To help those legalese challenged, we took the 10 most common terms found in a typical Venture Capital (VC) term sheet and tried to explain them very simply. Many of these terms can take on many different meanings, though, so we tried to use the most typical definitions.
When reading this, keep in mind one simple concept – Common Stock (CS) is typically owned by the founders/employees of a Company and the VCs typically own Preferred Stock (PS). It is called “Preferred” Stock because there are many preferences over “Common” Stock. The terms below all pertain to PS.
Series A Convertible Redeemable Participating Preferred Stock (PS) – a real mouthful. Let’s break this down:
- Series A – the first round of equity financing by VCs. The next, or second round, will be Series B, and so on.
- Convertible – these PS shares convert to Common Stock (CS), usually on a one-to-one basis. If you own 100 shares of PS, you can convert these to at least 100 shares on CS (usually only done when the Company goes IPO).
- Redeemable – PS holders can force the Company to buy back their PS for the money they invested plus dividends. This usually does not kick in until about five years from closing.
- Participating – upon the Company being acquired (not an IPO), the first money paid by the acquirer is paid to the PS holders (see Liquidation Preference below) to recover their investment plus dividends. Then they “participate” in the remaining money based on their stock ownership % (i.e., they get two bites of the apple).
Liquidation Preference – if the Company is sold, the PS holders get back the amount they invested in the Company plus dividends first. Then they “participate” in the remaining proceeds through their PS ownership. 1x liquidation preference means they get back one times their investment, 2x means they get back twice their investment, etc.
Anti-dilution – the PS holders cannot get diluted. If they bought 1M shares for $2 per share and the Company later sells shares for less than $2 per share, say $1 per share, the PS holders get additional shares (see ratchet for the amount of shares they get).
Ratchet (i.e., full-ratchet, partial ratchet) – if anti-dilution kicks in and there is a full ratchet, the PS holders in the example above would now effectively own 2M shares ($2M invested divided by $1 per share – rather than divided by $2). If there is a partial ratchet, the amount of shares the PS would effectively own is a weighted average function based on the amount of stock purchased and the total amount of shares outstanding.
Drag-along (or Bring Along) – forces CS holders to vote for an acquisition that has been approved by the PS holders.
Right of First Refusal – if the Company does a new equity round, the current PS holders have the right (but not the obligation) to participate in the new round to maintain their current equity ownership %.
Pay-to-Play – this typically kicks in the second and subsequent rounds in deals where there are more than one VC. It forces all the present VCs to participate in the new round based on their current pro rata share. If not, they get punished. The punishment can take the form of losing certain rights, such as liquidation preferences, anti-dilution, voting rights, or even forcing their current PS to convert to CS.
Now, before you jump to the conclusion that the VCs have a much better deal than the founders/employees, remember that in most of these startup Companies, the VCs are the only shareholders who invested real cash and because of the inherent risk with all startups, they deserve the potential for a high rate of return on these funds.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.