JONES DAY TALKS®: The Five Pillars of Protection for Later Stage VC Investors

Dave Dalton:

Early stage venture capital investments are complicated by their very nature, the challenges and mechanics of growing a new venture are complex enough. And when you throw in the competing interests of different investor classes, you can sometimes run into trouble. In particular, there are a few basic tenets or five pillars that a Series A investor should understand to make sure their interests are protected. And the third in a schedule, a VC-focused podcast, Jones Day partners, Tim Curry, Alex Wibaux, and Taylor Stevens are here to explain. Stay here. This is interesting. I'm Dave Dalton. You're listening to JONES DAY TALKS®.

Jones Day partner, Tim Curry, has for more than 25 years represented startup, emerging growth, and public technology companies and public offerings, venture capital transactions and growth equity finances. He advises boards of directors and executive teams and complex corporate governance and public reporting matters. Taylor Stevens has advised clients for more than 25 years in the areas of venture capital transactions, M&A, and capital markets transactions. His practice is focused on the representation of emerging growth and established technology and life science companies. And Alex Wibaux's practice includes all fields of private equity, M&A, and capital markets. He represents emerging growth companies in the US and in France, as well as the private equity and industrial investors that finance them, especially technology, internet related, and life science companies. Taylor, Alex, thanks so much for being here today.

Tim Curry:

Great to be here, Dave. Thank you.

Dave Dalton:

Yeah. And this is our third program of 2024, and they keep getting better. And this topic I think is especially interesting to probably people listening today, especially if they've heard the first two programs. So we'll pick up kind of where we left off, but we're going to drill down a little bit to concerns regarding how later stage investors in a VC dealer transaction deal with defending their rights and so forth. So let's start at a high level. Tim, tell us what the basic issue is we're talking about today and what VC investors typically have to be concerned about regarding some of their rights.

Tim Curry:

Yeah, thanks a lot, Dave. And first off, great to be back with Taylor and Alex and doing our third in our VC series of podcasts. So thanks so much for having us and really glad to do this.

Today's going to be a little different than the first two, we're going to really do a deep dive into some specific deal terms. And while today's podcast is really focused on investor rights, particularly the rights of Series Seed investors versus Series A and later investors, but we also think this is really important for founders to understand because founders need to have insight into the competing motivations of their existing investors, the Series Seed versus their new investors, the Series A or later and how that might drive term sheet negotiations and the ability to get a term sheet approved by their existing investors while still attracting the later stage investors.

So let me start with a really quick example of what we're talking about here, where we're going to talk throughout today's podcast about a very typical situation where you've got a company that has already raised a Series Seed, let's say, a year ago or so, at a relatively moderate valuation and raising a moderate amount of money, and now they're looking to do their Series A. And the Series A is going to be at a much higher valuation. This is a really good company we're talking about here, so a much higher valuation, and they're going to raise a lot more money.

And so the Series A investors collectively will have invested a lot more money than the Series Seed investors, but because of the higher valuation, despite the fact they're investing more money, they may get fewer shares than the Series Seed investors got collectively. So this sets up a dynamic where after you've closed your Series A, the Series Seed investors might control a majority of the total preferred stock, the total preferred stock being the Series Seed that was already existing plus the Series A that you've just closed on. And the Series Seed may own more of those shares than the Series A does, despite the fact that the Series Seed has invested less capital.

So it sets up a classic set of tensions between who should rule when it comes to corporate governance and other economic decisions. Is that the parties that invested more money, the Series A, or the parties that have more shares and came in earlier, the Series Seed? And this is really, really important because the NVCA forms and most other venture forms, the default provisions are that when it comes to economic decisions, the majority of the preferred controls decisions. So in our example, that would be the Series Seed.

And you might ask, "Well, who cares? Aren't investors investors, and they're all looking to do the same things, they want to build great companies, they want to have the best exit they can have and return capital at the highest multiple?" And that's absolutely true, but there are and can be some really significant differences between the economic motivations of the Series Seed who came in at that lower valuation and have more shares and the motivations of the Series A who put in a lot more capital, but have fewer shares.

