Venture capital (VC) investment involves a unique set of terms and concepts that are crucial for entrepreneurs and investors to understand. There are many examples I have seen that involve both investment and legal terminology. It remains advisable to hire a good lawyer for the legal part. However, it is also important to understand the basic concept. Here’s a comprehensive guide to the key terms in venture capital investment:
Anti-dilution protections: Safeguards for existing investors to maintain their ownership percentages from dilution caused by future equity issuances at a lower valuation. This clause protects investment from potentially losing value. Example of anti-dilution provisions include pro-rata rights, pre-emptive rights, full ratchet, and weighted average.
Pro-rata rights: The privilege granted to existing investors to maintain their proportional ownership in a company by participating in future financing rounds. With pro-rata rights, investors have the option to invest additional funds in subsequent rounds to ensure that their ownership percentage remains the same as before the new investment. This allows investors to protect their stake in the company as it grows and raises additional capital.
Pre-emption rights: Rights that allow existing shareholders to maintain their ownership percentage by purchasing newly issued share before they are offered to new investors. The difference to pro-rata rights lies in their range and timing. The pre-emption right focuses on the early opportunity to acquire new shares, while the pro rata right covers a broader range of situations in which shareholders can maintain their proportional ownership.
Tag along rights (for minority shareholders): Rights that allow minority shareholders to join in the sale of their shares when a majority shareholder sells their stake in the company. This protects minority investors by giving them the opportunity to sell their shares in a sale of shares by another shareholder on a pro-rata basis. This right is also referred to as a Co-sale right.
Drag along rights (for majority shareholders): Rights that allow majority shareholders to force minority shareholders to sell their shares in the company if a buyer is interested in acquiring a controlling stake. This provision aims to prevent a minority group of investors from blocking a sale or transaction against the will of the majority. This right is also referred to as a Come along right.
Protective provisions: Provisions in investment agreements that give investors certain rights to protect their interests, such as veto power or right to block important corporate actions and measures. Safeguard clauses can help protecting the interests of minority shareholders in the event that different shareholders disagree on the optimal management of the company.
Transfer restriction: Limitations or conditions placed on the transfer of shares, often to maintain control or protect the interests of existing shareholders.
Simple Agreement for Future Equity (SAFE): A contractual agreement between a start-up company and its investors, first introduced by Y Combinator. This investment agreement provides investors with the right to receive equity in a future financing round, commonly used in seed-stage investments.
Most Favored Nation (MFN) status in SAFE agreement: Protections that grant investors the same rights and benefits as those offered to future investors if they are more favourable. These provisions are designed to protect earlier investors from any potential disadvantages posed by subsequent investors. The basic idea is that if a future investor negotiates better conditions, an early investor will get them too.
Pre-money valuation: The valuation of a company before any external funding is raised.
Post-money valuation: The valuation of a company after external funding has been raised and added to the company’s balance sheet.
Side letter: A supplementary agreement that outlines specific terms or conditions for certain shareholders in addition to the main investment agreement.
Term sheet: A preliminary document outlining the key terms and conditions of a potential investment, used as a basis for negotiation before drafting an official agreement.
Capitalization table (cap table): A document like a spreadsheet or a table that outlines the ownership structure of a company, including details of shares, shareholders, and equity ownership percentages.
Convertible note: A debt instrument (e.g. a loan repaid with interest) that can be converted into equity in a future financing round and is usually used for early-stage investments.
Employee Stock Ownership Plan (ESOP): A program that allows employees to own a stake in the company, typically through the allocation of stock options or grants. ESOPs are also utilized to compensate early employees who may accept reduced salaries in exchange for equity in a start-up.
Right of first offer (ROFO): A right that gives existing shareholders the opportunity to purchase a selling shareholder’s shares before they are offered to external investors.
Right of first refusal (ROFR): A right that allows existing shareholders to accept or reject an offer to purchase shares after the selling shareholder has received an offer from a third party.
Pay to play: A provision or arrangement that requires existing investors to participate in future financing rounds to maintain their ownership percentage, rights and protections.
Preferred share: A class of share that typically carries additional rights and privileges compared to common share, often held by investors in venture-backed companies.
Dilution: Reduction in the ownership percentage of existing shareholders caused by the issuance of additional shares.
Ratchet dilution: Adjustment mechanism that maintains or increases the ownership stake of existing investors in response to a down-round financing.
Full ratchet anti-dilution: The strongest form of anti-dilution protection for existing shareholders that adjusts the conversion price to the lowest price issued in a subsequent financing round. While it protects early investors by ensuring that they are compensated for the dilution of their shares in future funding rounds, this provision may be less favourable to founders. It could discourage founders’ efforts to raise capital in future funding rounds.
Weighted average anti-dilution: The (arguably) more balanced approach for founders, early investors and later investors to calculate exchange ratio adjustments in a new financing round. In this new round, the value of preferred shares will be adjusted to a new weighted average price using the broad- or narrow-based weighted average formula.
Washout round: A financing round that significantly dilutes existing shareholders, often resulting from a down-round or financial distress. It is also known as a burn-out round, where new investors can take control of the company as the company urgently needs more funding to avoid bankruptcy.
Write-off: Removal of an asset or investment from a company’s balance sheet because it is considered to be worthless or unrecoverable.
Exit event: A liquidity event such as an acquisition or IPO that allows investors to realize a return on their investment.
Liquidation preference: Priority right for preferred shareholders to receive a predetermined amount of proceeds from a liquidation event before common shareholders receive any distribution. It basically determines who gets paid first and how much they get paid in liquidation events (e.g., IPO, being acquired, or shareholders selling their stake on a secondary market).
Initial Public Offering (IPO): The first sale of shares by a private company to the public on a stock exchange.
Lock up agreement: An agreement that restricts shareholders from selling their shares for a specified period, typically after an IPO or other significant corporate event. It serves to protect investors from excessive selling pressure from insiders.
Conclusion
When it comes to venture capital, there is a lot of mystification in this area. Not everyone has the privilege of having friends or mentors who can advise them, let alone an experienced VC lawyer. When seeking VC funding, it is crucial for founders to understand the different types of VC investment terms, as this can ensure that they arrange favourable terms and that their interests are protected. On the investor side, terms are used so frequently and sometimes interchangeably that investors often have to fall back on the basic concept to keep up with the rules of the game. A careful look at the VC glossary can enable investors to make informed decisions and negotiate terms that best suit their investment objectives. It is extremely important for both founders and investors to understand the terms of venture capital investments. By familiarizing themselves with key venture capital terms, both founders and investors can participate in VC funding arrangements with greater confidence.
