Introduction
For first-time entrepreneurs, the terminology and concepts around investments that are frequently bandied about in discussions and meetings with Venture Capitalists (VCs) can be very puzzling. Below is a glossary of various terms and concepts that would be helpful before approaching the investors for fundraising for anyone looking to raise the first round of funding for their startup and desirous of familiarising themselves with basic investment terminologies and concepts before negotiating a term sheet with investors.
Term Sheet
A term sheet is a non-binding contract that outlines the key conditions under which a venture capitalist or angel investor will participate in a business. Before the final shareholders' agreement is formed, discussions, negotiations, and clarifications are conducted using a term sheet as a foundation. A shareholders' agreement (SHA) formalizes the transaction legally and is a binding instrument.
Since the term sheet serves as the foundation for the final SHA, it addresses crucial issues such as the company's valuation, decision-making authority, exit alternatives, and how the investor's capital will be safeguarded against any risks.
Valuation
Finding a company's current (or future) worth is the process of valuation. There are numerous methods for performing an evaluation. In addition to other factors, an analyst who values a company considers the management of the company, the make-up of its capital structure, the likelihood of future earnings, and the market worth of its assets. To determine a company's valuation, analysts may employ a variety of techniques.
Simply put, the valuation reflects the price a buyer is prepared to offer a seller. For instance, if an investor offers to pay INR 10 lakh for 10% of an equity investment in a company (after considering pertinent indicators), he is valuing the company at INR 1 crore.
Equity Shares
A kind of firm ownership is represented by an equity share, also known as an ordinary share. These shares' owners are members (shareholders) of the corporation and are entitled to a certain number of votes per share.
Convertible Debt
Investors can employ convertible debt products like convertible debentures, which have the characteristics of a debt but can be converted into a specific amount of the underlying company's equity in the future. Investors seek the security that protects their principal amount from the downside while also enabling them to share in the upside (capital appreciation) should the underlying firm prosper, which is the main driver for the issuance of convertible debentures.
For instance, a startup or young business might take on a hazardous initiative that costs a lot of money upfront but could result in profitability and rapid expansion later on. If the firm fails, a convertible debenture investor may receive some of their money back, but if the business succeeds, they may gain from capital gains by converting their debentures into equity.
Preference Shares
In the case of a company's dissolution, preference shares have preferential rights to dividends and capital return over equity shares. Simply put, in the case of a dividend payment or company winding up, preference shareholders receive their payout before equity shareholders.
Preference shares that must be converted into equity shares at a later point are known as compulsorily convertible preference shares.
Dilution
Due to the issue of new equity shares by the company, dilution occurs when the ownership percentage of a corporation, or the percentage of shares of stock, decreases. When stock option holders (such as workers of the company) exercise their options, this can also result in dilution. Each existing stockholder's ownership of the company decreases as the number of outstanding shares rises, devaluing each share as a result.
For Example, if Shareholder A owned 100 shares, or 10% of Company X, as of January 1st, 2019, and Company X issued 1000 new shares to a new investor on February 1st, 2019, Shareholder A's shareholding would have been diluted from 10% to 5% as of February 1st.
Anti-dilution Clause
An anti-dilution clause is a clause that guards against the dilution of an equity position, which happens when an owner's percentage ownership in a company declines due to a rise in the number of outstanding shares.
As was previously indicated, the number of shares outstanding may rise as a result of new shares being issued as part of an equity financing round or even as a result of existing option holders exercising their existing options.
Liquidation Preference
The liquidation preference outlines the order and coverage of different investors' claims on dividends and other payouts. If a firm is sold, becomes public, pays dividends, or experiences another liquidation (payout) event, certain investors will receive their investment money back before other company owners. This is known as a liquidation preference.
Right of First Refusal (RoFR)
The right of first refusal is a legal privilege, not an obligation, to work out a deal with a person or corporation before anybody else. The owner of the asset who offered the right can open the bidding to other interested parties if the organization with the right of first refusal declines to enter into a deal.
For instance, a current investor in a company can insist on having the first option to buy shares in the event of a future round of investment. If the company wants to raise more money in this situation, the current investor will have the right to subscribe to the new shares that will be issued for that purpose. The existing investor may or may not exercise this privilege, which is important to remember.
Pre-emption / pro-rata rights
In general, a pre-emption/pro-rata rights agreement reserves the investor's right to take part in future funding rounds (similar toRoFR).
A pro-rata right allows an investor to invest INR 50,00,000 * 20% = INR 10,00,000 at the same terms as the other investors if, for example, they own a 20% ownership in a company that is due to receive an extra INR 50,00,000 investment.
Veto Rights: Veto rights are clauses that can be added to a shareholder's agreement to provide any party to the agreement the authority to make the ultimate decision regarding certain issues related to the internal management of a firm.
Drag-Along Rights
If a sale of the firm has been approved by certain groups, the corporation has the power to require all shareholders to participate in and vote on the sale (have such rights). The drag-along is normally activated for a Series A fundraising if it receives approval from the board of directors, the owners of the majority of the common stock, and the owners of the majority of the preferred stock.
The notion is that all shareholders must take part in the sale if all significant constituents of the company desire to sell, rather than that one group can compel another to sell.
Tag-along Rights
Contractual duties known as "co-sale rights" or "tag-along rights" are used to safeguard a minority shareholder, typically in venture capital deals.
When a majority shareholder sells his shares, the minority shareholder has the option to participate in the sale and sell his share of the company (on the same terms). If the tag-along right is used, it effectively compels the majority shareholder to include the minority shareholder's holdings in the negotiations.
Conclusion
The phrases listed above are only a first-level indicative list of the major ideas that the reader would find useful while engaging in discussions with investors.
Contact the specialists at HBF Direct Fundraising for assistance in raising money for your company at the most competitive rates. We can create a powerful pitch deck for you and put you in touch with some of our investor partners and mentors.