And while this is not an issue that comes up in the best companies out there that end up selling at 100x multiple or even a 10x multiple. It is something that comes up and is very rational with a company that sells for maybe just barely above the Series A or the last round financing, or maybe you go sideways or even down. That's when these economic rights are really, really important. And again, the incentives between the seed and the Series A can be quite different, and that's what we're going to focus on today.

Dave Dalton:

Can you talk more about that, the incentives in terms of I'm a seed investor, I came in really early, some people would argue I took on maybe more of the risk, the valuations maybe improved a little bit, and now we're Series A? So talk about some of the competing economic interests.

Tim Curry:

Yeah, it's a great question, and it basically breaks down to when you sell this company, are you going to divide the proceeds from the sale according to who owns the more shares that's very Series Seed favorable, or are you going to follow the liquidation preference and divide up the proceeds based on how many dollars or in from each group, which is much more Series A favorable? So when there's a limited pot of proceeds, the division of those proceeds is really important and critical to the returns that the venture funds will get. And so with that limited pot of proceeds, whether you divide it by the number of shares Series Seed favorable or the number of dollars Series A favorable can make a drastic difference in the returns that the investors make.

Dave Dalton:

Makes sense, makes sense. Well, let's talk about some of the defenses, if you will, that's the right term, I think, available to Series A investors that came in a bit later in terms of protecting their interests. Let's go to Taylor. Taylor, good to have you back, and it was good seeing you too in San Francisco.

Taylor Stevens:

Yeah, I likewise Dave. Great to be back. Thank you.

Dave Dalton:

FinAccelerate 2024, we'll put a tag at the end of this about that, but what a great event. Taylor, there are defenses available to Series A investors. Kick off this part of the conversation discussing what one of those is.

Taylor Stevens:

Yeah, you bet. We're going to talk about five pillars of protection here, and I'm going to touch on the first one, which ties into exactly what Tim was just talking about. So we're going to start here with the waiver of treatment of a deemed liquidation event. So that sounds a bit like a mouthful, right? So what is that? Well, the starting point here is to look at the defined term deemed liquidation event. So what does that mean? In its most simple form, a deemed liquidation event, it's a set of events that trigger the distribution of cash or assets of a company out to the stockholders.

So that's pretty important, right? Investors invest tens of millions, hundreds of millions into these venture-backed companies. So as Tim was talking about, how that money gets distributed back to the investors and to the other stockholders is really important. I think it's fair to say that this is among the most important feature of a VC investment, who gets what and when?

So under a company's certificate of incorporation that gets filed in Delaware, we call that the charter, the term deemed liquidation event is triggered by three scenarios. First, a merger or consolidation with another company, second, a sale or transfer of all or substantially all the assets to another company, or third, a transfer of a majority of the voting stock to another company.

So what happens if you have one of those three scenarios? If you have a deemed liquidation event, then the proceeds are going to be distributed to the stockholders in accordance with the liquidation preference, or sometimes we call that the liquidation waterfall, that's outlined in the company's charter.

So suppose a company has common stock Series Seed and Series A. A typical formulation would be that the Series A would be senior and they'd get one times their money back before any proceeds go to anybody else. Then the Series Seed would be next in line, and they get their money back, and then any remaining proceeds would be distributed to the common holders.

Now, for completeness, I will tell you that there can be variations here. You can see multiples on liquidation preferences and there can be participation. But for our purposes today, we're going to keep it simple, okay? We're going to just keep it to the fact that the A gets 1x first, then the seed gets 1x, and then the remaining amount goes to common. So that all sounds simple enough, right? So what's the issue? Well, as Tim outlined earlier, investors in later rounds typically invest more dollars, but they could receive fewer shares than the investors in the early round. So the Series A may invest way more than the Series Seed did, yet own less than a majority of the preferred as a class.

So is that a problem? Well, maybe not. If the sale proceeds are big enough and those dollars flow through the liquidation preference waterfall, the provisions in the charter and the Series A gets their money back and the Series Seed gets their money back and the remaining amount goes to the common, everyone is probably going to be pretty good.

