THE FUNDING DICTIONARY
FOUNDERS' PREP MEETING
There are many terms you want to familiarize with before starting a negotiation with potential investors: here you can find a short summary of the specific vocabulary of the funding process. This is a list we share with our founders before diving into negotiations. You can download our Founders’ Prep Meeting Pdf here:
HEAD OF TERMS / LETTER OF INTENT / MEMORANDUM OF UNDERSTANDING
The head of terms, or term sheet, outlines the key financial and other terms of a proposed investment such as the amount of money to be invested, the form of funding and deal structure, the valuation of the company and the key corporate governance and investor protection principles to set expectations for the final Investment Agreement. Investors, if interested, will send forward a proposal in the form of a draft term sheet. Once agreed by all parties, the Term Sheet is used as a basis by both parties lawyers for drafting the investment documents while in the meantime investors undertake due diligence of the company. Provisions of a Term Sheet are not usually legally binding except for the confidentiality clause, and the exclusivity on the deal for a certain period of time and agreement on who is bearing legal, due diligence and other costs. Usually, the Term Sheet is signed by all shareholders of the company and the potential Investors.
THE INVESTMENT AGREEMENT
The Investment Agreement is the contract stating all the rights and responsibilities of both parties and is the document that officially marks the closure of the deal. The Investment Agreement is a binding contract usually fairly long and describes in detail the conditions that have to be met before the investment, process of the investment and responsibilities and warranties that parties assume after the investment.
CAP TABLE (CAPITALISATION TABLE)
The Capitalisation Table is a table that summarizes the shareholder structure of the company. The Cap Table includes the Founders’ and Investors‘ shares and may include convertible notes and employee stock options.
Some early investors prefer structuring their investment as a loan that is converted to equity at the next round of the investment (qualifying round) with an agreed discount for the convertible note holder for taking an earlier risk. In this way, parties do not have to agree to a valuation just yet. Usually, investors agree on a valuation cap that is the maximum valuation at which the loan would be converted to equity.
MILESTONES AND TRANCHING
Investors may split an investment in a few payments called tranches, subject to various technical and/or commercial milestones being met. In case of failure to meet a milestone investors may renegotiate the deal or refuse to transfer any subsequent tranches. Tranching is used by investors to minimise the risks in cases where the company substantially deviates from the agreed plan. Investors may use a ratchet to adjust their shareholdings depending on either the company’s performance or the level of returns on an exit.
A list of conditions to be satisfied before the investment is disbursed to the company. Conditions precedent may include but is not limited to adopting new articles of association, adopting certain shareholders’ decisions, signing new employment agreements with key employees, having the investor’s board nominee(s) in place, and other conditions.
Shareholders warrant that the investors are provided with complete and accurate information on the current condition of the company and its past history so that they can evaluate the company prior to investing. Usually there is a detailed list of particular warranties and the Investment Agreement sets out limits and procedures how to remedy and deal with the warranty claims.
Document by the company and founding shareholders to inform investors about any exceptions or carve-outs from the warranties. Signing the disclosure letter is usually a completion condition of an investment. If a matter is referred to in the disclosure letter the investors are deemed to have notice of it and will not then be able to claim for breach of any warranty in respect of the disclosed matter(s). In some case Investor might ask founding shareholders to indemnify against some of the risks uncovered in the disclosure letter.
Usually investors are looking for veto rights on certain decisions like new share issue, issuing share options, paying dividends, entering voluntary winding-up, buying shares in other companies, increasing the remuneration of founders and so on. Usually, veto rights are given only to investors acquiring significant minority and may lapse at the next fundraising rounds.
Special rights in the event of liquidation or exit for the investor to receive an amount of the proceeds before anyone else, usually in an amount of their investment or with some fixed annual interest.
Preference shares, or preferred shares, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. At the same time, if the company enters a liquidation event, preferred stockholders are entitled to be paid from company assets before common stockholders. Preference shares are usually issued with no voting rights. A key feature of preference shares is that they are entitled to a fixed rate dividend. This dividend is paid before any ordinary shareholders receive a dividend, putting preference shareholders first in line to a share of profits. However, since preference share dividends are paid at a fixed rate, this means that they are not entitled to receive a share in excess profits (above their fixed dividend), unlike ordinary shareholders.
CONVERTIBLE PREFERRED SHARES
Convertible Preferred Shares are shares that can be converted into ordinary shares according to a pre-arranged formula. The conversion rate sets the ratio of how many common shares can be converted from preferred shares.
PARTICIPATING PREFERRED SHARES
Participating preferred shares receive an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event and, in addition, they participate on an “as converted to common stock” basis with the common stock in the distribution of the remaining assets.
