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Understand Term Sheets  -  Part 2: Protection for Future Down-Roundsby@darshitac
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Understand Term Sheets  -  Part 2: Protection for Future Down-Rounds

by Darshita Chaturvedi3mJune 2nd, 2022
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When you issue shares at a valuation (or price) lower than the previous round of financing, this new round is referred to as a down round. As founders, we should be aware of the provisions we are adding now that could impact us materially in a down round. The two most prominent ones are antidilution and pay-to-play.

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Understanding pay-to-play and antidilution provisions in a term sheet

In this series, we are looking at some of the most important provisions in a term sheet so that we know what these terms mean for our startups and which terms to negotiate.


In Part 1, we evaluated liquidation preferences and how shareholders are compensated when a company or its assets are sold.


In this Part 2, we understand which provisions protect startups in a future down round.

What is a down round?

When you issue shares at a valuation (or price) lower than the previous round of financing, this new round is referred to as a down round.


As founders, we should be aware of the provisions we are adding now that could impact us materially in a down round.


The two most prominent ones are antidilution and pay-to-play.

1. Pay-to-Play

Why is this provision important?

It ensures that only committed investors hold preferred stock and consequently, have special rights.

2. Antidilution

Why is this provision important?

Antidilution provision prevents investors from getting diluted in certain situations. One such situation is a down round.

When does it come into effect?

Antidilution provisions added in previous rounds of financing come into effect when you do a down round.


An illustrative example where a down round is immediately preceded by the round where antidilution provisions were added


What are the two different types of antidilution provisions?

  1. Full ratchet antidilution: All of the previous round stock is repriced to the new issuance price
  2. Weighted-average antidilution: The repricing is adjusted for the number of shares issued in this down round.


How are number of shares calculated for the weighted-average antidilution?

There are two entities to consider:

  1. Common stock outstanding
  2. Convertible securities: securities such as employee options can be converted into common stock


Depending on how you calculate the total number of shares, there would be a different repricing.


Different types of weighted-average antidilution


Can you add exceptions to these antidilution provisions?


From founders’ point of view, it’s usually beneficial to add exceptions to these antidilution provisions, formally called anti-dilution carve-outs.


Imagine a scenario where you want to do a down round. Your majority of investors agree to participate in this round of financing while the remaining investors do not.

In the absence of anti-dilution carve-outs, your common stock holders — founders and employees — will get diluted because these minority investors have invoked anti-dilution provision.


What if you had added these carve-outs though?


If the majority of investors invoke the anti-dilution carve-out, minority investors must participate if they want to avoid dilution.


Closing Thoughts:

In this post, we learnt the following:

  • What do pay-to-play and antidilution provision mean?

  • What are the different types of antidilution provisions?

  • Why you should consider adding carve-outs?


The infographic below summarizes some of these key points.



References:

Feld, Brad and Mendelson, Jason. Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist. Wiley, 2019.



Next up: Part 3: Vesting and Exercise Period

Disclaimer: Nothing in this article constitutes professional investment advice. Please do your own thorough research before making any investment decisions.