The anatomy of a preferred stock seed financing term sheet will vary depending on whether you are receiving the term sheet from a single investor, a superangel or micro-cap VC, an angel belonging to an angel network, or if the company is issuing the term sheet to the investors. There are many considerations for these transactions. The terms may be different than a Series A transaction, because certain terms are irrelevant or impractical in a seed stage venture, where the funding is much smaller. The following information is generally present in a pre-Series A, preferred stock transaction: 1. The offering
If the issuer (the startup company issuing securities) prepares the term sheet, which happens sometimes in seed financing, the founders may value the business themselves. There are startup valuation firms which keep market information about acquisition prices and such, but Once a pre-money valuation is calculated, an amount of stock or ownership interest that reflects the valuation is offered for the amount of capital required and/or the amount of money the investor wants to invest. This figure is usually reflected as a maximum (i.e. "up to an aggregate amount of"). Sometimes there are minimums or a fixed amount. 2. Terms of the Securities - Changes to the Charter  A. Dividend - In the event that a special class of stock (e.g., Seed Series Preferred Stock) is created for the transaction, the terms of that series of security will reflect a dividend payment. In the event of Convertible Preferred Stock, which is the favored vehicle for venture capital transactions, the investors might want a fixed dividend payment for their series of stock in addition to the dividends paid to Common Stock holders. This way, they receive a fixed dollar or percentage amount for their contribution, regardless of whether the company is profitable, assuming they don't become insolvent. B. Liquidation - Typically, upon liquidation, the investors will want to receive their full contribution. When that contribution is repaid, the rest of the assets are distributed on a pro rata basis as if the Preferred Stock had been converted to Common Stock. C. Voting Rights (Shareholders) - By default, Preferred Stock holders do not have voting rights. However, California and Delaware both allow a corporation to provide Preferred Stock holders to vote with the Common Stock holders. Many investors may want this right. In addition, the term sheets could require class votes on certain actions for protection of the investors. This may also be dealt with by Board Placement, requiring unanimous Board approval on decisions that could potentially devalue the investors' stock. Note that state and federal laws will also require majority class approval on certain actions. D. Conversion - The conversion rights of preferred stock that are used in VC transactions give investors a good deal of protection. They can recoup their investment from a company that was only successful enough to break even, but can convert to an equity stake in the company if it is more successful. The terms of conversion usually provide for an optional conversion right, which may allow the investor to convert to equity within a given time frame or subject to some other restriction. Very often, the terms allow optional conversion at any time. Mandatory conversion terms might be set for IPO's or majority votes to ensure the Preferred class can be retired when they get paid. E. Anti-Dilution Provisions - Dilution occurs when a company decides to issue additional stock. If the new valuation is less than the valuation at the time of the initial investor's contribution, they lose value. Anti-dilution provisions readjust the conversion price, allowing them to convert their Preferred Stock to more Common Stock than initially set, to ensure their investment is not unfairly devalued. Common mechanisms are weighted average and full ratchet. F. Redemption Rights - This provision may not be included in seed round financing, because it could be detrimental to a marginally successful startup. Redemption rights provide the power to trigger a redemption call. During the call, the company must buy back the Preferred Stock pursuant to the terms established. This can be good for investors who want to liquidate their interest and get out of the investment. It could also be good for founders who want to retire the Series of stock. 3. Investor's Rights Agreement Many of the terms I listed in the Terms of the Security section above work for the benefit and protection of the investors and could rightfully be included in this section. However, the terms that may be included specifically in this section are the following: A. Right to future rounds - This term allows investors to participate in future equity rounds on a pro rata basis. If for instance, an angel provides $250,000 for securities representing a 25% equity stake at the seed round, the company increases in value, and makes a new offering based on a valuation of $10 million, the investor could purchase 25% of the new securities. This allows investors to keep their proportion of ownership. B. Right to information - This term allows investors to access the premises and information of the company. Terms might include a right to enter and inspect the premises with reasonable notification, quarterly and annual financial statements, and budget forecasts. C. Board Composition - The selection of board members is an important issue to many investors. Many will want majority membership in the board. Others will be happy with a single board member, so long as certain actions require unanimous board approval. A middle ground position is to have one board member elected by the investors, one elected by the founders, and a third elected by mutual selection or by a third party. D. Registration Rights - Investors will often ask for registration rights. This means that the company agrees to register the securities with the SEC to allow the investors to resell them. Registration rights typically come in two varieties, demand and piggy-back. The demand rights require the company to register the public offering at the investor's demand. Piggy-back rights allow investors to tack their registration onto the company's public offering, when and if they make one. This term is premature for a pre-Series A financing. The demand rights, in particular, may cause an enormous financial burden on the company. Investors will often look to other terms to ensure their ability to liquidate. We have included all of the above mentioned terms in an online term sheet generator that allows you to structure your seed round transaction. This is a free service open to investors, founders, and attorneys.
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