This is the final installment in our key term sheet provisions series. This post reviews rights of first refusal, restrictions on sales, voting rights, proprietary information and inventions agreements, co-sale agreements, founders activities, no shop agreements, and indemnification provisions.
Right of First Refusal
The right of first refusal provision grants investors a right to participate in subsequent stock offerings. This right is sometimes called a pro rata right, because it enables investors to participate pro-rata. Pro rata means proportional, and in this context means that an investor can purchase an amount of new stock proportionate to their holdings in the company immediately prior to the issuance of the new offering. In more simple terms, it means that if an investor has 5% of the outstanding stock, he or she can purchase 5% of the new stock that is being offered.
Restriction on Sales
A restriction on sales provision is a right of first refusal for the sale of common stock by an existing stockholder. If a founder wants to sell stock on a secondary market, a typical restriction on sales provision would enable first the company, and then other (preferred) shareholders, the right to purchase the stock that was put up for sale.
The voting rights term details how the stock being offered will vote. In the venture capital context, voting rights are not as important as you might think. The protective provisions, which effectively grant veto power to preferred stockholders, are considerably more important. In other context voting rights will be more important. In any case, the voting rights provision will describe the rights of shareholders to vote in company matters.
Proprietary Information and Inventions Agreement
Investors almost universally require that each current and former officer, employee, and consult of the company enter into an acceptable agreement assigning intellectual property rights. It’s easiest for employers to require that all of their employees sign such agreements as part of the hiring process; it can be uncomfortable and even difficult to require existing and former employees to sign such an agreement.
A co-sale agreement allows investors to participate pro-rata in the sale of stock. For example: Company X has 1,000,000 shares of outstanding stock; Founder A has 500,000 shares and has a buyer lined to purchase 100,000 shares on a secondary market; Investor B has 100,000 shares (10% of the outstanding stock). In this example Investor B can sell an amount of shares equal to 10% of the offering—10,000 shares. If Investor B exercises this right, Founder A can now only sell 90,000 shares in this transaction. Co-sale agreements are extremely common and often viewed as unfairly burdensome. Accordingly, co-sale agreement terms are not often fiercely negotiated.
Investors will often require a term obliging founders to devote 100% of their professional time to the company. Understandably, investors do not want to fund a company that is going to be abandoned by its founders. However, sometimes founders have multiple companies that they are working for, and for many investors this will not be a deal-breaker.
Early in the negotiating process the best leverage companies can get is often to have investors competing against each other. However, at some point founders need to settle on one group of investors. At that point it may be necessary to enter into a no-shop agreement, which prohibits the company from soliciting investment from other sources. Companies should ask that the no-shop agreement be for an appropriately limited duration, and may also want to request a carve-out allowing for acquisitions.
An indemnification provision obligates a company to indemnify investors, officers, and board members against litigation arising from an individual’s relationship with the company. Indemnification provisions are generally a prerequisite to funding, and are not controversial because they benefit parties on both sides of the deal.