In our previous posts in this series on venture capital (“VC”) term sheets, we looked at the basic structure of an investment, at anti-dilution provisions, and at liquidation preferences and participation. Now let’s turn to some additional concepts that affect the economics and incentives involved in a VC financing round: pro rata rights, the employee option pool and vesting.
Pro Rata Rights
The “pro rata right” gives a VC investor the right to invest in future rounds of funding at a level that will maintain its level of ownership and not experience dilution. The investor Fred Wilson has called the pro rata right “the single most important term [any investor] can negotiate for in a venture capital investment” because in early stage investing “a small portion of your investments produce all of the returns” and “[i]n those investments you want to own as much as you can.”
Typically, only a “major investor” who invests a sufficiently large amount or buys a certain number of shares gets the pro rata right.
Employee Option Pool
Stock options – rights to buy a certain amount of a company’s stock at a certain exercise price – are an important incentive for employees of early stage companies. They drive employees to help the company grow so that the stock is worth more than the exercise price of the option.
The part of a company’s equity that is set aside for stock options is know as the employee option pool. The VC investor will want to ensure that the pool is of a size adequate to incentive employees without diluting their own ownership stake. Therefore VC investors sometimes effectively ask founders, as a condition of investment, to increase the size of the employee pool out of their own shares. As a founder, this is something to watch out for because it will decrease your ownership stake.
To avoid the unfortunate situation where a new employee immediately redeems his stock options and quits, there is vesting. Vesting means that the employee won’t have rights to 100% of the stock options at the outset, but that those rights will accrue (vest) in the course of the employee’s service to the company. The industry standard vesting schedule is four years, with a one-year “cliff.” If an employee quits or is fired before the one year cliff, none of the options vest. After the one-year cliff has passed, 25% of the options have vested, and continue to vest on a monthly basis thereafter until four years from the employee’s start date, at which point the employee is fully vested.
Knowing the significance of pro rata rights and the size of the employee option pool can help you be more effective as a founder in term sheet negotiations. And implementing a standard vesting schedule will help ensure that your employees stick around. As always, it’s a good idea to consult an experienced attorney when evaluating and negotiating the elements a VC term sheet.
In the next part of our VC term sheet series, we’ll look at issues of control.