You are executing on your strategic plan; you have a fully developed product; you have expanded your team; you have deployed ALL the proceeds from your initial Convertible Notes; and you need additional capital to further scale the Entity.
Time to raise Series A Preferred Stock!
What happens next?
Entrepreneurs must understand that by issuing Series A Preferred Stock, their lives and the operation of the entity will forever be transformed. As part of this transformation, entrepreneurs may find some of the following information helpful.
Key Concepts: In order to understand Series A Preferred Stock, there are some key concepts that are important. These concepts are detailed in a set of documents executed and delivered in connection with the issuance of the Series A Preferred Stock (the “Transaction”) including a Stock Purchase Agreement, an Investor Rights Agreement (“Information Rights” and “Pre-emptive Rights”), a Right of First Refusal and Co-Sale Agreement (“ROFR” and “Co-Sale Rights”), a Voting Agreement (Board of Directors), a Registration Rights Agreement, and an Observer Rights Letter (“Observation Rights”) – collectively, the “Transaction Documents.”
While the Transaction Documents make great reading and should be reviewed in detail, entrepreneurs should be familiar with the essential concepts embedded therein, including the following:
- “Series A Preferred Stock” is generally the first class of preferred stock issued by the Entity pursuant to an agreed to formal valuation. To create preferred stock, the Certificate of Incorporation will need to be amended and restated and a number of documents, including the Transaction Documents, will need to be negotiated, executed and delivered. It is also when an Entity often (i) enters into formal employment agreements with key employees (Founders); (ii) establishes an Employee Stock Option Plan or other equity incentive plan pursuant to which both ISOs and NQSOs can be issued; (iii) enters into a term loan or revolving line of credit with a commercial bank or other lending intuitions to provide further financial resources; and (iv) enters into a commercial agreement, including a “beta test” or other pilot agreement with one or more of the strategic investors.
- “Observation Rights” are the rights given to Investors or their representatives, to attend meetings of the Board of Directors. Observation Rights do not permit Investors to vote on matters voted on by the Board of Directors.
- “Information Rights” are the rights that Investors are given to receive (i) copies of financial statements (annual, quarterly and monthly); (ii) budgets; and (iii) to visit and inspect Entity’s business operations; provided, however, that generally, these rights can be withdrawn or limited by the Board of Directors when the Board determines that an investor is or has become a “competitor” of the Entity. This determination most often occurs when the Investor is acquired by a third party – a transaction outside the control of the Entity’s Board of Directors.
- “Pre-Emptive Rights” are the rights that an Investor, generally someone who has purchased Series A Preferred Stock, is given to purchase shares of Series A Preferred Stock subsequently sold by the Entity in an amount so that Investor can keep and maintain its original ownership percentage. With increased frequency, Investors are given pre-emptive rights but are also subject to “move-it or lose-it” provisions whereby if they fail to purchase their entire allocation and maintain their original investment ownership percentage, they lose the right to buy additional shares of Series A Preferred Stock in the future – in any amount.
- “Right of First Refusal” is the right that both the Entity and the holders of Series A Preferred Stock have, separately, to step into the shoes of a third party that has offered to buy common stock from another common stockholder, and whose offer has been accepted (“Third Party Offeree”).This Right of First Refusal is usually first exercised by the Company and then, if the Company declines to fully participate, to the other holders of Series A Preferred Stock. When fully executed, this Right of First Refusal effectively precludes the sale of the common stock from being sold to any third party. Rights of First Refusal can be, but rarely are, applied to preferred stock.
- “Co-Sale Rights” are rights provided to holders of Series A. Preferred Stock after the Right of First Refusal has “failed” and not all the common stock that was made available has been purchased and therefore, everyone who offered to buy common stock pursuant to the Rights of First Refusal, is precluded from executing on those offers. However, holders of Series A Preferred Stock who now want to liquidate part of their holdings, can sell their pro-rata portion to the Third Party Offeree whose original offer triggered the Right of First Refusal.
- “Protective Provisions” otherwise referred to as “blocking rights,” are rights that are specifically negotiated, generally by preferred investors, which allow either designated director (usually, the Series A Director) or the members of a designated class (usually all of the holders of the Series A Preferred Stock voting as group), to approve or disapprove of one or more actions to be taken by the Entity—notwithstanding the fact that the Series A Director only has one vote—and would not otherwise, alone, be entitled to approve or disapprove of the specific actions.
