Investment Terminology For Beginners: What Founders Need To Know
It goes without saying that you probably started your startup because you wanted to solve a problem, not because you wanted to learn a new language. But that’s precisely what comes with the territory––learning the language of investors and term sheets.
Fortunately, you’re not alone. Our deal desk team helps complete roughly 220 transactions per year. They understand the language of valuations, vestings, and so on like the back of their hand. In other words, we’re here to help.
In conjunction with our exclusive Inside The Minds of European VCs report, we’ve taken the opportunity to dive deeper into some of the most important terminology for founders to understand. Consider this a Lonely Planet-style phrasebook that you can bookmark and come back to whenever you need it.
The investment amount is the amount of money that an investor invests into a company, be it by way of an equity, SAFE or convertible investment.
The total investment amount of a financing round (or “round size”) is necessary for founders and existing shareholders to understand their dilution by a financing round and therefore one of the terms fundamentally influencing the economics of a financing round.
The valuation of a company is the economic value attributed to the company and its business.
In the present context, the most relevant valuation is the pre-money valuation, which is the value of a startup before a financing round, i.e. before new cash is injected. There are various methods for deriving a pre-money valuation. However, since there is no single source of truth for valuing early-stage companies and because of its importance to financing rounds (see below), the pre-money valuation of a startup is usually to a considerable extent the result of negotiations between founders and investors.
The pre-money valuation of a company forms the basis of the economic terms of an equity financing round because the price per share is derived from it. Consequently, the pre-money valuation determines how many shares in the company an investor will receive in exchange for their investment amount. Therefore, the pre-money valuation in combination with the investment amount is the most important terms of an equity financing round.
The post-money valuation of a startup is its pre-money valuation plus the newly injected cash and is mainly a starting point for deriving a new pre-money valuation for future financing rounds.
The founders are typically also a startup’s managing directors and therefore its most valuable asset and for many investors the main reason for investing. Therefore, the financing contracts will always contain provisions to ensure the (wo)manpower of, and adequate financial incentives for, the founders.
One of them is a dedication obligation of the founders, under which they agree to spend all or most of their professional time on the company.
Another one is the so-called founder vesting, under which the founders essentially have to “earn” the right to keep their shareholding in the company. Depending on the jurisdiction, this is structured in various different ways, but the fundamental principle is usually the same: The longer the founders dedicate their professional life to the company, the more of their shares in the company “vest” and are therefore the unrestricted legal and beneficial ownership of the founder; however, should the founder leave the company within the vesting period, they have to “give up” a corresponding portion of their shares.
This means that with a market standard monthly or quarterly vesting over a period of four years, if the founder leaves after two years, they would have to give up 50 percent of their shares. If they leave after the four year vesting period has lapsed, they get to keep all of their shares because they are all fully vested.
The vesting is typically also subject to a one year cliff, which means that the founder does not vest any shares during the first year, but after the first year has lapsed, they vest the entire portion of their shares attributable to this first year (e.g. in the above example of a four year vesting, this would be 25 percent of their shares).
Note that the employee options under an ESOP / PSOP / VSOP are also subject to a (typically) four-year vesting with a one year cliff, which in this case means that the options become exercisable.
In addition to paying their employees salaries, startups typically reserve a “pool” of share options which are granted to employees as an additional part of their compensation package (“employee share option pool” - “ESOP”).
The option holders have the right to exercise the options after a certain period of time (called the “vesting period” - see above), upon which they will become shareholders in the company. As such, they will be able to sell their shares in an exit of the company.
This direct participation in the company’s value is, firstly, a possibility for a company to attract top talent, and secondly, an incentive for employees to contribute to the company’s growth. For both reasons, professional investors will usually ask a startup to set up such an option pool.
In some countries, issuing shares to a potentially large number of employees imposes a significant administrative burden and costs on the company or employees. In these countries, virtual or phantom stock option plans (VSOPs / PSOPs) are more market standard. These are contractual agreements replicating the above mentioned economic participation of the employees in an exit scenario, without, however, granting them any shares in the company.
