Venture Capital Gloassary
Intellectual Property (IP)
A business's intangible (non-physical) but often valuable assets, such as its patents, trademarks, copyrights, and "brand." The protection of intellectual property can create distinct competitive advantages and can be vital to a venture's fund-raising and growth prospects.
Certificate of Designation
A certificate filed by a corporation with the appropriate state agency attesting to the board of directors' designation of the terms, rights, preferences, and limitations of a series of blank check preferred stock. Once filed, the Certification of Designation becomes a part of the corporation's charter (and the authorizing instrument of the security in question).
Clawback
A contractual provision in a private equity or venture capital fund's governing documents which provides that, over the life of the fund, the fund's managers will not receive a greater share of the fund's distributions than what they agreed and bargained for. Generally, this means that the general partner of the fund may not keep more than a specified percentage (e.g., 20%) of the fund's cumulative profits (and thus must return any "excess" to the fund's limited partners).
Pay-to-Play Provision
A contractual provision requiring an existing investor to participate on a pro rata basis in a subsequent investment round, especially a down round. If the investor does not so participate, then it suffers specific adverse consequences, including automatic conversion to common stock or a "shadow" preferred stock, loss of the right to participate in future rounds, loss of anti-dilution protections, loss of veto rights, and loss of board representation rights.
Automatic Conversion
A feature of a convertible security, whereby that security, upon the occurrence of certain specified events or transactions, automatically converts (without any action on the part of the holder or the issuer) into (and becomes) shares of common stock. See also Convertible Preferred Stock.
Payment-in-Kind (PIK)
A feature of a security pursuant to which dividends (in the case of an equity security) or interest (in the case of a debt security) are paid in the form of additional securities of the same type, instead of cash.
Washout Round
A financing round whereby previous investors, founders, and management/employees suffer substantial dilution (and loss of rights). As a result of a washout round, the new investors usually gain majority ownership and control of the issuer.
"B" Round
A funding round following the "A" round, in which Series B preferred stock is issued and sold to one or more outside investors (usually venture capital funds). This can be accomplished through existing and/or new investors. Subsequent rounds are called "C," "D," and so on.
"A" Round
A funding round in which Series A preferred stock is issued and sold to outside investors. This is typically the first institutional venture capital financing round (but may also include angels and other sophisticated investors). The "A" in the name comes from the use of Series A Preferred Stock, the securities issued in the round.
Accredited Investor
A funding round in which Series A preferred stock is issued and sold to outside investors. This is typically the first institutional venture capital financing round (but may also include angels and other sophisticated investors). The "A" in the name comes from the use of Series A Preferred Stock, the securities issued in the round.
Cram-Down Round
A funding round in which new investors (usually bringing substantial capital into the company and/or in a down round) demand that receive contractual provisions, contractual concessions, and new securities that significantly reduce (or dilute) the ownership percentage (and rights and protections) of previous investors. See also Washout Round.
Investor Rights Agreement
A key definitive agreement in a venture capital investment transaction, typically providing for various obligations of the issuer and existing owners, and rights of new investors.
Covenant
A legal promise in a definitive agreement that obligates a party either to take an action (referred to as an affirmative covenant) or refrain from taking an action (a negative covenant); or that requires the maintenance or achievement of some defined economic, operating, or financial measure (a financial covenant).
Cap
A maximum limit on indemnity claims or other provisions under a definitive agreement. Also referred to as a ceiling. Participating preferred stock may have the participation feature subject to a cap.
Anti-Dilution Provision; Anti-Dilution Protection
A provision (in an option, warrant, or convertible security) intended to protect the holder from dilution of its ownership interest that may result from future sales or issuances of capital stock by the issuer. See also Weighted Average Ratchet and Full Ratchet.
Right of First Refusal
A provision, typically in a shareholders' agreement or investor rights agreement), that prohibits a shareholder from accepting a bona fide offer made by a third person to purchase the shareholder's shares unless and until other specified shareholders are first given the opportunity to purchase the shares at the same price and on the same terms.
Right of First Offer
A provision, typically in a shareholders' agreement or investor rights agreement, that prohibits a shareholder from selling her/his shares for a defined period unless s/he has first offered to sell the shares to the other shareholders (or to other specified shareholders) at the price and on the terms fixed by the selling shareholder.
Dilution
A reduction in the percentage ownership or the value of equity security holdings of a given shareholder (e.g., a founder, employee, or previous investor) caused by the issuance, or potential issuance, of additional equity securities (or rights to acquire equity securities).