NON-PARTICIPATING PREFERRED SHARES
Non-participating preferred shares typically receive an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event. Holders of common stock then receive the remaining assets. If holders of common stock would receive more per share than holders of preferred stock upon a sale or liquidation (typically where the company is being sold at a high valuation), then holders of preferred stock should convert their shares into common stock and give up their preference in exchange for the right to share pro rata in the total liquidation proceeds.
PARTICIPATING VS. NON-PARTICIPATING
Participating preferred stock is favoured by investors because they will receive a preferential return over both low and high exit transaction values. An argument in favour of participating preferred stock is that if a company is sold shortly after the investment, the founders may receive a significant return on their investment (since they have typically paid a much lower price than holders of preferred stock) while the holders of preferred stock may receive little or no return on their investment, particularly where the liquidation preference is 1x. A counter-argument is that if a company is sold for a high price, the holders of preferred stock have no incentive to convert their shares into common stock and, as a result, are able to “double-dip” into the proceeds by receiving both the preference amount and the participation proceeds. Thus, one compromise is a participating preferred with a cap.
PARTICIPATING PREFERRED SHARES WITH CAP
A cap on participation limits the amount received by the preferred stock to a fixed amount. The cap is typically fixed as a multiple of the original investment, such as 2x or 3x. Once holders of preferred stock have received the cap amount, they will stop participating in distributions with the common stock.
Rights to protect the value of an investor’s stake in the company if new shares are issued in the future at a valuation which is lower than that at which the investor originally invested. This protection effects the issue of a number of new shares which the investor will receive, for no or minimal cost, to offset the dilutive effect of the new issue of cheaper shares.
FULL RATCHET ANTI-DILUTION PROVISION
The full ratchet provision is an anti-dilution provision designed to protect the interests of early investors. The provision guarantees that if an equity investment decreases the share price, in a subsequent funding round, to a price that is lower than what the investor paid for, its investment should be adjusted to match the new price. It prevents the original shareholders’ stake from being diluted by the issue of new shares for new shareholders to subscribe. The shareholders maintain their stake without incurring additional funds. It is achieved by reducing the conversion price to allow investors to convert their preferred stocks into a given percentage of the common stock that maintains their original percentage of ownership of the company. Including a full ratchet provision in the company’s charter documents will deter new investors from investing in the company. The company will appear less attractive to invest in since the anti-dilution only protects the current shareholders and puts the burden of dilution on the new shareholders.
WEIGHTED AVERAGE ANTI-DILUTION PROVISION
Similar to the full ratchet provision with the notable difference that the investors’ conversion price is reduced to a lower number which takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued, then the conversion price does not move much; if many shares are issued then the price moves accordingly.
Where the company issues new shares, investors will require the right to maintain at least their percentage stake in the company by participating in the new offering up to the amount of its pro-rata shareholding, under the same terms and conditions as other participating investors.
The right assures that if a majority shareholder or shareholders sell their stake, minority holders have the right to join the deal and sell their stake on the same terms and conditions as would apply to the selling majority shareholder(s).
The right assures that if the majority shareholder(s) or investors sell their stake, minority holders are forced to join the deal. A drag-along right gives the investor the right to force the other shareholders to exit. These rights are very essential when an exit is made to a strategic investor who is willing to acquire 100% of the company. A successful exit is a primary reason why VC/PE investors invest in the first place, thus drag along rights is one of the most important rights for a typical venture investor.
Investors require the company to provide them with a regular business update concerning its financial condition and business progress, as well as have a general right to visit the company and examine its documents and accounts. Reports are usually either monthly or quarterly and reporting templates are attached to the Investment Agreement.
If the management team and founders were to leave the company to create or work for a competitor, this could significantly affect the company’s value. Investors normally require that non-compete clauses be included in the Investment Agreement as well as in the employment agreements with particular key employees of the company.
EMPLOYEE SHARE OPTIONS
Investors may require to set aside 5%-15% of the company’s share capital for an employee option pool so that the company, with investor consent, can issue new shares/options to new and existing employees as part of their long-term motivation and remuneration.
Usually, options to employees are given with a condition that they will stay with the Company for an agreed period of time – the vesting period. If a person leaves before vesting period has lapsed, respective employee options are nullified.
Usually, founding shareholders are defined as key people in the Investment Agreement. Key people are significant shareholders and/or important employees and if they were to leave the company that would have an adverse effect on business operations, and on the value of the company and future fund-raising prospects. Therefore investors require commitment from the key people to stay with the company for a certain period and may require Good Leaver and Bad Leaver clauses.
Often is defined as a key person who resigns within a short period of time, or who breaches their terms of employment or the shareholders’ agreement. Usually, bad leavers will be required to sell back their shares to other shareholders for a nominal value.
Unlike under incentives such as an option to buy shares, or a clause that vests shares, the person is already a shareholder with the benefits that ownership confers. The reward of being a Good Leaver is the unconditional continuation of ownership after the occurrence of an event, or retained ownership if the employee leaves the company beforehand but under “good” circumstances.