But what if the proceeds are not enough to flow through the liquidation preference provisions such that the A and the seed get their full money back? Or what if the Series Seed could simply stand to get more money if the proceeds were distributed on a pro rata, a percentage basis rather than in accordance with the liquidation preference waterfall in the charter? So if you have one of those scenarios and the Series Seed could do something to get more money, they're going to do it, right?

Look, if I'm supposed to get $100 per the liquidation preference waterfall in the charter, but I could push a button and magically disregard the charter provisions and get $150, I'm going to push that button. Now, don't call me greedy here, Dave. I think everyone would do the same thing probably. But where I'm going here is this, if the Series Seed could disregard this liquidation preference structure in the charter and waive the treatment of a deemed liquidation event and get a lot more if the proceeds of the sale are distributed pro rata, they're going to do that.

And as Tim outlined earlier, look, if the proceeds were distributed on a pro rata basis, the Series Seed could actually even get more than the Series A, even if the Series A invested a lot more. So what's the takeaway here with this first pillar? Here it is, as the Series A comes in with its new investment, they need to have a consent right or a block right on waiving the treatment of a deemed liquidation event. It can't simply be the majority of the preferred, unless of course the Series A holds a majority of the preferred.

So maybe that threshold needs to be set to a super majority so that the A could effectively block that waiver, or maybe the Series A needs a series-based consent right on the waiver. Both would work, but as the new money coming in, the Series A in this case, you can't let the prior preferred holders, which is the Series Seed in this case, eviscerate the economics of your Series A investment.

Tim Curry:

And Taylor, let me chime in on one thing on that, and your example was a really good one, but I just want to make sure that the listeners hear this part, which is the same exact dynamic can occur even where the Series Seed and the Series A are pari-passu. So it's not only when the Series A is senior in the liq pref like you articulated and is true, but it's also the case when they're pari-passu, the same exact economic dynamics can occur.

Taylor Stevens:

Yeah, you bet. It's a great point because if they waive the treatment and share the proceeds on a pro rata basis regardless of seniority or pari-passu, they still could stand to make a lot more, and therein lies the incentive for them to do something that might run to the disadvantage of the Series A.

Dave Dalton:

Is this something negotiated or structured on the way in? You don't do this after the company's doing well and there's going to be a sale. Or do the Series A investors need to have this understood going in, Taylor?

Taylor Stevens:

Yeah, you bet they do. And oftentimes you need to lay out this framework to best protect the investors for a later stage. You're not really close to a liquidation event at these early stages. So the company will raise its seed round and then new money comes in, in this case, it's the Series A, and they need to be thinking about this. So thematically you'll hear here, Dave, as we all talk about these five pillars of protection and defense, these are put in place to protect against something that's going to happen way down the road. And look, it may not happen, they may not need the protection, but we're going to highlight the situations in which it becomes really important and you need to be thinking about it at the outset.

Tim Curry:

And I just have one more thing to that, Dave, which is just that I think that these things, while they absolutely need to be negotiated way ahead of the liquidation event, they actually need to be negotiated in the term sheet. I've gotten another point where I, when representing later stage investors, I try really hard to get these in the term sheet because if they're not on the term sheet and you're arguing about them during the deal negotiation, it can be really difficult. And we end up spending most of our time, frankly, on negotiating these points, these five points that we're about to get through than anything else in the transaction. And so you can really mute a lot of that if you put it in the term sheet right up front.

Dave Dalton:

It's where experience and good lawyering comes in, I imagine. So let's go to .2 or I guess protection number two, pillar number two with Alex. Alex, another option is conversion of preferred stock. How would that work?

Alex Wibaux:

Thank you first and foremost to have me back again on this podcast.

Dave Dalton:

And you were in FinAccelerate also, Alex.

Alex Wibaux:

That's correct. And we really had a good time all together, so looking forward to yet another edition next year.

Dave Dalton:

A little mini reunion today, but go ahead. Sorry, I didn't need to pull you off.

Alex Wibaux:

The second pillar I would say is on the conversion of preferred stock, because similar to the waiver of the liquidation preference, there is a section in the NVCA charter that allows for the majority of the preferred shares to decide an automatic conversion of all preferred shares into common stock. And that way a Series Seed can accomplish the same goal and being paid on a pro rata basis by approving the conversion of all preferred stock into common stock by vote of the majority of the preferred, which it controls.

