Nowadays it´s more than usual to read, hear or discuss among peers about finance. More than ever before, some finance jargon is being used by many non-finance professionals... but, do you really understand what are you saying?
On this blog post, I will try to explain and demystify many of the most terminology used by finance professionals in the field of entrepreneurship.
Feel free to write any comment below for further clarification! Enjoy.
Shares
What is the difference between authorized shares and issued shares?
Authorized shares are the maximum number of shares a corporation can legally create. This amount is written into the articles of incorporation (such as company charter) and includes the sum of issued and un-issued shares of both common and preferred stock. Shareholders can vote to increase this number if needed. Issued shares are shares that the company has created. The total number of issued shares is the sum of outstanding shares (shares owned by the public) and treasury shares (shares owned by the company).
What does “fully diluted” mean?
The term “fully diluted” means calculating price-per-share based on outstanding shares including all diluted securities that may not have been exercised yet. This should include all stock issued to common stockholders as well as all stock options, warrants, and convertible preferred stock or convertible debt that were not yet exercised, but were guaranteed to employees and other interested parties. In the fully diluted case, investors assume all options and warrants are exercised (although this may never actually happen). Companies typically release financials in terms of fully diluted shares outstanding.
What is participating preferred stock?
Participating preferred stock is a type of preferred stock that can become eligible for additional dividends in addition to the normally specified rate. Participating preferred stock dividends are paid before the common stock dividends and holders are given precedence to common stockholders in the case of liquidation.
Valuation
Which is more important pre-money valuation or post-money valuation?
Both pre-money valuation and post-money are ways to value a company. Pre-money valuation is the company’s value prior to receiving the current round of funding, while post-money valuation is the company’s value after receiving the latest round of funding. Both valuations are important: pre-money valuation and dilution of ownership is important when raising capital, since investors will use this to determine how much equity should be provided in return for the cash invested. Meanwhile, post-money valuation represents current ownership percentage. Pre-money + cash raised in current round of financing = post-money.
Liquidation
What is a “Liquidation Event?” What is a “Deemed Liquidation Event?” Why / when is each relevant?
Broadly speaking, both liquidation events and deemed liquidation events turn equity into cash. A true liquidation occurs when a business is winding up and all assets are sold with proceeds going to creditors and investors. Investors with liquidation preference are given priority over common shareholders, and can also be given a premium amount greater than their investment. Deemed liquidations are events in the preferred stock terms that are treated as liquidation events and trigger liquidation preference. Typical deemed liquidations include: mergers, sales, and initial public offerings. If these events are not deemed liquidations, investors are not able to cash out their investments and continue to hold their shares in the new corporation. Liquidation preference is a feature of preferred stock.
Dilution
What is the difference between weighted average and full ratchet anti-dilution protection? Which is better?
Anti-dilution provisions refers to options or convertible securities that protect investors from dilution due to stock being issued at a later time at a lower price than the investors initially paid. Full ratchet anti-dilution protection ensures that if a share of stock is issued at a lower price in a later round of financing, then the conversion price of existing preferred shares is automatically reduced to the lower price (ie, if a preferred investor buys in for $1/sh in the first round, and a later round issues at $0.5/sh, each preferred share converts to 2 common shares). This is extremely powerful for VCs as they are receiving more shares in the next round of financing without putting in more cash; and potentially extremely harmful for entrepreneurs (or common stock holders) whose equity is diluted.
Weighted average anti-dilution protection is similar but instead reduces the conversion price by a factor that takes into account the number of shares or rights that are issued in the dilutive financing as well as the initial financing round (ie, the more shares issued, the greater the conversion price moves). This is called weighted average because the reduction amount is determined by a weighted average calculation of the amount of money raised by the company initially (at an associated price per share) and the amount of money raised by the company in subsequent dilutive financing where new money is being raised. One formula for this is CP2 = CP1 * (A+B) / (A+C), where CP2=Conversion price immediately after new issue, CP1= Conversion price immediately before new issue, A=Number of shares of common stock deemed outstanding immediately before new issue, B=Total consideration received by company with respect to new issue divided by CP1, C=Number of new shares of stock issued. While this type of protection is still powerful for VCs, it is to a lesser degree than full ratchet provisions are.
