BOOK of LISTS

Our expert, a venture capitalist, knows lots and lots of complicated terms that could make any small business owner’s head spin! But here he provides us a list of some of the more typical terms you should familiarize yourself with if you’re looking into a venture capital deal.

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Our expert, a venture capitalist, knows lots and lots of complicated terms that could make any small business owner’s head spin! But here he provides us a list of some of the more typical terms you should familiarize yourself with if you’re looking into a venture capital deal.

1. Price
   

All deals have a “price.” Unfortunately, the actual price per share of stock in a venture capital deal is rarely the only factor in the actual “price of the deal,” although it is often the term that entrepreneurs focus on most. Venture capitalists will often talk about “pre-money” (the valuation before the money is invested in the company) and “post-money” (the valuation after the money is invested in the company). Price per share in both situations will be equal; the post-money valuation is equal to the pre-money valuation plus the amount invested.

2. Liquidation preference

The liquidation preference determines how the pie is shared on a liquidity event (sale, merger, wind down). Most investors will get their money out first, followed by the common shareholders (founders, employees, and option holders). Liquidation preferences can be simple (e.g., the venture capitalist either gets his liquidation preference or he converts into common stock and gets his percentage of the company) or complex (e.g., with a “participating preferred,” he will get his money out first and then convert into common stock and get his percentage of the company).

3. Protective provisions

Venture capitalists typically want to have meaningful control of any company in which they invest. One of the ways they do this is through protective provisions, which are effectively vetoes on certain actions by the company. These provisions require that the venture capitalist agrees for the company to be able to do a number of things, such as issue new classes of stock, sell the company, repurchase stock, change the certificate of incorporation or bylaws, change the board of directors, or borrow money in excess of a certain amount.

4. Antidilution
   

When VCs invest, they buy shares at a certain price. They typically include an “antidilution” provision to protect themselves from share sales via investment at a lower price (including shares sold to them in the future). While almost all these deals have something called “weighted-average antidilution” (this gives them some downside protection), some deals will have “full-ratchet antidilution” (if shares are issued in the future at a lower price, the previous shares issued will be adjusted down to that same lower price).

5. Redemption rights

Venture capitalists invest with a 3- to 7-year time horizon on investments. After holding an investment for 5 years, they start to consider ways to get liquidity (e.g., sell their investment). The redemption rights clause in a financing agreement gives them some leverage to start to agitate for liquidity, especially if the company is “sort of successful” (e.g., generating some profits but not growing very fast).

6. Vesting
   

VCs want to make sure there is an incentive for the founder and employees to stay at a company after their investment. The primary tool for this is through a vesting agreement where stock and options will “vest” over 4 years. This means that you have to be around for 4 years to own all of your stock or options. If you leave the company earlier, the vesting formula applies and you only get a percentage of your stock.

7. Information rights

When they invest, they typically end up with a minority (less than 50%) interest, but they want to make sure that they have a contractual right to be informed of the activities at the company. “Information rights” provides this capability and is a standard feature in venture capital deals.

8. Registration rights

One of the possible successful outcomes of a venture-backed company is an IPO. Venture capitalists fantasize about this when they make their initial investment and correspondingly load up the terms associated with registering their stock in and around an IPO. These terms rarely come into play, both because the IPO is a rare event for a start-up and because most of them get renegotiated in the IPO anyway. Our advice to entrepreneurs: don’t worry about these too much.

9. Right of first refusal

When venture capitalists make an initial investment in a company, they almost always expect to make investments again in the company. They want to reserve the “right of first refusal” to be able to participate at least up to the level that maintains their ownership in later financings.

10. No-shop agreement

Once a venture capitalist wants to invest in your company, you negotiate a term sheet that lays out the terms listed here, among others. This term sheet is simply an outline of the deal; you still have work to do to draft the definitive agreements, have the venture capitalist complete due diligence, and close the financing. During the period between the signing of the term sheet and closing the financing, the VC will almost always want the company to sign a no-shop provision. This reinforces the handshake that says “Okay, let’s get a deal done—no more fooling around looking for a better/different one.” In all cases, bind the no-shop by a time period; usually 45 to 60 days is plenty.

Source: Brad Feld has been an early-stage investor and entrepreneur since 1987. The best way to contact Brad is by email at brad@feld.com.