F|R Crib Sheet: The Term Sheet Glossary

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