and triggering the conversion. (The most common exception to this is when the convertible debt or equity is converted into a subclass of the preferred stock to avoid the problem of the liquidation overhang.)
Negotiating the preferences and pricing can consume a lot of legal resources, especially if they are unfamiliar with the terms. (If you’re a founder raising your first angel round, we suggest reading the Holloway Guide to Raising Venture Capital, which dives deep on term sheets from the entrepreneur’s perspective.)
In addition, one of the typical terms of a preferred stock round is a requirement that the company pay the reasonable attorneys’ fees of the investors.
What can often feel the most onerous to entrepreneurs are the liquidation preferences, especially if these stack up across multiple rounds. As we will explain below, it can mean that in an acquisition scenario that is not a home run, the investors might double their money, while the entrepreneur is left with little.
Investors like preferred stock rounds for a number of reasons:
The price is set and the investor knows what percentage of the company they own.
If an investor has participated in non-priced rounds like convertible debt or convertible equity, they will finally know what they have bought for their money. This is the case as long as the preferred stock round is a qualified financing that converts the convertible notes into stock shares and any convertible equity into actual stock shares on the cap table.
The investors get specific preferences reflected in the definitive documents that can improve their outcomes in both good and bad scenarios, and sometimes give them a measure of control beyond what their specific share count would provide.
VCs almost universally insist on preferred stock, because they want to price the stock and have as much upside in good times and as much control in bad times as they can. You will start to get a feel for how this works as you read through the specific types of preferences below.
The term sheet for a preferred stock offering will contain the following key elements:
The type of security (for example, series A convertible preferred stock). (Note that the word “convertible” here refers to the fact that the preferred converts to common.)
The amount of money being raised in the round (referred to as an “offering”).
A summary of the cap table post investment. Because the cap table represents the ownership of the company, it is really useful to have a summary cap table in the term sheet, so that there are no surprises on either side as the deal comes together. Everyone has a clear picture of what they are going to end up with.
The preferred stock term sheet will also contain a list of preferences for the preferred stockholders, discussed in this section.
A liquidation preference entitles the holder of the security with the liquidation preference to be paid before other stockholders on a sale of the company or all of its assets.
exampleFor example, suppose you invest in Series A Preferred Stock at $1 per share, and the Series A Preferred Stock has a 1X liquidation preference. On the sale of the company, after the payment of creditors (lenders), the Series A Preferred stockholders would get paid back their $1 per share liquidation preference before the common stockholders received anything.
Liquidation preferences come in a variety of different flavors. A preferred stock might have a liquidation multiple. In this case, the Series A Preferred might have the right to receive twice its purchase price per share (a 2X liquidation preference) before any other stockholder is entitled to receive any liquidation proceeds.
Another critical characteristic of each liquidation preference is whether the preferred is “participating” or “nonparticipating” preferred.
Non-participating preferred stock is preferred stock that entitles the holder on a liquidation to receive the greater of either (i) its liquidation preference, or (ii) what the preferred stock would receive if it converted to common stock.
Participating preferred stock is preferred stock that entitles the holder to a return of its liquidation preference, and then to participate with the common stock on an as-converted to common stock basis.
exampleFor example, suppose you invest $1M in non-participating Series A Preferred Stock with a 1X liquidation preference, for a post-closing ownership of 10% of the company and a post-money valuation of $10M (the company has 9M shares of common outstanding in this example). If the company is sold for:
$1M, you would be entitled to all of the liquidation proceeds. There would be nothing left for the founders and earlier investors.
$3M, you would receive the first $1M, and the common would get the remaining $2M; you would only get your money back.
$100M, you would forgo your $1M liquidation preference, and either convert to 10% of the issued and outstanding common stock or be treated as if you had converted, and receive $10M on the sale.
exampleNow let’s look at the same example above, with a participating preferred stock, with a 1X liquidation preference. If the company is sold for:
$1M, you would be entitled to all of the liquidation proceeds.
$3M, you would get the first $1M, and then 10% of the remaining proceeds (10% x $2M = $200K) for a total of $1.2M.
$100M, you would get your $1M liquidation preference, and then your 10% share of $99M, for a total of $10.9M.
exampleUsing the same example, if there were no liquidation preference, the outcomes are very different.
If the company is sold for:
$1M, you would get only $100K back, a 90% loss on your investment.
$3M, you would get $300K, a 70% loss on your investment.
$100M, you would get $10M.
As you can see, the liquidation preference—and especially the participating preference—is very important to achieving a positive ROI if the company is not acquired for a very large multiple of its post-money valuation.