In the early stages, setting up an unallocated employee option pool of 10 percent of the company’s fully diluted share capital (or a PSOP/VSOP structure of equivalent value and size) is considered market standard; however, the size depends on the individual circumstances.
Most importantly though, employee incentive schemes have to be carefully structured in order to secure their most preferential tax treatment for employees. Investors and founders alike should therefore always make sure to seek expert tax advice.
Finally, note that option pools, whether virtual or not, impact the economics of a financing round, because they are typically included in the fully-diluted share capital of the company prior to the financing round. I.e. an investor calculating a share price for the financing round will treat the option pool as if a corresponding number of shares has already been issued, which leads to a lower price per share and therefore more dilution of the founders and existing shareholders by the financing round. Founders are therefore well advised to set up an option pool of a size that is large enough to attract the top talent they need to hire for the planned growth of the company, but small enough to not overly dilute them.
A liquidation preference is a fundamental economic term for VCs as it impacts the return investors will receive on an exit. In short, a liquidation preference means holders of preference shares (investors) participate in exit proceeds before any holders of ordinary or common shares (usually founders and employees).
There are two key features of a liquidation preference: (i) the multiple that applies and (ii) whether it’s a participating or non-participating liquidation preference.
The multiple is the amount the investor must be repaid (considering their initial investment) before holders of common or ordinary shares can participate in exit proceeds. By way of example, if an investor invested €2 million into a company in return for preference shares that carry a 1x non-participating liquidation preference (more on this below), and the company is sold for €3 million, the investor will be entitled to receive €2 million in the exit. The founders or other common shareholders in this example would then be distributed the remaining €1 million pro rata to their respective shareholding once the €2 million liquidation preference was satisfied.
A participating liquidation preference means the investor––in addition to recovering their investment in the company (or a multiple of it)––can also participate in the balance of proceeds distributed to the remaining shareholders. This allows investors to “double dip,” by both receiving their money back (first) and also getting a share of any surplus proceeds that are left after satisfying the investors’ liquidation preference.
Under a non-participating liquidation preference, the investor only recovers their investment in the company (or multiple of it). If remaining shareholders would receive more per share than the investor in this case, the investor can always elect to convert their shares (or be deemed to have converted their shares) into ordinary shares and participate pro-rata in the exit proceeds (and forfeit their non-participating liquidation preference).
The most common and market standard formulation of the liquidation preference we see in early-stage VC deals in Europe is a 1x non-participating liquidation preference. Requiring higher multiples, or “participating” liquidation preferences, reduces the potential value of equity, which is required to attract, retain and incentivise qualified and high-performing employees and management team members. Early-stage VCs also know that it’s highly likely additional rounds of funding will be raised before the company achieves an exit, so requiring a higher liquidation preference multiple at Seed or Series A sets a bad precedent for future rounds – future VCs could be inspired to stack an even higher preference multiple on top of the existing preference stack, which is bad news for everyone.
The liquidation preference is generally triggered by any liquidity or exit event, no matter how the exit is structured, most commonly including a share sale (change of control), asset sale (sale of substantially all assets) or a merger. VCs will usually also require dividend distributions (if any) to be paid out in accordance with the liquidation preferences (see below).
Liquidation Preference of 2x or greater
An investor with a 2x liquidation preference gets to double their original investment amount before any shareholder below them in the preference stack receives anything. In case of a “bad” exit, this could mean founders see no money in the exit, despite building the company for years for a below-market salary.
While the traditional 1x non-participating liquidation preference is still the norm in early-stage VC deals (even in the current market environment), more aggressive liquidation preferences have begun to find their way into term sheets for some growth-stage deals (Series B onwards). The highest liquidation preference multiples we have seen recently is 3x, although this has so far been an outlier.
Founders facing investors insisting on a higher multiple and/or a participating liquidation preference, could consider a third alternative to the non-participating or participating liquidation preferences discussed above – a capped participating liquidation preference. A capped participating liquidation preference means the investor recovers their investment amount (or a multiple of it) and participates in the balance of proceeds distributed to the remaining shareholders until a maximum amount (“cap”) is reached. Typically the cap is around 2 to 3x the investor’s investment amount. Once the cap is reached, the remaining proceeds are distributed only to common or remaining shareholders.
