By Suzy Strutner, managing editor at Grow Wire
This article is part of a Grow Wire Guide on how to get VC funding. See links to published articles below, and stay tuned for more.
Part 1: What to Know Before You Go
Part 2: How to Tell if You’re Ready
Part 3: Pitch Deck & Presentation
Part 4: Finding the Right VC
Part 5: Anatomy of a Term Sheet
Part 6 (upcoming): Closing the Deal
Venture capital terminology can be tough to maneuver, especially as you’re navigating the early stages of venture capital fundraising.
Here's an easy-to-read rundown of terms, listed in the order you'll typically encounter them on a VC term sheet.
A convertible note is a financial structure that VCs use to invest in a company. A convertible note is a loan whose outstanding value converts into equity for the VC at a later date.
Convertible notes are usually used during seed rounds, if at all, because they allow companies to delay valuation talks until a later fundraising round (usually Series A). Per SeedInvest:
“The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there really might not be much to base a valuation on--in some cases the company may just be an idea. That valuation will usually be determined during the Series A financing, when there are more data points off which to base a valuation.”
This is an acronym for “safe investment for future equity.” A safe is another type of financial instrument (along with convertible notes) that VCs use to invest in a young company. Like convertible notes, safes are usually only used during the seed round. A safe is a warrant to purchase stock in a future priced round (aka a round in which the company has been assigned a valuation). Software company inDinero offers more about the choice between convertible notes and safes on its blog.
In seed-round VC deals, equity most often refers to the amount of ownership each party (the founding team and VC) has in the company. Equity can be doled out in the form of “securities” like convertible notes and safes (described above) or straight-up stock.
Preferred stock is a type of “security” that delivers VCs their “equity” (aka ownership) of a company. Preferred stock is a special type of stock that entitles the holder to receive a fixed amount of money after a company exit and to receive that money before the other “common” shareholders get theirs, thus the related term “preferential return."
VCs love to receive their securities in the form of preferred stock. Per Investopedia:
“Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price.”
This is the system of rules by which VCs and founders work together to run the company, ideally in a fair and transparent manner. The corporate governance section of a VC term sheet lays out how much access VCs have to company information, how much control each party has in decision-making, and how the board will be structured.
Voting rights are assigned to both the startup team and its other shareholders (i.e. the VC). These rights allow each party to vote on matters of company affairs.
When negotiating a term sheet, “voting rights” usually refers to the question of whether preferred shareholders (i.e. VCs) will be able to vote alongside common shareholders (i.e. founders). In early-stage companies, VCs often don’t actually have their stock yet--it’s promised in the form of convertible notes or safes--but they want to vote on company matters alongside the founders.
This refers to the balance of “founder-friendly” and “VC-friendly" individuals on your company’s board. Your first term sheet is likely to allocate at least one board seat to someone from the VC firm. According to VentureBeat:
“After your initial seed round, you’ll usually have to allocate a board seat to the firm or person who led that seed round. To ensure that the founding team still remains in control of the board, a fairly typical setup at this stage would be for the common stockholders (i.e. the founders) to retain two board seats and your new investor to have one seat.”
Redemption rights require the company to buy back its stock at a specific time or when certain conditions are met. Redemption rights give investors an additional level of security by allowing them to potentially recoup their investment. (They’re rarely exercised.)
As a founder, your exit strategy is your plan to sell your ownership in your company (and hopefully make a lot of money in the process). This could include “going public” (via an IPO) or being acquired. The liquidation and exit section of a term sheet details what will happen financially--to both you and the VC--if and when an exit occurs.
Employee stock option plans (ESOPs)
These allow employees of a company (in this case, founders) to buy a certain amount of shares in the company for a set price at a specific time. VCs often work ESOPs into term sheets to make founders happier, as these shares come at a favorable price.
VCs often use the term sheet to set vesting schedules that ensure founders won’t just “take the money and run.” Usually, vesting schedules ensure that founders don’t receive the full value of their stock until at least four years into the company’s future, incentivizing them to stick around.
VCs often don’t own the majority of a company they invest in. Therefore, most insist on having veto rights when voting on certain company matters. These matters usually include hiring and firing as well as strategic and financial planning, according to Black Dog Venture Partners.
A non-compete agreement will make you (the founder) promise not to leave your own company for a competitor for a set length of time. This protects the VC, who gets peace of mind knowing your talent will stay with the company.
Intellectual property rights
The VC will likely also want rights to your intellectual property--i.e. the inventions and designs that make your company tick--so you can’t take it elsewhere.
A "cap table" is a spreadsheet showing who owns which securities (stock, options, etc.) related to your company. When raising VC, founders use cap tables to "play out different scenarios," or model how different valuations or round sizes will affect their potential payout.
❓Got more questions about VC? We can answer them in future posts! Email your suggestions to firstname.lastname@example.org.