In a financing negotiation, valuation determines how much money is raised this time; the clauses determine who leaves first and who absorbs the loss the next time the money cannot be raised. Most AI companies concentrate on valuation before Series A and discover only after signing that the liquidation preference is a 2x participating preference, that the repurchase trigger has been drafted as a failure to list within a fixed period, and that the drag-along threshold is low enough for a majority investor to sell the founders with the company. None of the three is triggered while financing is going well; once triggered, each is a question of control.
Liquidation preference: the multiple first, then participation
The liquidation preference determines how much investors recover first when the company is sold or wound up. A 1x preference — repayment of principal — is the common formulation; the real question is participation. Under a participating preference the investor recovers principal and then shares the remainder with the founders pro rata; under a non-participating preference the investor must choose between recovering principal and taking a pro rata share.
For an AI company, what has to be negotiated is the multiple and the cap. A 2x preference leaves founders with almost nothing of the consideration when the valuation corrects. The concession order suggested is: seek 1x first, then a participating preference subject to a cap (for example, recovery of no more than 2x), and only then accept uncapped participation.
A further point that is easily overlooked is whether the preference applies to a deemed liquidation event — a sale of core assets, an exclusive licence or a change of control. The core assets of an AI company are frequently its models and data, and an asset sale is more common than a share sale; this must be expressly drafted.
Repurchase: company repurchase and founder repurchase are two different things
A repurchase clause typically provides that, if a qualified listing is not completed within the agreed period, the investor may require the company or the founder to repurchase. The enforceability of the two obligations is entirely different.
A valuation adjustment arrangement with the target company requires, under Article 5 of the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, that a capital reduction procedure be completed; otherwise the court may dismiss the claim or hold that it cannot be performed. A company repurchase is constrained in practice by creditor protection procedures and may not be executable.
A founder repurchase is a personal liability. Three matters should be confirmed before signing: whether the obligation is limited to the equity held by the founder, whether joint and several personal liability is excluded, and whether the repurchase price includes a fixed return — a formulation of 8 to 10 per cent per annum converts the repurchase into a rigid debt.
The trigger for an AI company is also often drafted as the departure of core technical personnel. This should be narrowed to departure without investor consent that causes the project to stall materially; otherwise any ordinary resignation may trigger it.
Anti-dilution: full ratchet and weighted average
A full ratchet recalculates the investor’s conversion price at the new, lower price in a down round and dilutes founders most heavily; a weighted average adjusts by formula and dilutes less. A company that accepts a full ratchet before Series A may find that its founders lose control once the valuation corrects.
The room for negotiation usually lies between narrow-based and broad-based weighting: a broad-based weighted average includes the option pool and convertible instruments in the denominator, which favours founders.
Drag-along: threshold, valuation floor and exceptions
A drag-along right allows shareholders holding a given proportion to compel the others to sell. Three matters require negotiation: the trigger threshold, usually above 50 per cent; a valuation floor; and whether founders receive equivalent terms. Where the threshold is low and no valuation floor applies, an investor can carry the founders out in a low-priced sale.
The board and protective provisions
Beyond board seats, what actually affects the conduct of the business is the list of protective provisions. The matters commonly subject to veto include new financing, material asset disposals, unbudgeted expenditure, executive remuneration and equity incentives. The longer the list, the slower the decision. Ordinary operations and material matters should be separated, with monetary thresholds attached.
Information rights and the conflict with trade secrets
It is normal for an investor to require monthly financial and operating data and core metrics, but the training data, model evaluations and customer composition of an AI company may themselves be trade secrets. An information rights clause should simultaneously fix the scope of disclosure, the persons entitled to know, confidentiality obligations and non-compete restrictions, and provide that the investor and its affiliates may not use the information for purposes other than those of the portfolio company. Otherwise a single diligence exercise may breach the confidentiality system entirely.
Three matters before signing
First, a term sheet is generally non-binding except as to confidentiality and exclusivity, but its liquidation preference, repurchase and drag-along provisions will pass into the definitive agreement unchanged, and should be negotiated as if final. Second, a founder’s personal repurchase and guarantee obligations should be reviewed separately and not signed as part of the company’s obligations. Third, the terms of this round become the anchor for the next: an uncapped participating preference accepted at Series A will be demanded by Series B investors on the same terms.
Frequently asked questions
Q: Is counsel needed at term sheet stage? A: Yes, though not throughout. The most valuable step is a single clause review before signing, focused on liquidation preference, repurchase, drag-along and personal liability; the cost is far below that of correcting matters afterwards.
Q: If the investor insists on a 2x participating preference, can it be accepted? A: That depends on the expected exit. Where a sale is expected at a modest multiple, a 2x participating preference will absorb most of the consideration; a cap at 2x, or a 1x participating preference, may be sought in exchange.
Q: What if a company repurchase clause is signed but cannot be performed? A: A valuation adjustment arrangement with the target company requires a capital reduction procedure, and the courts will generally not order direct performance where it has not been completed. The company’s solvency should be assessed at signing, with a founder repurchase agreed in parallel as the alternative route.
This article is prepared on the basis of the Company Law (as revised in 2023), the Minutes of the National Courts’ Civil and Commercial Trial Work Conference and the contract provisions of the Civil Code. For assistance with term sheet review or with the negotiation of investment agreements, please contact Geason Law Offices.