So the second pillar of defense really is the following, the Series A needs to have a series-based block on any preferred conversion decision. To Tim's and Taylor's good point, I believe that this should be negotiated at the term sheet stage because it should either be a super majority or a series-based block for the benefit of the Series A.

I would personally prefer the second option because it would be clearly highlighted in the documentation that is a Series A specific right that should be enforced in later stages.

Interestingly enough, this very issue has been heavily debated before the courts. I understand that in 2012, there were two very enlightening decisions. In the first one, a plaintiff whose series of preferred stock did not have a blocking vote on mandatory conversion unsuccessfully argued that its consent right and actions that would alter or change its series rights prevented the majority of preferred holders from converting all preferred stock to common stock.

So similarly, I mean, in the same year a plaintiff who did not have a blocking vote on mandatory conversion also unsuccessfully argued that it was entitled to its liquidation preference rather than its common stock payout where its preferred stock was converted to common stock prior to a liquidation event. So you see that regularly people think that they can log this mandatory conversion that was decided without their prior approval when they actually can't, unless this has been clearly set out in the documentation that they have a series-based blocking right.

Dave Dalton:

Okay. Alex, I also have a note here that yet another option or pillar is protective provisions. What's that about?

Alex Wibaux:

The NVCA charter provides for a list of matters that require preferred holder's approval. Those are the so-called protective provisions, and it's not unusual for them to be subject to the mere consent of the majority of the preferred. This is an issue because Delaware law provides that changes to the rights preferences and privileges of the preferred stock that don't affect any single series differently and adversely can be approved by the majority of the preferred.

So you should really add an extra layer of protection when setting up the appropriate majority for this list of consent matters. You should actually request a separate approval of the Series A majority or the later stages majority. This will be critical in particular on the protective provision referring to the amendment alteration or repeal of the charter, because as you may know, under Delaware law, absent a specific protective provision, the authorization of another series of preferred stock with rights that are senior or pari-passu to those of the existing preferred stock would generally not constitute an amendment that adversely affects the rights of the existing preferred stock.

So unless you specifically negotiate when the Series A investors are getting in the company their rights to be specifically protected, any additional issuance of preferred stock with right senior or pari-passu to them will not be possible.

Tim Curry:

I think that the most dangerous aspect of what you just mentioned, Alex, is that like what Taylor was talking about in terms of waiving the liquidation preference in connection with the sale of the company, here the majority, the preferred without discriminating against any particular series can just amend the charter to get rid of the liquidation preference. And so if you've gotten rid of the liquidation preference, you've gotten rid of dividing the proceeds by dollars in and then moved towards dividing the proceeds by share count, which again, favors the Series Seed in our example over the Series A.

Dave Dalton:

Tim, let's stay with you. Pillar four, talk about how waivers might be of benefit to a Series A investor.

Tim Curry:

Yeah, this one's a really interesting one because I feel like it gets missed in a lot of deals. It's a little bit sneaky, and part of the reason why it's sneaky is that it's at the very end of the NVCA charter and most other Delaware charters. And what it is, it's a waiver provision, and it says that we've already gone through, Alex has already led us through a discussion of amendments to the terms of the preferred, but here you could be just as sneaky or evil by waiving the rights of the preferred.

So a poorly drafted waiver provision, and a lot of them are, and the NVCA form starts out poorly drafted if you're a Series A investor, it says that the majority of the preferred, as long as they don't discriminate against a particular series can waive the rights of the preferred. So what does that mean here? What that means is that in connection with this sale, that's not an absolute home run, so we're in the game talking about all of this. The Series seed could just vote to waive the liquidation preference as it relates to that transaction. So once again, you're back to dividing the proceeds on a share count basis, not a dollars in basis.

So the fix on that one is pay attention to that waiver provision, and what you should try to do is add at the end of it that something like provided however that the rights of the Series A can only be waived with the consent of the Series A. Or to Taylor's good point earlier, you could interject a super majority of the preferred concept that covers the Series A, but I think it's crisper and certainly more direct to just give the Series A a blocking right on any waiver of the Series A's rights preferences or privileges. So don't forget about that waiver provision.