Which issuances of securities do not trigger anti-dilution protection?
Issuances of securities that do not trigger anti-dilution protection typically do not affect the total number of issued shares or the conversion from preferred to common shares. These include securities such as calls, puts and bonds, which do not change the underlying ownership structure of the company, ensuring that none of the parties is at risk of dilution. Securities that do change the underlying ownership structure such as warrants can be written into the term sheet as exemptions to anti-dilution protection.
Investing & Rights
What is a pay-to-play provision? Who benefits from it?
A pay-to-play provision is issued by companies to incentivize investors to finance a specified percentage for future funding rounds. Investors that decide not to participate are in turn punished by losing certain preferential rights such as anti-dilution or liquidation as outlined for that round. These provisions are typically important protection for the company.
What are representations and warranties? What is indemnification? When should founders provide indemnification for representations and warranties?
Representations and warranties are a portion at the end of an insurance document that the applicant needs to sign, declaring that all personal information provided is true and accurate and provides protections in case of contract breach. Representations are what is stated by the applicant on the form (questionnaire, personal information, documents provided) while warranties are impositions by the insurance company to make sure their risk level doesn’t increase due to factors outside of their control. Warranties are often what allow the insurance company to reject a claim, similar to a covenant on the contract. For example, the contract may state that no C-level executives can be hired without board approval and if the CEO violates that, he has broken the investment contract which can lead to punitive damages. Indemnification is the process of protecting both parties from loss or damages and creating an agreeance method in the case of early termination of the sale, contract, etc. An example is when a swap is truncated and termination payments are calculated.
Indemnification is an obligation to cover losses of the other party if your party has caused harm or loss for the other party. Founders should provide indemnification depending on relationship with the VC and VCs can request stringent indemnification including taking the founder’s shares, equity or even personal property to shift the risk and increase accountability for the founders. Founders should be willing to provide indemnification against representation and warranties only up to their equity and in early stage start ups, they should also limit what representations are included (i.e. they may not want to include lack of hitting projected revenue numbers as a potential contract breach).
What is a demand registration right? What is a piggyback registration right?
A demand registration right allows investors to require a company to register shares of the company as common stock so that investors can sell their shares, and is essentially the right to demand an IPO. Piggyback registration rights allow an investor the right to register shares of the company as common stock for sale, but unlike demand registration they cannot force a company to IPO or begin the process, only piggyback once shares are beginning to be registered for sale.
What is a lock-up agreement?
A lock-up agreement is an agreement or provision written into a contract, between trading insiders and the underwriting company, preventing insiders from trading or selling stocks for a set time period (usually 6 months, but up to 36 months). It is created to ensure stability in stock price for the first few months of trading or impending large public announcements in senior level management or organizational changes.
Why should investors have information and inspection rights? Should investors have the right to receive audited financial statements?
Investors should have information and inspection rights to allow for open and informed discussion between stockholders and a clear understanding of the entire financial landscape when making their decisions. Investors must provide the reason for the information request (unless it is simply looking at stockholder’s list and ledger) and use only the pertinent documents to complete the specified purpose. Whether or not investors have the right to receive audited financial statements depends on who is paying for the audit and the use case for audited vs. unaudited statements. If the purpose is for an investor’s internal financial reporting that must be audited, the investor should incur the cost associated with it. However, if the investor provides another reason that the court accepts as valid (ie, for doubting the unaudited financial statements), the cost of the audit is up for discussion.
What is a pre-emptive right? Should all stockholders have a pre-emptive right?
A pre-emptive right is a term written into the contract allowing certain stockholders to purchase more shares prior to an initial public offering. Not all stockholders should have a pre-emptive right as it is usually reserved for those with significant equity, have provided significant guidance along the way, or are preferred stockholders.
What is the most important corporate action an investor should have the right to approve?
For directors and investors, one of the crucial decisions is around authorizing additional shares because it impacts dilution of the company and equity ownership. From a management perspective, another crucial decision is change in company leadership, whether it is transitioning a founder out of a leadership role or hiring a C-suite executive who will help shape the culture and drive the organization forward.