In the US context, preferred shares are said to have participation rights when they have a participating liquidation preference, as discussed above under “Liquidation Preference”. Participating liquidation preferences are currently not market standard in early-stage VC transactions in Europe.
Please see “Liquidation Preference” and “Liquidation Preference of 2x or greater” for more detail.
Dividends (and Cumulative Dividends)
Pursuant to company law, one of the fundamental rights of the shareholders is that they are entitled to the company’s profits. Therefore, (even though they will normally follow the recommendation of the management) they are typically competent to decide whether or not to pay out a company’s profits, such payment being called a “dividend”.
However, startups usually do not make any meaningful profits or, if they do, both the management and shareholders usually want the company to reinvest all of its profits into its growth. Hence, the shareholders of a startup usually do not decide to pay out dividends. In fact, it is typically a common understanding amongst all shareholders not to expect any dividend payments from a startup.
For the same reason, cumulative dividends - which are not discretionary, but must be paid to a certain class of preferred shareholders - are also not commonly seen in the early stages of a company, especially not in Europe.
Consequently, the corresponding provisions in the company’s articles of association are typically not a focus in the negotiations of a financing round. Note, however, that in the exceptional case of a dividend payment, such dividend should be subject to either the consent of a pre-defined investor majority (e.g. a majority of preference shares) or the liquidation preference of the investors (see above), which could otherwise be circumvented.
Anti-dilution rights protect investors from excessive dilution caused by the valuation of the company going down in the future (a so-called down-round). If a company issues additional shares to new investors in a future round at a price that is lower than the price paid by previous investors, previous investors with anti-dilution rights will have the right to receive additional shares for free (or for a nominal amount). This compensates investors for the excessive dilution caused by down-rounds or their “economic dilution”.
Exactly how many “free” shares investors should receive in a down-round depends on the type of anti-dilution clause. The three main approaches are broad-based weighted average anti-dilution protection, narrow-based weighted average anti-dilution protection and full-ratchet anti-dilution protection. Weighted average anti-dilution is fairer than full ratchet as it looks at the dilutive impact of the shares issued in a down-round across the company’s share capital. “Broad-based” is calculated by reference to the company’s fully diluted share capital (including issued share capital and also any outstanding rights to shares which may be exercised, e.g. options, warrants, convertibles), while “narrow-based” looks at the issued share capital only. Narrow-based is less favorable to founders compared to the broad-based alternative but is still preferable to full ratchet. Full ratchet anti-dilution is discussed further below.
The most common form of anti-dilution protection in Europe has so far been broad-based weighted average protection, which is also the most “founder-friendly.” In the current market environment, we are slowly seeing an increase in the use of narrow-based weighted average protection, but this has not yet become the market norm.
For a more detailed explanation of the different anti-dilution formulas, how these should be calculated and what each approach means for founders, see this article.
Full ratchet anti-dilution protection
Full ratchet protection is the most investor-friendly approach as it has the effect of putting the investor in the position they would have been in if they had subscribed for shares at the down-round price. The previous investors can essentially “re-price” their entire investment at the lower share price – which significantly dilutes existing shareholders and importantly, founders. As discussed under “Vesting” above, founders are a start-up’s most valuable asset and an investor’s key concern is making sure founders are properly incentivized in terms of their equity stake in the company. A founder suffering disproportionate dilution due to the strict enforcement of full-ratchet anti-dilution rights is generally in no one's (company, founders or investors) interests.
For this reason, full ratchet anti-dilution is uncommon and founders should consider the implications before giving these rights to an incoming investor. For a more detailed look at how full ratchet anti-dilution protection is calculated, see this article.
Pro Rata Rights
Pro rata rights (sometimes called pre-emption rights) give an investor the right – but not the obligation – to participate in future equity financing rounds in proportion to their pre-financing round shareholding. This means investors’ can maintain their percentage stake in the company and not be continuously diluted by future funding rounds.