Anti-dilution protection, or, more precisely, purchase price anti-dilution adjustment protection, refers to provisions of stock, most typically preferred stock, that automatically adjust the conversion ratio of the stock to greater than 1:1 if the company sells shares in the future at a price less than what the investor paid.
confusionAnti-dilution adjustment protection typically only comes with preferred stock, but it is possible (though very rare) under corporate law to make it part of any type of stock, including a subclass of common stock, for example.
Preferred stock starts out as convertible into common stock on a 1:1 basis. However, if the company issues shares of stock in a financing at a lower price than you paid, the anti-dilution conversion adjustment protection may be triggered. If it is triggered, you become entitled to more than one share of common stock on conversion of each share of your preferred stock.
exampleYou buy Series A Preferred Stock at $1 per share with anti-dilution protection. The company later sells Series B Preferred Stock at $0.50 per share. Your shares of preferred stock would become convertible into more than one share of common stock. The exact ratio at which your preferred would convert into common depends on what type of anti-dilution protection you have.
confusion Anti-dilution protection is a typical preferred stock preference but it is not included in all preferred stock. For example, Series Seed Preferred Stock typically does not have it. Instead, the Series Seed Preferred Stock terms say that on the company’s next round of preferred stock, if that round has anti-dilution adjustment protection, at that time the Series Seed will be conferred those rights as well.
importantIf the valuation of the company and its stock is increasing with each successive round of funding, anti-dilution adjustment provisions are not triggered. If, however, the company needs to raise money at a lower valuation for whatever reason (called a down round), the anti-dilution protection could be valuable. The anti-dilution clause is intended to prevent the prior investors from getting too badly diluted by the new money coming in at a lower valuation. However, if the company is really struggling to raise new money, a new investor coming in can essentially dictate terms, which may mean that you have to negotiate away some or all of this protection to close the deal (the golden rule again)—but at least you have some say in the matter.
There are a few different types of anti-dilution adjustment protection:
Broad-based, weighted average anti-dilution adjustment
Full ratchet anti-dilution adjustment protection
Narrow-based, weighted average anti-dilution adjustment protection.
Broad-based weighted average anti-dilution protection is the friendliest anti-dilution protection for founders
Broad-based weighted average anti-dilution protection is a type of purchase price anti-dilution protection that has the effect of adjusting the conversion price of a class or series of preferred stock entitled to the protection if the company subsequently raises money by selling shares at a lower price per share than the price per share paid. This type of repricing takes into account the amount of shares the company sold at the lower price. The more the company raises at the lower your conversion price becomes.
The formula for broad-based weighted average anti-dilution, from NVCA, is:
⚖️legaleseFor purposes of the foregoing formula, the following definitions shall apply:
(a) “CP2” shall mean the Series A Conversion Price in effect immediately after such issue of Additional Shares of Common Stock
(b) “CP1” shall mean the Series A Conversion Price in effect immediately prior to such issue of Additional Shares of Common Stock;
(c) “A” shall mean the number of shares of Common Stock outstanding immediately prior to such issue of Additional Shares of Common Stock (treating for this purpose as outstanding all shares of Common Stock issuable upon exercise of Options outstanding immediately prior to such issue or upon conversion or exchange of Convertible Securities (including the Series A Preferred Stock) outstanding (assuming exercise of any outstanding Options therefor) immediately prior to such issue);
(d) “B” shall mean the number of shares of Common Stock that would have been issued if such Additional Shares of Common Stock had been issued at a price per share equal to CP1 (determined by dividing the aggregate consideration received by the Corporation in respect of such issue by CP1); and
(e) “C” shall mean the number of such Additional Shares of Common Stock issued in such transaction.
How broad an anti-dilution adjustment is depends on what is included in the “A.” Typically you include issued and outstanding options in the “A.” We have included an §interactive spreadsheet for you to play with these formulas.
Full ratchet anti-dilution adjustment protection (or full ratchet) refers to a method of purchase price anti-dilution protection in which an adjustment is triggered upon the sale of stock at a lower price. Full ratchet rights entitle the holder to have their conversion adjustment formula reset in order to give them the number of common shares that they would have received had they purchased their shares at the lower price.
With full ratchet protection, if the company sells shares at a price per share that is lower than you paid, your purchase price gets adjusted to the new, lower price, regardless of how many shares are sold at the lower price. Even one share sold at a lower price triggers the adjustment in the price you paid for all of your shares.
In a narrow-based purchase price anti-dilution formula, the investors receive more shares on an as converted to common stock basis than with broad-based protection because in narrow-based you do not count the issued and outstanding options in “A” in the formula above, only the issued and outstanding stock. This results in a lower conversion price, making it less friendly to founders than broad-based. Narrow-based anti-dilution results in a greater adjustment than broad-based, weighted average anti-dilution adjustment provisions, but less than full ratchet adjustment provisions.