For example, if a “Protective Provision” gave the Series A Director the right to approve an increase in compensation to the President of the Entity, even if the reminder of the Board of Directors approved such an increase, notwithstanding the fact that the Series A Director only had one vote, the President would not receive any without the approval of the Series A Director. Protective Provisions are, in fact, a tool by which Investors assure themselves a continuing role and influence over important decisions by the Entity, notwithstanding their diminishing holdings.
Formalization of Corporate Governance: With all the various rights detailed in the Transaction Documents, entrepreneurs often experience an enormous transformation in the decisions making process. Informality may be a thing of the past. Now, meeting of the Board of Directors and Annual Meetings of the Stockholders, properly noticed and recorded, are the new norm. While unanimous written consents can lessen the burden, documentation of strategic decisions becomes important. Approved Budgets (that must be compiled with) become a reality as failure to meet specific budgets or strategic goals can result in further dilution if additional shares of equity are issued to the disappointed Series A Preferred investors.
Interrelationships: One of the key elements to successfully navigating the transformation of the Entity from Convertible Notes/SAFE Agreements, through the issuance of Series A Preferred Stock, is to understand the details and inter-related nature of the Term Sheet and the documents that form the basis of any investment in Series A Preferred Stock.
For example, when Protective Provisions are included in the Certificate of Incorporation, there are usually very limited methods by which they can be amended or waived—and generally it includes the approval of both a majority of the holders of Common Stock and the Series A Preferred Stock. In contrast, when Protective Provisions are detailed in an Investor Rights Agreement, that agreement, when drafted properly, can be amended by the consent of the designated groups – which may be simply a majority of the holders of the Series A Preferred Stock and not the holders of common stock. Hence, entrepreneurs should understand these differences and their effect on future decisions.
Misinformation: A note to the wary: there are many misconceptions about Series A Preferred Stock and Preferred Stock in general. There are some who claim that Preferred Stock is non-voting stock. Series A Preferred Stock, issued by an Entity to Investors (especially when the Investors are Accredited Investors), always has voting rights – and sometimes, as detailed above in “Protective Provisions,” voting rights which are unrelated to the number of shares of stock held thereby.
Security Interests: Series A Preferred Stock can be (but is rarely) secured with the assets of the Entity. Moreover, frequently there is a Protective Provision which precludes the Entity from securing future debt with its assets without the prior approval of the holders of the Series A Preferred Stock – approval that is not often provided. And this position is well understood – for if the Entity were to fail, anyone secured by a lien on the assets of the failed Entity is entitled to seize those assets to the full extent of its investment, leaving little or nothing for the unsecured Investor, including the holder of Series A Preferred Stock.
This also explains why Investors who also have a commercial arrangement with the Entity disfavor liens – once the assets are seized by the secured party, it will be difficult for the commercial agreement to be fulfilled. True, former employees of the Entity can be enticed to now work for the secured party (the new owner of the seized assets), but commercial transitions are often difficult under the best circumstances. A forced transition rarely results in a positive commercial relationship.
It should also be remembered that in the event there is a liquidation of the Entity, it is the holders of the Preferred Stock who will be paid first – with whatever proceeds exist once creditors are paid. This is true even if the holders of the Series A Preferred Stock don’t have a lien on the Entity’s assets – they get paid first. Therefore, it may well be that the holders of Series A Preferred Stock will receive repayment in full on their investment while the holders of Common stock will receive nothing – unless, of course, there is a different allocation set forth in the Transaction Documents.
InsurTech Entrepreneurs:.Entrepreneurs often attempt to negotiate complex and convoluted (and sometimes very creative) provisions for Series A Preferred Stock. That can be a mistake. Complexity often creates ambiguity – which can create conflict. Straightforward market terms, understood and agreed to by both the holders of Common Stock and holders of Series A Preferred Stock, is the foundation for a harmonious relationship. This foundation, moreover, is critical if future funding rounds are anticipated, as terms for future fundings generally build off of the terms set forth in the Series A Preferred Stock transaction. So clarity of the initial round of investments facilitates future funding rounds.