Venture Capitalists want three basic things before investing in your business. As a result these terms appear in nearly every venture term sheet:
- The right to get paid back what they invested (liquidation preference);
- The right to maintain their ownership through future VC rounds (pro-rata rights); and
- The right to know what is going on with the company (a seat on the board).
As was discussed in our previous posts, liquidation preferences protect the VC’s investment when a liquidation event is about to take place. The preference ensures that the VC gets paid first (i.e. preferred) and can choose the greater of having his or her investment paid back or participating as an owner getting paid their share (i.e. preference). Obviously, this is a simplistic view, as there are varying types of liquidation preferences. For example, there is “participating preferred” where the VC gets paid back their investment first and “participates” as an owner in whatever is left over. There are also multipliers which give the VC the right to get paid first up to some multiplied level of their investment (e.g., 2X, 3X, etc.). In short, liquidation preferences protect the VC when the business is not doing so hot.
Pro-rata rights protect the VC from having their ownership level diluted when future rounds of capital are invested in the company. In most arrangements the VC must “pay to play,” meaning VCs have the right to participate in future rounds of investment up to the level of their current ownership level. It’s an opportunity to preserve their percentage of ownership. This is important because in later rounds of investment the prospects of a huge payout might be looming, making these later rounds of investment less risky. Sometimes this situation is referred to as a “bridge” to sale. Pro-rata rights protect the VC when the business is doing well.
The last thing every VC wants is to know what is going on with the company. One sure way to do this is to put the VC (or VC’s representative) on the board of the company. Another way to accomplish this is to give the VC observer rights or observer status so that they are entitled to being present at board meetings.
When negotiating with a VC it is important to know what you can negotiate and what you cannot. Generally, the above three terms are pretty much non-negotiable. But the particulars of each term can be subject to considerable debate. For example, should the liquidation preference have a 1X, 2X, or 3X multiplier? Should a pay to play obligation accompany any pro-rata rights? Should the VC be a board member or just an observer? Make sure you fully understand the terms before signing a venture term sheet.