What actions are precluded by a non-competition and non-solicitation agreement? What is the shortest / longest period of time a founder should agree not to compete and solicit?
A non-competition agreement precludes an individual from competing against or working in the same industry, role, and/or geography for a specified amount of time. A non-solicitation agreement bars a former employee from soliciting their former employer’s clients, and, in some cases, complementors. Non-competition and non-solicitation agreements typically have a 1 year agreement, though state laws allow up to 2 years. Certain states (California included) do not allow non-competition agreements (source Investor’s Rights Agreement doc).
What is a right of first refusal? Co-sale right? Tag-along right? Drag-along right?
The right of first refusal gives an entity the opportunity to enter into a business transaction or contract with another entity before anyone else. In that sense, the right of first refusal is similar to having a call option on an asset which the entity has the opportunity to buy. The owner of the asset is free to open the bidding up to other interested parties if the holder of the right of first refusal is not interested on exercising it.
A co-sale right gives an investor the right to sell its shares on the same terms that founders sell their shares to a third party investor. It prevents founders from jumping ship after a major investment made in the company.
Similar to a co-sale right, if the majority shareholder sells his stake, a tag-along right ensures that minority holders have the right to join the deal and sell their stake at the same terms and conditions applied to the majority shareholder. This right protects minority shareholders.
On the other hand, a drag-alone right enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the terms and conditions as any other seller.
Redemption Rights
What is a redemption right and when is it helpful to the corporation / start-up company?
If an investor has redemption rights (which is another feature of preferred stock), they are able to force a company to repurchase the investor’s shares after an allotted amount of time for a predetermined price per share, similar to a put. Redemption rights are typically not favorable for corporations or startups and are not usually exercised by investors.
However, redemption rights could be helpful to a corporation if the founders and investors have different views of the company’s performance or mission. Investors will invoke redemption rights if they believe the company has stagnated and lacks an exit. If the company believes the opposite, that it has a clear path forward, this becomes a stock buyback at an attractive price. Redemption rights are also a motivation for the corporation and start-up to meet performance and financial targets.
Vesting
What is vesting? What is a typical vesting schedule? Should founders agree to subject their shares to a vesting schedule?
Vesting is the process by which certain employees accrue the “non-forfeitable” rights of full ownership over stock (or other type of incentives) during a specific time period or completion of goals. It is traditionally implemented using a vesting schedule set up by the company after which employees acquire the complete ownership of the asset.
A typical vesting schedule considering 100 restricted stock units as part of an annual bonus with the intention of retaining an employee for 4 years can be like this: ¼ at the of the first year, ¼ at the end of year two, ¼ at the end of year three and ¼ at the end of year four. If the employee leaves the company after year three, only ¾ of the shares would be vested while the other 25 are forfeited.
Founders should agree to subject their shares to a vesting schedule in order to promote the “earning” of the future work specially needed for growing the company.
No-Shop
What is a no-shop clause? When should a corporation / start-up company agree to a no-shop clause?
A no-shop clause is a type of clause made between a potential seller and a buyer with the intent of preventing any solicitation from the seller to any other party for purchasing proposals once a letter of intent has been signed. Typically these clauses have effect for a limited period of time.
From the potential buyer’s point of view a no-shop clause can be very useful because it prevents the seller from looking for other buyers. However, from the point of view of the seller, the shorter the time this clause is in place, the better in order to avoid potential risks of encountering a buyer who walks away during the period.
A start-up/corporation should agree to a no-shop clause when the likelihood and value of the offer are high enough for their interests (since of the nature of the clause which prevents looking for other buyers). In this sense, the traditional use of these clauses are during the period of due diligence.
Board
What is the optimum number of directors for a board of directors?
There is no standard optimum for the number of directors for a board of directors. The minimum number for every board is at least three members, and while there is no set maximum, too many board members can result in inefficiencies and lack of meaningful participation by all members. There are a number of different factors that should be considered when determining the appropriate size for a Board, including cooperation between members, complexity of the business, and size of the company (typically board size grows as the company grows). Many analysts believe seven is the optimal number of directors for efficient decision making and financial/business performance and typically all boards should have an odd number of members.
Have your heard more financial jargon that would like help? let me know and in a new post I will try to explain it to you!
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