Continuing our series on navigating NVCA term sheets, this third article focuses on essential charter provisions and shareholder rights. These terms significantly influence how your startup is governed, investor protections, and long-term company structure. If you missed our previous discussion on valuation and funding, revisit Valuation, Investors, and Amount Raised: Decoding NVCA Term Sheets.
Understanding Charter Provisions
Charter provisions are critical clauses within a company’s certificate of incorporation, dictating fundamental aspects of governance and operations. NVCA standard term sheets typically outline key charter provisions, including:
Dividends
Clarifies whether dividends are cumulative or non-cumulative, and how dividends impact investor returns and company cash flow.
Liquidation Preferences
Liquidation preferences specify how proceeds from a liquidation event (e.g., company sale, merger, or winding down) are distributed among shareholders. Key considerations include:
- Participating vs. Non-Participating: Participating preferred shareholders receive their liquidation preference plus a share of any remaining proceeds with common shareholders. Non-participating preferred shareholders must choose between their liquidation preference or converting to common shares to participate in remaining proceeds.
- Multiple Preferences: Indicates how many times the original investment an investor receives before common shareholders receive any proceeds.
Common Issues:
- Misalignment of interests, leading to complex negotiations during exit events.
- Founder dissatisfaction if liquidation preferences overly favor investors.
Key Shareholder Rights under NVCA Term Sheets
Protective Provisions
Protective provisions grant investors veto rights over critical company actions, such as:
- Issuing new shares or debt.
- Changing business strategy or key personnel.
- Selling the company or its major assets.
Common Issues:
- Excessive investor control limiting operational flexibility.
- Unclear terms leading to disputes and stalemates.
Anti-Dilution Provisions
Anti-dilution rights protect investors if future funding rounds are priced lower than their original investment, typically through:
- Full Ratchet: Adjusts investor shares fully to the new lower price, greatly benefiting investors but heavily diluting founders and early investors.
- Weighted Average: Adjusts based on a weighted formula considering the number of shares previously issued and new shares issued.
Common Issues:
- Unanticipated severe dilution for founders in future funding rounds.
- Investor disagreements over the method and application of anti-dilution provisions.
Mandatory and Optional Conversion
Specifies conditions under which preferred shares convert to common shares, typically during an IPO or agreed-upon triggers.
Common Pitfalls to Avoid
- Ambiguity in Voting Rights: Lack of clarity can lead to disputes and decision-making stalemates.
- Inflexible Protective Provisions: Overly restrictive provisions limit operational flexibility.
- Misunderstanding Liquidation Preferences: Misinterpretation can result in unfavorable outcomes for founders during exit events.
- Overly Aggressive Anti-Dilution Terms: Can significantly deter future investors and negatively impact founder equity.
Strategic Implications for Founders and Investors
- For Founders: Thoughtfully structured charter provisions help preserve operational flexibility and strategic control, preventing unintended limitations.
- For Investors: Clearly defined rights offer critical safeguards for investment security, ensuring alignment of governance with investor interests.
Best Practices in Structuring Charter Provisions
- Balance: Seek a balance between investor protection and operational flexibility.
- Clear Communication: Ensure all stakeholders understand the implications of each provision clearly.
- Forward-Thinking: Anticipate future scenarios, structuring provisions to accommodate growth and change effectively.
Looking Ahead
Stay tuned for our next article, which will delve deeper into Anti-Dilution and Conversion Mechanics, exploring how these elements protect investor equity and impact future fundraising strategies.
At Veritas Global, we assist startups and investors through each financing stage, ensuring robust governance frameworks and strategic alignment. To discuss how charter provisions can best support your fundraising and governance goals, schedule a consultation with our expert team today.
Explore additional insights on startup governance and investment strategies in our Insights section.
