Funding Column

 

Making Sense of Venture Term Sheets

 

By Chris Anderson

 

Be prepared — investors use a lot of unfamiliar terms. A little homework will help you speak and understand their lingo, and to know which terms are likely to have the most significant impact on the founding stockholders and their investments. The following is a simplified key to understanding a few of the new terms that might start swirling around as you look to raise needed equity capital.

 

Common stock: The basic ownership unit in a corporation. The holders typically have voting rights and the right to receive the net assets of the corporation upon dissolution, subject to any preferential rights granted to holders of preferred stock.

 

Preferred stock: Consists of a group of shares that are given certain rights and preferences regarding matters such as voting, dividends, liquidation preferences, conversion rights and anti-dilution protections. Investors typically like preferred stock because of the rights and preferences that can be built into the shares.

 

Pre-money valuation: The value established for the company immediately prior to giving effect to
the financing.

 

Post-money valuation: Refers to the state of affairs immediately after completing the financing and is simply the pre-money valuation plus the amount of the investment. So when a valuation figure comes up, any given number is more attractive as a pre-money valuation because the post-money valuation will by definition be higher, and the purchase price per share will be based on the pre-money valuation.

 

Liquidation preference: The amount the purchasers of preferred stock are entitled to receive before the holders of common stock get anything. It is typically calculated in reference to the purchase price paid for the preferred stock. The basic right would be a return of that investment (plus any dividend that is owed). This provision will have the most direct impact on the return ultimately realized by the founders when the proceeds of a liquidation transaction are divided.

 

Participation rights: A participation right means that after the preferred investors get their preferential payment, they also share in distributions made to the holders of common stock — typically on a pro-rata basis. A company may negotiate for a cap on what the holders of preferred stock may receive in a liquidating transaction.

 

Anti-dilution protections: A mechanism to protect the investors from having overestimated the value of the company, or a downturn in company fortunes. It is implemented by changing the conversion rate of the preferred stock so the investor gets more shares on conversion if the company issues shares to others at a price below what the investor paid. They can be in the form of either a "direct ratchet" or "full ratchet" adjustment — with the investor treated as if he or she paid the lower price, or a "weighted average formula" adjustment — with the investor benefiting from a weighted average adjustment to the conversion price, based on the number of shares issued at the lower price.

 

Pay-to-play: Extends the benefit of the full anti-dilution protection and the right to participate in future offerings only to investors who participate in the lower-price offering.

 

Chris Anderson, a partner at Ballard Spahr Andrews & Ingersoll LLP, practices primarily in the areas of business, securities and international law. Mr. Anderson can be reached at andersonc@ballardspahr.com.

 

Launch - Fall & Winter 2008 (Special Print Edition)