What Should you know if you’re taking on Financing?
Taking on financing can be a stressful and confusing time for many. Many entrepreneurs do not fully understand the terms of their financing. To make it less stressful, we’ve pinpointed a few things you should know as you look for financing.
- This vocabulary is probably new to you so get to know it.
» VCs and other investors use a vocabulary that, while familiar to them, is often new to entrepreneurs. This is to no fault to them; it is their job to know these terms. However, it is crucial to understand the financing terms, such as liquidation preference and participating preference, when reviewing term sheets offered by investors.
- Your percentage ownership rarely indicates what you receive in an exit.
» Ownership percentage rarely equals the percent paid out when a company is sold. Payouts will vary depending on financing terms received from investors.
- You should always keep track of company ownership and any documents that go along with it.
» Tracking company ownership is commonly done in “cap tables”, aka capitalization tables. In order to properly keep track of company ownership, three main components should be outlined; who the equity holders are, the type of equity they hold (what class/security), and the equity events (rounds of financing, employee options being increased, etc.). There are typically legal agreements, which hold the terms, which go along with each equity event. These should always be stored in a secure, but accessible, place.
Speak the Language. Get To Know Industry Terms.
»Term Sheet – A document containing terms and conditions of an investment. Typically, this non-binding document sets for negotiations and serves a template for a legal, binding document.
» Capitalization table – Commonly called a Cap Table, is a table that shows the ownership of the company. The cap table should include the equity holders, the class or security (types of equity) they have been issued, and the equity events (rounds of financing or increasing options) in which the equity has been given.
»Securities/ Classes – Represents a specific form of equity that has been issued. Different kinds of security include options, common stock, preferred stock, etc. *See Types of Equity for more detail. *
»Equitsy Holder – The individuals or investors that hold equity in the company.
»Round of Financing – A fund raising event in which companies receive money from investors.
»Seed Money/ Seed Capital – A very early on investment made in a company. Usually happens when a company is pre-revenue or in the development/ concept stage. Commonly comes from company founders, friends and family, crowd funding sources or angel investors.
»Series A, B, etc. – The series of investments in the company with a VC or other investors. The first round is called the “A Round” or “Series A”, the second is called the “B Round” or “Series B”, and so on. If terms are the same, there can be Series A1, Series B1, and so on.
»Option Pool / Option Refresh –A type of equity (options) that are set aside for (future or current) employees is called an option pool. Option Refreshes are done to make options available for these employees. *See Types of Equity for further clarification on Options*
»Money – What goes into your company from the VCs or other investors.
»Pre-Money Valuation – Company worth prior to the investment.
»Post-Money Valuation – Company worth after the investment.
»Per Share Price – What the investor pays for shares into your company. Note that this price will stay the same pre and post money when there is no liquidity event.
»Exit – When the VC or investor is “cashing out” of the investment. This is most commonly because the company is sold to another player in the industry or does an IPO (Initial Public Offering). Can also be referred to as a Liquidity Event.
»Liquidity Event – When investors or shareholders convert their equity in the company to cash. A type of exit strategy that typically happens during an IPO.
»Waterfall – The breakdown of payout when a company is exited. The waterfall shows who will get what and is contingent on the terms of investments and types of equity.
»Money over Money – The amount of money returned from an investment over the amount of money invested.
»IRR (Internal Rate of Return) – What the rate of return (or growth) was equivalent to as a percent returned. IRR is used measure profitability. It is commonly used in the capital investing process to compare investments and typically the higher the rate the more desirable the investment. Sometimes also referred to as ERR (economic rate of return).
»Hurdle Rate – The minimum acceptable rate or target rate for return on an investment. Typically if the investment is risky, the hurdle rate is higher.
Types of Equity
»Preferred Stock/ Preferred Shares – Preferred stock can come in many different forms and have several different kinds of provisions that will entitle holders to certain payouts, multiples of payouts, incentives, etc. If stock is “preferred”, there is some sort of advantage over common stock; they are paid out first during an exit. Common preferred stock provisions include:
- Accrued Interest of Dividends (Convertible and Non-Convertible)—The interest that has been accumulating since the investment but not yet paid. Convertible allows the holder to convert interest into shares.
- Liquidation Preferences – A provision of preferred stock that determines how much money the preferred stockholders receive in an exit before the remaining proceeds are distributed to the common shareholders. This safeguards investors during low exit valuations and are most commonly stated in the agreement as a multiple of the invested amount. Can be non-participating or participating.
»Non-participating Preference – The VCs will get paid out first and then common stock is caught up on a per share basis. Payouts are distributed according to percentage ownership.
»Participating Preference – A provision that provides additional incentive; allows for investors to share in the proceeds received in an exit beyond their liquidation preference. This means investors with participating preferred stock receive their money back with interest and still participate in the payout of distributable money prorated out of any remaining common shares.
- Dividend – A payment of company earnings made to shareholders when the company is profiting. Typically paid in cash, but some companies allow for reinvestment for additional shares.
- Preferred with a “Cap” – A cap amount is a provision that limits the amount of proceeds investors can receive and allows for a more even distribution among stockholders. Also referred to as Cap Rates or Hurdle Rates. There are two forms of Caps in preferred stock
»Hard Cap – Investors are entitled to the proceeds only up to the specified cap amount.
»Preference Removed after Cap Exceeded – If investors are set to receive more than their cap in a normal payout, shares will convert to common. These common shares would lose any liquidation preferences.
»Common Stock – The ordinary shares in a company. Common stock holders are entitled to a portion of company profits and dividends. In a liquidity event common shareholders have the right to a company’s assets after preferred stock and other debts have been paid in full. A Board of Directors typically exercises their control.
»Options – A type of security in a company that are written in a contract, giving the “Option Holder” the right to the security at a given price (strike price) before a certain time (exercise date). Typically, options are given to employees as incentive or as compensation. There can be two forms of Options:
- Call – Has the right to buy at a certain price.
- Put –Has the right to sell at a certain price.
»Warrants – A type of security that give the holder the right to purchase at a specific price (strike or exercise price) before a certain date (exercise date). Typically, warrants are given to investors alongside an investment as additional incentive.
»Convertible Note/ Convertible Bond/ Convertible Debt – This type of debt is able to be converted to preferred or common security. Typically these notes are for a predetermined amount of stock and are used for companies with lower ratings but high potential.
»Bridge Loan – A short-term loan typically given until a financing round is completed. The Bridge Loan can be convertible; meaning it can have the option to convert into the round of financing. Bridge loans are not mean to last long and are typically high interest. Also known as a Swing Loan or Gap Financing.
»Restricted Stock – A type of security that is not fully transferable until certain criteria has been met. Restrictions are often time or performance based. Commonly used as form of compensation for executive level employees.
»Preemptive Rights – Allow shareholders to maintain their ownership if the company issues additional stock. Shareholders have the right (not the obligation) to purchase as many new shares as it would take for them to maintain proportional ownership in the company.
Keeping Track of Company Ownership
The best way to keep track of company who owns what and when it was issued is in a Cap Table. Cap tables clearly define who the equity holders are, what kind of equity they hold and when it was issued.