Venture Capital Term Sheet Negotiation — Part 8: Carve-Outs to Anti-Dilution Provisions and “Pay to Play” Provisions

This post is the eighth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior seven posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, and analyzed anti-dilution provisions. This post will discuss carve-outs to anti-dilution provisions that typically do not trigger dilution adjustments and also examine “pay to play” provisions.

Anti-Dilution Provisions

As we discussed in a previous post, dilution refers to the phenomenon of a shareholder’s ownership percentage in a company decreasing because of an increase in the number of outstanding shares, which can happen for various reasons. Dilution is not always a negative but can be a concern for venture capital investors because of the possibility a company may engage in a “down round,” or a later issuance of stock at a price that is lower than the price the venture capital investors paid. Anti-dilution provisions protect against the consequences of a down round by adjusting the conversion price of their preferred stock upon new issuances at lower per-share prices, so as to partially or completely protect the venture capital investor’s investment from a decrease in value resulting from the down round.

For examples of different types of anti-dilution provisions, see the National Venture Capital Association’s (NVCA) term sheet here.

Customary Carveouts

An anti-dilution provision generally lists certain issuances of stock that do not trigger adjustment of the conversion price. These carve-outs comprise various common situations that are distinct from the typical capital raise, including the following:

  • stock issued upon the conversion of any preferred stock or as a dividend or distribution on preferred stock;
  • stock issued upon conversion of any debenture, warrant, option, or other convertible security;
  • common stock issued upon a stock split, stock dividend, or any subdivision of shares; and
  • common stock or options issued to employees, directors, or consultants as part of an equity compensation plan.

In addition, other issuances that do not trigger conversion can be negotiated by the parties. Other possible exclusions include the following issuances of common stock, options, or convertible securities:

  • to banks or other financial institutions pursuant to a debt financing;
  • to equipment lessors pursuant to equipment leasing;
  • to real property lessors pursuant to a real property leasing transaction;
  • to suppliers or service providers in connection with the provision of goods or services;
  • in connection with an M&A transaction, reorganization, or joint venture; and
  • in connection with sponsored research, collaboration, technology license, development, OEM, marketing, or similar.

Any of these exclusions can contain a limit on the number of shares or underlying shares that can be issued, and can require the approval of the director(s) appointed by preferred stockholders or even the vote of the preferred stockholders. Founders should be careful to review the carve-outs and make sure that the customary ones are contained in the term sheet. In addition, if the founders anticipate that the company may need to make use of any of the optional carve-outs described above, they should consider asking for those as well. Investors shouldn’t find the most typical of these carve-outs to be particularly problematic.

Pay to Play Provisions

“Pay to play” provisions work together with anti-dilution provisions to encourage venture capital investors to participate in subsequent rounds of financing. When such a provision is in effect, if an investor does not participate in a subsequent round, the anti-dilution provision does not apply. (The investor may lose other rights of a preferred stockholder as well, depending on how the provision is structured.) Because the investor will want that protection, it has an incentive to participate. Such a provision is favorable for the company because it prevents the investor simply from sitting out a down round and passively receiving the benefits of the anti-dilution provisions without committing more capital to the company. A pay to play provision is certainly something that a company can ask for when negotiating a term sheet, though the company should expect to receive some push back. A company is only likely to get a pay to play provision if it has considerable leverage going into a deal.

In the next post, we’ll discuss redemption rights.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Alexander J. Davie

Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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