Deal Dictionary Key Terms
The most important terms you’ll need to know before meeting with potential investors include:
Change of Control
This generally occurs when a company is acquired by or merged into another entity, or when a majority of the voting power of the company changes hands.
Drag Along Provision
This is a contractual provision, often found in Voting Agreements, that obligates the parties to vote in favor of the sale of the company if a key group of constituents vote in favor of the sale (i.e. if the key group votes for the sale, then everyone else is “dragged along” (i.e. forced to vote in favor of, support and not oppose/disrupt the deal) into voting for the sale). For example, one formulation might be if the board, a majority of common stock and a majority of preferred stock approve the sale, everyone else must also so vote to approve. Another formulation might be if the board and a majority of all stock (preferred stock voting on an as-converted to common stock basis) approve the sale, everyone else must also so vote to approve.
Fully Participating Liquidation Preference
This is similar to a Partially Participating Liquidation Preference, except there is no cap on the preferred stock’s participation in the proceeds with common stock after payment of the original investment amounts plus dividends.
Non-Participating Liquidation Preference
This type of Liquidation Preference entitles the holders of preferred stock to receive back an amount equal to their original investment plus any dividends owed to them in the event of a liquidation event. The remaining proceeds in the liquidation event go to the holders of common stock and/or the holders of participating preferred stock (if any). Note though that this does not lock a holder of preferred into receiving just their original investment plus dividends – if it would receive more as a common stockholder after converting, then an investor can elect (by opting to convert to common stock) to receive such greater amount (often times, the Certificate of Incorporation is drafted to make that result automatic).
Partially Participating Liquidation Preference
Like a Non-Participating Liquidation Preference, this entitles the holders of preferred stock to receive back an amount equal to their original investment plus any dividends owed to them in the event of a liquidation event. In addition, the remaining proceeds are shared between the preferred stock and common stock on a pro rata basis (treating the preferred stock as if-converted to common stock), up to a certain cap that is usually expressed as a multiple of the original amount invested.
No Shop Provision
A provision in term sheets that prohibits the company that is being invested in from shopping the deal around to other investors. Also referred to as an “exclusivity” provision. Depending on deal dynamics and who has leverage, the No Shop typically ranges from 30-45 days, and occasionally, a No Shop is not included in the term sheet.
Protective Provisions (Negative Covenants)
The list of actions a company cannot take without the prior approval of a specified portion of the holders of preferred stock. These provisions are typically included in the company’s Certificate of Incorporation, usually when it is amended in connection with the company’s first significant third-party investment. This list is typically limited to a set of fundamental corporate actions (such as a sale of the company, an increase to the size of the Board of Directors and issuing a new series of preferred stock), but is often heavily negotiated with investors.
Valuation Cap (Capped Conversion)
This is a valuation figure used in Promissory Notes dealing with the conversion of the note into equity and is a specialized form of a Conversion Discount. Conversion works by taking the principal plus accrued interest and dividing it by the price per share of the preferred stock being issued in the Qualified Financing in which the Promissory Note is converting. However, the “Valuation Cap” would be the maximum Pre-Money Valuation that could be used to calculate the price per share of the preferred stock just for the purpose of converting the note. It provides the investor with a more stable expectation of the percentage of the company that it will own following conversion. For instance, if an investor invests $1,000,000 at a Valuation Cap of $9,000,000, then the investor can expect to convert into equity later and generally hold approximately 10% ($1M invested / postmoney of $10M, but it will not be exactly 10% because the investor will also take some dilution caused by other investors converting or new investors putting cash in at the Qualified Financing). However, without that Valuation Cap, an investor investing $1,000,000 with a Promissory Note could convert into any percentage of the company, which would be completely dependent on the Pre-Money Valuation in the Qualified Financing.
The valuation of the Company after the investors have made their investment. Typically, this is just the Pre-Money Valuation plus the total amount of investment in the round.
The dollar valuation the investors have placed on the Company prior to making their investment. This is the valuation that is used to calculate the price per share for the preferred stock to be sold by the Company in a financing.
Vesting (Right of Repurchase)
Vesting is the method of tying equity ownership to time served with the company. The most common vesting terms for employees is when 25% of equity vests after 1 year of service (often referred to as a “one-year cliff”), and the remainder vests monthly in equal installments over the next three years. Founders will often have different vesting schedules to reflect their early committment to the company and higher level of involvement. A “Right of Repurchase” is the way vesting is implemented when founders or employees purchase or are granted stock (rather than options). In that case, the person “owns” and can vote all of the stock, but the stock is subject to the company’s right to buy it back at the purchase price when the person’s service to the company ends (subject to any accelereation provisions), and that right lapses at the rate of the vesting schedule (i.e. when the person is not vested at all, the company can buy back all of the shares, and when the person is fully vested, the company cannot buy back any shares).
Double Trigger Vesting Acceleration
This is a type of accelerated Vesting that causes all or a portion of the shares to be deemed Vested upon the occurrence of a combination of two events, which are typically (1) a Change of Control and (2) an involuntary termination (customarily defined as termination without cause or a resignation caused by events/circumstances that essentially forced the person to resign) within some period after that Change of Control. Full acceleration pursuant to this version of vesting acceleration is generally acceptable to investors.
Single Trigger Vesting Acceleration
This is a type of accelerated Vesting that causes all or a portion of a person’s shares to be deemed Vested upon the occurrence of a single event, which is typically (1) a Change of Control and/or (2) an involuntary termination (customarily defined as termination without cause or a resignation caused by events/circumstances that essentially forced the person to resign).