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Summary:

I work as an attorney to a lot of company founders, and I know from experience that when the time comes to negotiate a round of funding, entrepreneurs often find themselves at a disadvantage. Much of it has to do with language. There is an array […]

I work as an attorney to a lot of company founders, and I know from experience that when the time comes to negotiate a round of funding, entrepreneurs often find themselves at a disadvantage. Much of it has to do with language. There is an array of terms and issues that investors and lawyers work with regularly and understand, but that entrepreneurs deal with only once in a while. It would take many posts to cover all of them, but here is a Crib Sheet of 10 Key Terms that clients most often ask me to explain when they receive term sheets from prospective investors.

Let’s start with the basics of valuation. The three biggest questions I get are: How much is my company is worth? How much of my company will I have to give up? How is that calculated? Three valuation terms you need to know are:

1. Pre-money valuation: Investors will assign a valuation to the company and its shares before they even think about dropping a dime on it. Your “pre-money valuation” is what your company is worth before the VC deal happens.

If the pre-money valuation is $10 million and there are 4 million shares outstanding, the investors are offering to pay $2.50 a share for the company.

2. Post-money valuation: This is what your company is worth after the deal. If the investors then put in $5 million, the post-money valuation will be $15 million and the investors will own one-third of the company.

3. Fully diluted capitalization: This is how that 4 million share number is calculated. It’s not necessarily obvious. You may have issued 3 million shares to your co-founders and early employees. However you’ll need to issue more shares (in the form of stock options) to future employees, so you budget for those by creating a share pool consisting of 1 million shares. The 1 million shares have not been issued, but they are treated as if they’ve been issued when the valuation is calculated. Thus, 3 million issued and outstanding shares plus 1 million reserve shares set aside for future stock options grants equals 4 million fully diluted shares.

Once you have a command of the valuation being placed on your company, you’ll need to comprehend the many other preferred rights you’ll be asked to give your investors in exchange for their money. This will matter when you get to a liquidation event, because not all shareholders will get paid equally.

4. Preferred stock: Founders and employees of companies get common stock, which gives them bare ownership rights. Investors get stock with rights that are in some way superior to those of common stock; we call this preferred stock. At a minimum, preferred stock gets its money out first, so if there isn’t enough to go around, preferred has dibs and common gets the scraps.

5. Liquidation preference: This is the right to “get out” (get paid) first if the company is sold, merged or otherwise liquidated. What someone is paid usually starts as the amount invested per share ($2.50, in our example).

6. Liquidation multiple: Investors may ask to be paid a premium on their liquidation preference, meaning the company may have to pay back $5 for every $2.50 invested, before common stockholders get anything. That’s a liquidation multiple.

7. Participating and non-participating preferences: A liquidity event produces the potential for a “double dip” for the preferred shareholders. They get paid once in their liquidation preference, and then have the option to get paid again as if they are common shareholders. There are two buckets of money: After the liquidation preference is paid, whatever money is left over gets distributed among common shareholders and those preferred shareholders who wish to “participate.” Non-participating preferred holders take their preference payment, then let the common stockholders take what remains.

So, if the company from our example is bought for $20 million, the preferreds will get their $5 million back (this is without a liquidation multiple) before the remaining $15 million goes to common shareholders. And if they’re “participating preferreds,” they’ll get a share in the remaining $15 million, too. Bottom line: You want non-participating preferreds if you’re a founder!

Bear in mind: liquidation multiples and participating preferreds are most common in high-risk, troubled company situations. If your VCs are using these terms, be careful.

8. Right of first refusal: Investors want to make sure (i) a company’s shares stay within a small group, (ii) that they get an advantageous crack at additional financing rounds. They’ll ask for a clause in your investment documents saying that before you can sell additional shares, you must first let the company and/or the investors buy them at the price offered by the third party.

9. Co-sale right: This further locks things up by saying that if for some reason both the company and the current investor pass on the next round, the current investor can still benefit by selling his shares to a third party, alongside the founder.

10. Participation right: This says that the investor has the right to invest in any new offerings the company conducts.

These are some of the key terms that appear in VC term sheets. I’ll add to this crib sheet over time, so: What terms do you need help understanding?