By way of example, if a seed investor invests €1 million in a seed round at a €5 million pre-money valuation, and a total round size of €1.5 million, the investor will own 15 percent of the company. The next Series A round is a €5 million round at a pre-money valuation of €12 million. If the seed investor doesn’t participate, that investor will be diluted and only own 11 percent of the company post-round. If the investor does participate by exercising their pro rata right in full, an investment of approx. 769k, the investor will continue to own 15 percent of the company post-round.
Although pro rata rights protect investors against percentage dilution, pro rata rights should not be confused with anti-dilution protection. As illustrated by the example, an investor’s pro rata right is generally exercised at the same terms (same share price for the same newly issued class of shares) of the respective financing round. Anti-dilution protection, as discussed above, protects investors against economic dilution and allows investors to subscribe for additional shares for free or for a nominal sum. For a more detailed comparison of percentage dilution vs economic dilution, please click here.
Pro rata rights are a fundamental deal term most VC investors will not budge on – not only to protect against percentage dilution in the VC’s successful portfolio companies but also because often other rights (e.g. board seat or information rights) are tied to an investor holding a minimum percentage shareholding in the company. Having pro rata rights, therefore, provides a better guarantee the investor will not inadvertently lose other important rights along the way (unless they do not continue to invest in the company).
Although any early-stage VC’s ability to continue to exercise its pro rata right in full will lessen the later-stage (and expensive) a company becomes, VCs commonly require the right to transfer its pro rata rights to affiliated funds (i.e. other funds with the same fund manager or general partner as the initial investor). This allows those VCs which also have later-stage growth or opportunity funds to continue to invest in those “winners” that have become too late-stage and beyond the investment scope of the initial early-stage fund.
Board control relates to the question of what board composition the company has or will have post-closing and which interest group (founders or investors) has a majority of seats (votes) on the board and is, therefore, able to veto/control board decisions. Founders usually retain board control at seed stage, with a typical seed board composition to include two members appointed by founders and one member appointed by the lead (seed) investor. In later stages as the board grows, a balance is generally met in which investors and founders have equal representation on the board (or, if boards are controlled by investors they may be subject to some form of founder consent rights) and the board likely includes an independent industry expert.
The board composition also depends on the legal form of the board in the company’s local jurisdiction, and whether the local corporate governance rules call for a one-tier board (e.g. UK, US, Spain, certain Scandinavian countries) or a two-tier board (e.g. Germany, Austria). Early-stage start-ups in two-tier jurisdictions typically by law only have a management board, which includes the founders or executive directors (with no investor representation) as well as a separate voluntary “advisory board”. The advisory board is not recognized by law as a separate legal body and is set up and regulated solely by contract. Investors nominate members to the contractual advisory boards which acts as the discussion and approval forum for certain management decisions, as governed by the relevant rules of procedure or shareholders’ agreement.
Regardless of the board composition or the legal form of the board, VCs typically carve out a specified list of material board decisions that require the approval of an investor director (or the contractual advisory board). These decisions typically include decisions that are outside the company’s ordinary course of business, like approving or making changes to the annual budget, making material share option grants, incurring debt, commencing litigation, engaging C-level employees with salaries above a certain threshold, etc. This also grants investors a level of control at board level in the form of veto rights.
Redemption rights are the rights of an investor to force a company to repurchase or buyback its shares on certain trigger events (e.g. if there has not been an exit within a specific timeframe) at a fixed price. A right of redemption where the fixed price is based on fair market value or a multiple of the investor’s investment amount is very rare in Europe (and in some jurisdictions is legally not allowed or has strict limitations).
An investor’s redemption rights are more commonly implemented in Europe in the form of a “put option”, under which the investor has the right to “put” its shares to the company or, if the company can’t buy back the shares, founders or other shareholders. The put option is usually exercisable for a nominal amount, e.g. €1 for all of the investors’ shares. The put option gives the investor an easy and quick exit route in case portfolio companies are no longer performing or there are other reasons why the investor can no longer hold shares (e.g. regulatory reasons).
We have very rarely seen redemption rights implemented in practice, other than in the form of a nominal put option discussed above.