Every field of study has its basic vocabulary of words and phrases that come up over and over again. This vocabulary is so fundamental that it is used to explain other concepts that are more advanced. Well, fundraising is no different. This article is intended to serve as a primer of sorts with a description of ten basic terms that must be understood by any startup pursuing fundraising.
A term sheet outlines the key and material terms of your funding activity and is produced by interested lead investors for an equity round of funding. It usually fits on 3-4 pages and is used as a key negotiating instrument. Once the terms are agreed and the term sheet is executed, it serves as guidance for the attorneys as they produce the full set of legal execution documents to close the round of funding.
Side Note: For a seed round of funding using a convertible note (see related article titled “Convertible Note Basics”), the company often conveys the proposed terms via a term sheet and uses it as a high-level summary describing the key terms. It is shared with interested investors first before later sending the whole convertible note document for execution. If, instead, the funding is via a priced/equity round, the investors interested in leading the round will produce a term sheet to communicate their offer. Accepting a specific offer involves signing the term sheet and then negotiating the remaining details.
Equity is simply ownership in your company. It is expressed as a percentage whereby the equity amounts of all investors and shareholders add to 100%. So if I say that I have 5% equity in your company it means I’ve got 5% ownership. See below a complementary term called “fully diluted”.
Usually referred to as the “cap table”, it is a ledger that keeps track of the various equity holders in your company and their relative equity stakes (ownership percentages). This includes investors, advisors and company employees alike – assuming all have equity of some sort. The equity amounts can be expressed in different ways (see definition for “Fully Diluted” below as an example).
Authorized and Issued Shares
When US companies incorporate, they file for a certain number of shares to be created (authorized) but often only a subset of them are actually issued into the company at the start. This leaves shares in reserve that could be issued into the company without much additional legal work. For this reason, you’ll see a lot of US startups incorporate with something like 10M authorized shares but they will initially only issue 8M of those shares into the company.
You’ll almost always hear this phrase in context of “equity amount on a fully diluted basis”. Your cap table probably includes shares that have been issued into the company but not yet to any particular individual. The best example is the stock option pool. Over time, shares in the stock option pool will be issued to employees. Calculating someone’s equity on a fully diluted basis means dividing their quantity of shares by all shares issued to the company, assuming all have been issued to someone. Don’t make the mistake of dividing by the number of authorized shares unless all have been issued into the company.
Common and Preferred Shares
These are two different classes of shares. Before taking on external funding, most startups only have Common shares. But later when professional investors put money into the company, they want special rights such as voting rights, board seats, etc. These extra rights define a new class of shares called Preferred shares. It should be noted that taking investment via a convertible note does not involve equity but rather debt. As a result, a Preferred class of stock isn’t usually established until the first round of financing in which equity is sold to investors.
A liquidation preference is a common right given to Preferred shareholders (see definition above). It protects them in the event the company is sold at a value near or below the last post-money valuation (see definition below). If the company is sold in distress, the professional investors want to make sure they at least get their money back before non-investing equity holders get any money. If fact, these Preferred shareholders with a liquidation preference get to choose between whatever is better – taking their liquidation preference or taking their relative equity % of the total acquisition price. Not a bad deal but that’s what they get for investing capital into your company.
Side note: Be on the lookout for two variations that are considered fairly aggressive terms. One is a multiple of the liquidation preference (ie – 1.5X or 2X). The other is called a “participation feature” or “participating preferred”, which means the investor don’t simply have to choose one option or the other but rather gets both (they get their money back and then also get their pro rata share of whatever is left over).
Your valuation is simply the value of your company. And since the value of your company is only what someone else is willing to pay for it, your valuation is usually determined during fundraising events, an acquisition or an IPO. During these activities, you and the investing party(ies) must agree how much equity they will get for their investment. As a result, you are effectively setting the value (valuation) of your company. And since the value of your company increases immediately after completing an equity financing (versus using a convertible note), you will also hear the terms “pre-money valuation” and “post-money valuation”. The only difference is the post-money valuation includes the cash that was invested into the company.
If enough time goes by after the last fundraising event, the board of directors or the company accountant might suggest the company have a professional valuation done (called a 409A in the US) so that your stock price can be adjusted accordingly.
Side note: When trying to figure out how much equity an investor will get, remember to divide by the post-money valuation. In other words, if your negotiated pre-money valuation is $4M and an investor is putting in $1M, they will end up with 20% equity (post-money valuation = $5M and $1M / $5M = 20%)
Side note: You might hear someone say they’re “doing a priced round”. This means they’re raising money via equity financing in which a stated valuation is used to “price” the round.
Dilution happens when there’s an activity that causes a shareholder’s equity to be reduced. Since equity is calculated by dividing the shareholders quantity of shares by the total shares issued into the company, the most common cause of dilution is issuing additional shares into the company. Why might this happen? Here are a few causes:
- Raising money via equity financing (aka – a “priced round”)
- Issuing some of the previously authorized shares into the company to make room for a co-founder
- Issuing some of the previously authorized shares into the company to create an employee stock option pool or increase the size of it
In all cases, the number of issued shares increases and this causes each of the previous shareholders’ equity positions to be reduced (diluted).
Side note: Dilution is natural and is often evidence of a growing and successful company. For example, two co-founders might each have 50% equity in the early days when the company is only valued at $2M. Later, after the creation of a stock option pool and a couple of funding rounds they are diluted to 10% equity but the company is valued at $30M. Eventually, they are acquired for $100M when they each have 6% equity. Their starting position on paper was $1M each (50% of $2M) and they each ended up earning $6M in the acquisition (6% of $100M). As long as the amount of dilution is more than offset by an increase in valuation, the math works just fine.
At the time of this writing, for most investments into private companies the US security laws stress the importance of only accepting investment into your startup from what are called “accredited” investors. There are various financial tests to determine this status and the spirit of the laws are to protect those that don’t have enough money to be investing in the most risky asset classes like startup venture investing. Crowdfunding and other trends are changing some of the requirements and designations. But it is important to consult with your attorney to make sure you don’t accidentally jeopardize your company’s future by taking investment from the wrong people or using the wrong process (if interested, research “SEC general solicitation”).