Preferred stock usually has a dividend preference, which means that dividends cannot be paid on the common stock unless a dividend is first paid on the preferred stock. A dividend preference might say that the preferred stock is entitled to a certain percentage dividend—say, 8% of the purchase price of the stock, per year, noncumulative, “as, if and when” declared by the board. The preference would go on to say that no dividends may be declared on the common unless and until the preferred dividend is paid.
If the preferred stock is participating preferred, the dividend preference would also dictate that after payment of the preferred dividend, the preferred would participate with the common on any dividend paid on the common stock on an as-converted to common stock basis. For example:
⚖️legaleseHolders of the Series A Preferred shall also participate pro rata on an as-converted basis with respect to dividends, if any, declared with respect to the Common Stock.
If the preferred stock is not participating (meaning, it is not entitled to its liquidation preference and to participate alongside the common, it is only entitled to either its liquidation preference or to participate alongside the common), there is no need for the language immediately above, and in fact its presence would not be appropriate.
Dividends can also be “cumulative.”
A cumulative dividend would accumulate every year, year over year, but be paid only “as and when” declared by the board. Cumulative dividends would be paid on liquidation, if not paid before. Cumulative dividends can be economically harsh on founders and junior investors and are not common in competitive deals.
For most startup and early-stage companies, dividends are not paid. However, the language remains in investment documents to protect the preference of the preferred stock over the common. One scenario preferred stock investors are protecting themselves from is the following: The company grows slowly but is cash flow positive. The founders treat it as a lifestyle business and pay themselves out a dividend to the common stock without paying a dividend to the preferred stock.
The voting rights of stockholders come into play whenever the company is taking an action that requires stockholder approval. The typical items that require stockholder approval include, among other things: the election of directors; an increase in the company’s equity incentive or stock option plan share reserve; an amendment to the company’s charter (other than purely a change of the company’s name).
Preferred stock usually votes on an as-converted to common stock basis. Meaning, it votes just like common stockholders. It also usually, but not always, has additional, special voting rights known as protective provisions.
Voting rights are part of the company charter.
Protective provisions are provisions in a set of investment documents which require the separate approval of a particular class of investor before the company can take certain actions. For example, the separate approval of holders of a majority of the Series A Preferred Stock might be required before the company can undergo a sale transaction.
It is not a requirement that protective provisions appear in a charter filed with the Secretary of State. It is the most common place for them to appear, but they can also appear in an agreement signed by the company. For example, suppose you were investing in common stock, but wanted protective provisions. In that instance, you could put the protective provisions in a side letter agreement with the company, or in an Investor Rights Agreement.
The Series Seed term sheet includes the following pretty typical protective provisions:
⚖️legaleseVotes together with the Common Stock on all matters on an as‑converted basis. Approval of a majority of the Preferred Stock required to (i) adversely change rights of the Preferred Stock; (ii) change the authorized number of shares; (iii) authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock; (iv) redeem or repurchase any shares (other than pursuant to the Company’s right of repurchase at original cost); (v) declare or pay any dividend; (vi) change the number of directors; or (vii) liquidate or dissolve, including any change of control.
Below is a list of the types of items that may be listed in the protective provisions:
amendments to the charter or bylaws
changes to the terms of the preferred stock
the issuance of a series of preferred stock that is on a parity to or senior to the preferred stock
a sale of all or substantially all of the assets of the company
the entry into an exclusive license for the company’s intellectual property
a change to the size of the company’s board of directors
the authorization or payment of a dividend
the incurrence of debt above a certain amount.
Other open source documents that include protective provisions include:
Redemption rights (or put right) are the rights to have your shares redeemed or repurchased by the company, usually after a period of time has passed (3-7 years). It is also possible to prepare these provisions to allow redemption in the event the company fails to reach a milestone, or breaches a covenant.
caution Be aware, however, that even if you have redemption rights, if a company is insolvent it will not be able to legally satisfy a redemption demand. Under most states’ corporate laws, corporations are disallowed from redeeming shares when the corporation is insolvent either on a balance sheet or ability to pay its debts as they come due, and directors are personally liable if they authorize a redemption when the corporation is insolvent.
Redemption rights are not common in angel deals.* However, they can be appropriate and a good mechanism to employ if a business has the danger of becoming a lifestyle business for the entrepreneur. If you want to put redemption rights in place, in order to avoid a lifestyle business outcome, you will probably also want to put in place covenants, such as restrictions on founder salaries—perhaps subject to the approval of a compensation committee composed entirely of independent directors—to ensure that the redemption rights will have value and are enforceable when they come due.