Dave Dalton:

Sure. Forgive the 101-ish question. Are waiver provisions part of the original term sheet you've referenced a couple times typically, or is that something separate?

Tim Curry:

That one slips out of the term sheet off, and I do try to put it in there, but again, people just don't focus on that waiver provision as much. But what I try to do in the term sheet is maybe just have a separate section that says Series A approval rights. And I'll say Series A has to approve any changes to its rights, preferences, and privileges, any waivers to its rights, any deeming something not a liquidation event. So I try to capture all of them in one or two sentences, so at least it's in the term sheet. And then when we're negotiating, nobody can turn around and say, "Well, it's not in the term sheet." Well, there it is in the term sheet, and so therefore we've got to follow that in the documents.

But you're right, the waiver provision is a little wonky, and I'm not sure people focus on that at the term sheet phase, but it's just as important and can be just as damaging as any of the other pillars that we've gone through.

Dave Dalton:

I mean, I'm wondering if we ought to do another program at some point on term sheets, what to look for, what's so important? Is that worthy or not worthy of a separate program?

Tim Curry:

I think that'd be great, and there's a lot to be said there. There's different styles, there's really short-term sheets leaving a lot to be negotiated later, there's very long-term sheets that might cause you to lose the deal because they're so long and seem so difficult, and then there's everything in between. And then there's certain key rights like these pillars that you can really save yourself a lot of headaches and speed the transaction by coming to an agreement on these key points prior to negotiation of the definitive documents. So yeah, Dave, I think that would be a great one.

Taylor Stevens:

Yeah, I agree. I think it's a ripe topic for the discussion because not only do you have important considerations within the four corners of the term sheet, you have some strategic considerations too to Tim's good point. Sometimes you have a very streamlined truncated term sheet, and other times it's going to be really long. There can be advantages or disadvantages to that depending on what your objectives are. So there's a lot that goes into the term sheet aside from just the terms that go into the four corners. There's some strategy around it too, so it's a ripe topic for discussion.

Alex Wibaux:

Especially because I guess that the leverage really is at the time of negotiation at the time sheets on both sides of the table.

Dave Dalton:

Sure. We'll put it on the list for 2025, so now you guys are committed. I have witnesses. All these people listening said you do, so here we are. So let's go to our fifth pillar though, Taylor, anti-dilution waivers.

Taylor Stevens:

All right, here we are, the fifth and final pillar of defense. Okay, so this is the waiver of anti-dilution protection. So let me start by saying for any listener who wants to better understand how anti-dilution protection works and all the mechanics, I invite you to listen to our last podcast on down rounds and pay to plays where we went into some real detail on the mechanics of anti-dilution. But here today, I'm going to keep it at a really high level and simply say that anti-dilution will apply if the company does a down round, or if the company issues shares of stock at a per share price that's less than the purchase price of the outstanding preferred.

So suppose the company sold Series Seed at 50 cents a share, and then it goes on and it sells Series A at $2 a share. Now the company goes out and it does a Series B, and it does its Series B at $1.50 a share. So that's going to trigger anti-dilution adjustment for the Series A, but not the Series Seed because from the Series Seed's lens, it's still an up round to the price that they paid, right? So the issue here is that it's not in the economic interest of the Series Seed to allow the Series A to get that anti-dilution adjustment because when that happens and the A gets the anti-dilution adjustment, it dilutes the Series Seed, it dilutes the common too for that matter.

So we're making the Series Seed sound like really bad guys here, and that's not really the case. The reality is is that the Series Seed would simply be incentivized to waive anti-dilution on behalf of the Series A if they could.

So what's the takeaway here? Just like the discussion on the first pillar where we talked about waiver of the treatment of a deemed liquidation event, here if the charter provides that anti-dilution adjustment for the A could be waived by anyone other than the A, then the Series A folks are at serious risk. So the Series A needs to have a series-based block right on any waiver of its anti-dilution protection. So again, the reason here and thematically with all of these points or most of them is that the economic interests of the seed and the A are not aligned here.

