Venture Capital Term Sheet Glossary
Following are some of the terms an entrepreneur may find on a term sheet from a venture capital firm.
Provisions that protect the investor from dilution that would results if a company issues new shares at a price below the price per share paid by the investor. Two common forms of anti-dilution provisions are (1) Full Ratchet and (2) Weighted Average. A Full Ratchet has the effect of re-pricing all of the investor’s shares at the lower share price, even if only 1 new share was issued at the lower price. Weighted Average is a formula that in addition to the lower price also takes into account the number of new shares issued at the lower price as a percentage of all issued and outstanding shares. These adjustments are in addition to proportional adjustments that can occur upon stock splits, stock dividends, reverse stock splits or other similar recapitalizations of the capital stock of a company
The investor’s right to convert to common stock, at its option, or automatically upon the vote of a majority of preferred stockholders or a qualified IPO - based on a ratio (initially 1 for 1, as then adjusted).
- No Preferential Dividend: The holders of the preferred stock have a right to participate, pro rata on an as-converted to common stock basis, with holders of common stock, when and if dividends are declared by the Company.
- Non-Cumulative Preferential Dividend: Before the company can pay any dividends on its common stock in any particular year, it must pay dividends scheduled for the preferred stockholders for such year (i.e., 8% on the initial purchase price of such preferred stock). If not declared in any year, these dividends go away.
- Cumulative Preferential Dividend: Before the company can pay any dividends on its common stock in any particular year, it must pay all accrued but unpaid dividends for the preferred stockholders whether or not these dividends were declared. Typically in these instances unpaid dividends are subject to compounding so that after 3 years of unpaid dividends the holder of stock bought for $1.00 with a dividend rate of 8% would not be entitled to $1.24 but instead would be entitled to $1.26 per share before anything is payable on the common stock. Also, unlike other accrued but undeclared dividends, cumulative dividends are often added to a preferred stock’s liquidation preference in the event of any liquidation event.
Drag Along Rights
The right of a pre-requisite number (i.e. majority) of the shareholders, who agree on a proposed sale of the company or its assets to require the remaining shareholders to participate in the transaction.
Right to financial and other information relating to the company, such as quarterly and annual income statements, balance sheets, cash flow statements. Information could also include budgets and budget reconciliations, a dashboard of key metrics as well as notices of material litigation.
A mechanism by which the investor seeks to recoup its original investment or a multiple thereof, plus any declared and unpaid dividends, before there are any distributions to the common stockholders. This usually is defined to occur upon a liquidation, dissolution or winding up of the company, a merger, or a sale of the company or its assets.
- Participating Liquidation Preference: The investor receives further distributions along with the common stockholders after receiving the Liquidation Preference.
- Non-Participating Preferred Liquidation Preference: Limits the investor to its liquidation preference.
Click on “You Finally Received a Venture Capital Term Sheet” for an example.
The investor’s pro rata right, based on percentage equity ownership, to participate in subsequent financings. If the investor owns 20% of Company before the subsequent financing, it typically has the right to take at least 20% of the subsequent financing.
A security that represents an equity ownership interest in a corporation. Preferred stock is a form of stock that has any rights or preferences (priorities) over common stock, which can include priorities related to the assets and profits of a company, special voting rights or protective provisions that limit actions that can be taken by the company without preferred shareholder approval.
Price Per Share on a Fully-Diluted Pre-Money Basis
The share price calculation includes the total number of shares then outstanding and that would be outstanding if all convertible notes, warrants and all stock options authorized for issuance were issued, exercised and/or exchanged for common stock. This is ordinarily the value a VC firm gives a business before taking into account new money it plans to invest and is often increased by any increase in the option pool to be required by their investment. Click on “You Finally Received a Venture Capital Term Sheet” for an example.
Provisions that require the approval of a majority (or supermajority) of a series (or multiple series) of preferred shareholders, before certain actions can be taken by the company. Some examples of protective provisions include amending the certificate of incorporation and bylaws, a repurchase or redemption of shares of stock, a material change in the nature of the company’s business, a change the size of the board of directors, the issuance of a superior class of securities, and the liquidation, dissolution, and winding up of the company. Typically the preferred stock (or series) will approve separately and then may vote with the common stock as a single class on any matter requiring common stock vote except as otherwise specifically required by the certificate of incorporation or applicable law.
The investor’s right to require the company redeem its shares at a point in the future (i.e. 5 years) normally at the greater of the purchase price or the FMV (which can be determined by a formula, the Board, or an independent appraisal of the business).
The investor’s right to force the company, after a period of time, to register the investor’s shares and offer them publicly, or to include them as part of a registration and public offering made by the Company or a Management Stockholder.
Rights of First Refusal / Co-Sale Rights
In the event a common shareholder has a bona fide offer to buy its common stock, the preferred shareholders have a pro rata right to either acquire those shares on the same terms, or to sell their shares, on an as converted basis, as part of such sale of the common shares.
Right of the preferred shareholder to vote with the holders of common shares (except as limited by law), on as converted basis, in addition to specific voting rights granted to the preferred shareholders. Preferred shareholders typically have the right to vote as a separate class for one or more directors as well as with respect to Protective Provisions.
The attorneys in the Business & Tax practice at Lerch, Early & Brewer in Bethesda, Maryland provide a range of services for emerging businesses, including formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. For more information about how to review a term sheet, formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. For more information about how to review a term sheet, contact Lerch Early's Business & Tax department at (301) 986-1300 or visit the Business & Tax practice page.