Jay Parkhill
serves as outsourced general counsel to startups and growth-oriented companies, and writes on legal and business matters at his blog, StartupToolbx

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  2. “Bottom line: You want non-participating preferreds if you’re a founder!”

    As a founder why would I “want non-participating preferreds” for myself as the language “you want” seems to imply?

    Don’t you mean “You want the term sheet to have non-participating preferreds for the investors, if you’re a founder.” Alternatively, and more clearly “having non-participating preferreds for the investors is in the founder’s interest.”

    Am I understanding this correctly?

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    1. As a founder, yes you do want … for the pfd.
      Founders get common, not pfd, that’s for investors.

      so your clarifying language is right, just not necessary in the context.

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  3. Entrepreneurs are getting ripped off.

    I can’t believe they accept terms such as Preferred Stock, Liquidation preference and Liquidation multiple.

    This just turns the advantage towards the investors not the people that actually work and make the company what it is.

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  4. Saul Lieberman Sunday, May 25, 2008

    CORRECTION?
    9. Co-sale right: This further locks things up by saying that if for some reason both the company and the current investor pass on the RIGHT OF FIRST REFUSAL, the current investor can still benefit by selling his shares to a third party, alongside the founder.

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  5. Venkat,

    While there are some VC terms that are onerous, preferred stock and liquidation preference are absolutely necessary.

    1) If the VCs own the same class of stock as the founders, and only take 30% of the company, the founders could vote out the board at any time based on holding a majority of shares. Without preferred classes of stock, VCs would always insist that founders give up more than 50% of their stock in the first round of financing.

    2) If there were no liquidation preference, founders could make easy money by instantly liquidating their company after financing. For example, let’s say I raised $5 million on a $10 million premoney. The day after the close, I could liquidate the company and walk away with $3.3 million, leaving investors with a -66% return.

    I agree that liquidation preferences of more than 1X are onerous, but a 1X preference is absolutely essential.

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  6. [...] haggling and termsheets in mind, the often excellent blog at Found and Read has a great Termsheet glossary outlining the most common terms. Also, check out http://www.thefunded.com which now has termsheet details [...]

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  7. Another great post, thanks guys.

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  8. jay, this is a *great* article – i’m going to push it out to the babson crowd, a lot of students are terribly unaware of how it all works, the fantasies as well as the REAL tool used for valuation (congeniality ;)

    any chance you could throw up a google spreadsheet with some phony valuations and triggers that folks could play around with or something like that? it would really help to illustrate the points….

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  9. another great post – these details are so easily overlooked yet magnify in importance as the value of your company grows…and many created problems are often hard if not impossible to go back and “fix”

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  10. Dave-

    Cap table spreadsheets get complicated and deal-specific very quickly, though I’d be happy to do a mockup to show some different concepts. Here’s one I did a while back comparing Charles River Ventures’ QuickStart funding model with a “traditional” VC financing.
    http://blog.jparkhill.com/2006/11/10/more-on-crv-model/

    And Kevin-

    *Exactly*. It is 3x as hard/expensive to fix problems later than to get them right the first time around. Understanding the terms well is the first step toward a successful financing for all parties.

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  17. [...] get what Rafer calls “thin preferreds,” but you’re unlikely to suffer the dreaded participating preferreds. Without a multi-tiered equity structure, every investor, including founders, gets paid in [...]

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  18. Pardon the delay in responding.

    @Nitin Yes.

    @Venkat
    When entrepreneurs want a ton of cash to really go for it, the terms are fine. I just think they are overused terribly at the early stage with startup management who don’t really understand what they are buying into.

    @Chris Yeh
    The Preferred need protection but they don’t need control as a starting point of the negotiation. A 1X liquidity preference isn’t at all necessary. There are a hundred ways to solve that problem. Unlike @Saul Lieberman I think a co-sale right is much fairer to all parties than a liq pref.

    The mechanism that I like best is a co-sale right plus an _expiring_ liq pref tied to a drag along, i.e. below a certain multiple of cash-on-cash return, the Preferred has a bunch of rights and a bottom line payout. Above that multiple, everyone gets paid solely proportional to share ownership and the Common rules the roost change of control decisions.

    The reason to have a Preferred is to give out Common Stock options to new employees at a lower price than the investors paid.

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