Pro rata rights (or pro rata) in a term sheet or side letter guarantee an investor the opportunity to invest an amount in subsequent funding rounds that maintains their ownership percentage.
You will want to try to negotiate for pro rata rights. If a company is doing well, you will want to own as much of it as possible. Some founders include a major investor clause in the term sheet, which reserves certain rights and privileges to those they deem “major investors.” Whether to grant pro rata rights to all investors or only those above a major investor threshold is a tricky decision.
When companies use a major investor threshold to determine who gets pro rata rights and who does not, angel investors usually don’t make the cut. Angels hate this because it limits their ability to gain more ownership in a company they see themselves as having spotted and supported early on. VCs want the threshold because they don’t want to share pro rata rights with a larger group of investors. This is a major source of conflict between angel investors and VCs.*
Pro rata rights, when they appear in an angel round, typically show up in a preferred stock financing. But they can appear elsewhere.
The topics below are important elements of a preferred stock financing. These issues may or may not be represented in the term sheet.
In early-stage company financings, preferred stock is almost always convertible into common stock at the option of the holder. It is also typically converted automatically upon an event such as an initial public offering that meets a certain size, or upon the election of a majority (sometimes supermajority) of the preferred stock to convert to common. This clause in the term sheet will typically specify the conversion ratio of preferred stock into common stock (always at a 1:1 ratio) and any events or other provisions that would impact that conversion ratio. For example, take a look at the Series Seed Term Sheet, which says:
Subscription procedure refers to the documents you as an investor will be asked to sign. In a preferred stock financing, the documents you will be asked to sign will depend on what type of preferred stock is being sold. If it is a Series Seed Preferred round, you might just be asked to sign the Stock Investment Agreement. If the round is a Series A or beyond, you will probably be asked to sign a number of documents, including:
In a fixed-price financing it is critical that the company and the investors have clarity on the ownership of the company’s capital stock. Without clarity it is impossible to determine the price per share. There is usually a representation and warranty in the stock purchase agreement in which the company represents and warrants to the investors the current capitalization of the company.
If you are investing in a fixed price round in a company that has convertible debt outstanding, you will want to make sure the convertible debt converts when you invest. This is accomplished by adding a condition to the closing that all convertible securities must convert. Otherwise, your interest will be subordinate to the outstanding debt of the company.
For a preferred stock deal, the definitive documents will include, at a minimum:
A preferred stock purchase agreement, including any disclosure schedules which may be attached to the stock purchase agreement.
An amended charter, or amendments to the company’s charter (a preferred stock financing requires that the company’s charter be amended to include such things as the liquidation preference per share, the anti-dilution adjustments, protective provisions).
If there are ongoing investment rights such as the right to a board seat, information rights, et cetera, then there will be a shareholder agreement of some kind, such as an Investor Rights Agreement, a Voting Agreement, and so on.
Disclosure schedules are attachments to a stock purchase agreement in which the company discloses any items required to be disclosed on the schedule. If you are not familiar with stock purchase agreements, the representations and warranties are written in absolutes. The disclosure schedules are there to provide the details. Disclosure schedules are important to review as part of your diligence before signing the definitive documents.
exampleThe representation and warranty might say that the company has never had its tax returns audited. But the company might be under an audit, or might have been audited in the past. In such a case, the company would typically disclose this on the schedules rather than re-negotiating the phrasing of the representation and warranty.
Preferred stock term sheets come in a variety of different shapes and sizes. You can find example preferred stock term sheets at the following sites:
Series Seed (a simple term sheet that’s appropriate for smaller preferred stock rounds)
Techstars (intermediate-length term sheet)
NVCA (full-blown, full-length VC-style term sheet for large rounds)
Alliance of Angels Model Term Sheet (a middle ground approach, more detailed than Series Seed, but less complex and lengthy than the full-blown, full-length VC-style term sheet found at NVCA)
In the appendix, you’ll find an example of what you would call a light-weight Series A Term Sheet.
While purchasing convertible debt and preferred stock are the most common types of investments angels make, there are other financings out there that you or a company you’re investing in may prefer. Some of these are newer to the angel investment world.
Convertible equity is an entrepreneur-friendly investment vehicle that attempts to bring to the entrepreneur the advantages of convertible debt without the downsides for the entrepreneur, specifically interest and maturity dates. The convertible equity instrument the investor is buying will convert to actual equity (stock ownership) at the subsequent financing round, with some potential rewards for the investor for investing early. Those rewards are similar to the rewards for convertible debt, such as a valuation cap and/or a discount.