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Doing the Deal 101: Series A Financings for Startups

This blog post discusses certain structural features of the Series A round of venture capital financing. We’ll consider first the form of the security that the Series A investors are likely to receive in the financing.

The Series A investors typically obtain a class of preferred stock in exchange for their Series A funding, with that preferred stock being convertible into shares of the startup’s common stock. One of the reasons why the Series A investors obtain preferred stock is because holders of that class of stock have a claim (called a “liquidation preference”) that is senior to the claims of common stockholders, with the amount of the claim typically being the amount paid for the preferred stock. (It’s worth noting here that, depending on a number factors affecting the negotiation of the preferred stock’s terms, the amount of the liquation preference can exceed by some multiple the amount actually paid for this stock.)

This senior claim status benefits the Series A investors because if, as a result of the startup’s liquidation or the occurrence of a “liquidity event” when the startup is sold, a payment is to be made to the startup’s equity holders, the preferred stockholders’ liquidation preference must be paid in full before common stockholders receive any liquidation or liquidity event proceeds.

What’s more, by obtaining shares of preferred stock, the Series A investors can tailor the provisions governing that class of shares to provide additional investor protections and financial advantages including, among other things: (i) protections against dilutive issuances of startup stock that occur after the Series A round closes, (ii) a requirement for investor prior approval of the issuance of other classes of shares by the startup (whether dilutive nor not), (iii) as mentioned above, a liquidation preference in excess of the amount invested in the Series A round by the investors, and (iv) a cumulative dividend that, even if not paid currently, can accumulate so as to add to the preferred stock’s liquidation preference or to the number of shares of common stock into which the preferred stock is convertible.

A second structural feature of a Series A financing involves adjustments that the Series A investors will seek concerning the startup’s incentive equity arrangements for startup founders and employees. In this regard, the Series A investors will want to make sure that there is adequate motivation for existing and future hires to work diligently for the company and will, therefore, insist that a specified percentage (say 10%) of the startup’s common stock equity (an “option pool”) be reserved for options to be granted to these hires. One “fact of life” typically confronting pre-Series A round investors is that, at the Series A investors’ insistence, shares of common stock eventually issued out of this option pool are dilutive of the pre-Series A investors’ equity interest in the startup, not the equity interest of the Series A investors.

Another fact of life that pre-Series A round founders and non-founder employee stockholders typically face when a Series A round closes is the Series A investors’ insistence that these holders’ equity interests become subject to a vesting schedule. Broadly speaking, what this feature of a Series A round means is that any equity previously held outright by founders or employees will be subject to a startup’s re-purchase right should the founders or employee cease to work for the startup, with a stated percentage of each such person’s equity ceasing to remain subject to this repurchase right for each year that the person remains in the startup’s employ.

Among the rights and powers granted to the Series A investors are those that go beyond the terms of the preferred stock and the startup’s post-Series A round capital structure. The Series A investors will acquire contract rights (often set forth in an “investors rights agreement”) that involve, among other things: (i) the mandatory registration of their shares of post-conversion common stock should the startup go public, (ii) the power to compel founders, employee and angel stockholders to support an acquisition of the startup by a third party should a requisite percentage of the equity favor such a deal (a so-called “drag-along” right where the Series A investors can drag the other stockholders along into that deal), and (iii) restrictions on the ability of even vested stockholders to sell their equity (above a stated percentage threshold) to another party unless the Series A investors are permitted to participate in that sale (a so-called “tag-along” right where the Series A investors given the option to tag along with other stockholders in a deal that permits those other stockholders to cash out some or all of their startup holdings).

Let’s close this post with a brief rundown of one other feature of a Series A round’s structure. The Series A investors will want to participate in startup decision-making in a manner that goes beyond the rights and powers set forth in the investor rights agreement or the preferred stock’s charter provisions. This form of participation involves giving seats on the startup’s board of directors to one or more “lead” Series A investors (i.e., those investors with the biggest financial stake in the financing round) for at least as long as the startup remains a private company and those investors retain a stated percentage of the startup’s equity.

One variation on the theme of giving certain Series A investors seats on the startup’s board is granting “observer” status for board meetings to non-lead investors or to investors who cannot hold board seats for regulatory reasons. Under this arrangement, investor representatives will have the right to attend each startup board meeting as “observers,” and, as such, to participate in board discussions, but without having power to exercise any director voting rights.

There are, of course, many more aspects of a Series A round venture financings than those discussed in this short blog post. However, the discussion above should provide a start for grounding newcomers in this area of corporate finance.

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