Dave Dalton:

Sure, and we've talked about five different ways in terms of ensuring that the playing field's at least level, that's for sure. Let's wrap up. Let's start with Tim though. Tim, takeaways. We've talked about a lot, covered a lot of ground certainly. What's your one takeaway? What are people listening to this that have an interest in this sort of arrangement, what do they need to know in here?

Tim Curry:

The biggest takeaway is that Series A investors and their lawyers put a lot of thought into crafting their economic rights at the term sheet phase and then in the definitive document phase. And you don't want to put yourself in a situation where after all that work and all the time and money that you've put into negotiating these documents that literally, but perhaps theoretically, but literally all of your economic rights that you fought so hard for could be wiped out the day after the Series A closing by the preferred majority. And so that's obviously untenable, and that's one of the arguments that I use when I'm pushing for these things is we've all put a lot of work into this deal, it can't be the case that the preferred majority can just wipe out all the hard one economic points that the Series A has negotiated in this transaction. So we've got to have most, if not all of these pillars in each deal.

And then just finally, I would say that in a typical deal for a Series A or later investor, I would just reiterate that I think we probably spend 70% of our negotiating time on these five pillars. So they're really important.

Dave Dalton:

Really?

Tim Curry:

And if we can flush them out at the term sheet stage, that's even better to avoid that time. But there's something to absolutely focus on in all second or third round deals.

Dave Dalton:

70% of the time as you're negotiating is around these five things. I guess I'm not surprised hearing how serious this is and some of the points you brought, but that's major. Alex, same question, what's your main takeaway from today's discussion?

Alex Wibaux:

It really is essential to negotiate the charter as much as the other investment documents because if the Series A consent rights are contained in the charter, the Series A investor can argue that an act by the corporation in contravention of those provisions would be void or avoidable rather than simply a breach of contract. So this may sound very lawyery, but a charter is just as important as the other documents that you would enter into in the context of a Series A financing.

Dave Dalton:

For certain. Taylor, bring us home, wrap us up, what's the one point you want everybody to make sure they remember from here?

Taylor Stevens:

Happy to do it. I have two points. One's a reality check and one's a market check. The first point is that there's no one size fits all. Look new money could come in and own a majority, or they could come in and have a minority, but they could have terrific relations with the whole rest of the syndicate. They could be investors that they co-invest with all the time. So you want to look at the broader picture, and there can be lots of factors that drive the protections that new money investors may need. So just be mindful of that.

The second point is a bit more of a market check, and we remain in an investor-favorable market right now. So I think for investors looking at new deals, they should not only be aware of market terms and trends in their relative leverage, but they really should be thinking about protecting their economic interests through these five pillars, especially as a new investor that's coming into a later round where number one, they may not hold a majority of the overall preferred, or number two, the economic interests aren't necessarily aligned with the prior preferred. So that would be my two-point takeaway.

Dave Dalton:

Terrific. Hey, as I mentioned just a minute ago, we covered a lot today. Great follow-up to the previous two programs. I think we put together one heck of a series, so I thank all three of you sincerely for your time, and sounds like we're going to do quite a bit more next year. I'm looking forward to that.

Taylor Stevens:

Likewise.

Tim Curry:

Thanks so much, Dave and Tom.

Alex Wibaux:

Likewise.

Taylor Stevens:

Thanks, everyone.

Dave Dalton:

All right. Hey, Alex, Taylor, Tim, thank you so much, and we'll talk to you soon. Take care.

Tim Curry:

Thanks, everyone.

Alex Wibaux:

Thank you.

Taylor Stevens:

Yeah, thanks, everyone.

Dave Dalton:

For complete bios and contact information for Tim, Alex, and Taylor, visit jonesday.com. While you're there, check out our insights page from our podcasts, videos, publications, newsletters, and other interesting content. Subscribe to JONES DAY TALKS® at Apple Podcasts or wherever else you find your podcast programming. JONES DAY TALKS® is produced flawlessly by Tom Kondilas. As always, we thank you for listening. I'm Dave Dalton, we'll talk to you next time.

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