Founder Vesting
A requirement imposed by outside investors that founders' shares "vest" (in effect, be earned) over a period of years before they are fully owned (and may be sold or transferred). This is typically required (if at all) early in the valuation and investment process (e.g., seed and early-stage financings), to ensure that founders do not receive a windfall from their initial share allocations and to discourage founders from leaving the company or selling their shares prematurely.
Down Round
A round of financing (i.e., a separate, later investment transaction) in which the valuation of the company (and thus the effective price per share) is lower than the valuation utilized (and embraced in securities issued and sold) in a previous round.
Convertible Security
A security of a company that by its terms is convertible into exchangeable for another security of the same company (e.g., convertible preferred stock, convertible notes, and convertible debentures can be convertible into shares of common stock). See also Convertible Preferred Stock and Conversion Rights.
Warrant
A security that provides the holder with the right to purchase stock (equity securities) at a specified price (referred to as the exercise price) within or over a specified time period. Similar to an option, but typically issued to third parties (not directors, employees, or insiders) in connection with the issuance of debt securities.
Capitalization (or Cap) Table
A table showing the capitalization of a company, which typically includes all securities issued by the company, and the identity and security/share ownership of each security-holder (or, at least, of the significant ones). The Cap Table also lists the form of security (whether equity or debt), such as common stock, preferred stock, warrants, options, senior debt, and subordinated debt.
Full Ratchet
A type of anti-dilution provision that is favorable to the investor (and most unfavorable to the company). It adjusts the exercise price or conversion ratio of a security to the lowest price at which securities (including convertible securities, options, and warrants) are, or any single share is, issued after the issuance of the subject security (i.e., the one entitled to the full ratchet provision). As a result of the implementation of a full ratchet, founders, management, and others who own common stock typically suffer substantial dilution.
Weighted Average Ratchet
A type of anti-dilution provision, which applies a weighted average formula to adjust the exercise price or conversion ratio of a security downward based on the sale price and number of common equivalent shares issued by the company (in a subsequent down round) after the issuance of the first security. The broad-based weighted average ratchet is the most commonly used anti-dilution formulation in venture capital transactions. In essence, the effect of the share issuance in the down round is spread over a large number or broad base of shares (all fully diluted outstanding shares), including unexercised options and outstanding convertible securities). In a narrow-based weighted average ratchet (a protection more favorable to the investor), the effect of the share issuance in the down round is spread over a smaller number or base of shares (e.g., issued and outstanding shares only).
Convertible Preferred Stock
A type of preferred stock that is convertible into or exchangeable for shares of common stock at a specified (and adjustable) conversion ratio. Convertible preferred stock is clearly the most commonly used form of security for venture capital investment transactions. See also Conversion Rights.
Participating Preferred Stock
A type of preferred stock that is entitled to participate (or share) with holders of common stock in dividends and/or liquidation payments (after and in addition to collecting any stated liquidation preference or dividend rights). Where participating preferred stock is utilized, the participation feature may be subject to a cap (e.g., at two or three times the investment amount). See also Participation.
Elevator Pitch
A very concise oral presentation, lasting only a few minutes (the duration of an elevator ride), by an entrepreneur (or business owner or manager) to a potential investor concerning the business model, strategy, market, and solution (and the compelling investment opportunity presented) of the company in question.
Letter of Intent (LOI)
A written expression, in the form of a letter, of two (or more) parties' intentions to effect an investment transaction. It summarizes the material terms of the deal and other matters, and serves as the basis for preparing a definitive agreement. By its terms, an LOI generally is not legally binding (except that it may include certain legally binding provisions—typically those addressing confidentiality, no-shop agreements, and expenses). Sometimes also referred to as a term sheet, memorandum of understanding, or agreement in principle.
SBIC
Acronym for Small Business Investment Company.
Follow-On Funding; Follow-on Investment
An additional investment in a company made by its existing (or previous) investors. Portfolio companies often require more than one round of funding.
No-Shop
An agreement (usually in the letter of intent or term sheet) whereby the issuer gives an investor an exclusive right during a limited time period to negotiate and enter into a definitive agreement with the issuer, and agrees not to solicit or encourage other investment proposals during that period or to talk (or, if specified, to provide information) to other potential investors.
Shareholders' Agreement
An agreement among the shareholders of a company regulating the governance of the company, the ownership and transfer of its equity securities, and other matters. Often contains provisions relating to preemptive rights, drag-along rights, tag-along rights, rights of first offer/refusal, and veto rights.
Management Fee
An annual fee, typically fixed at a percentage of the limited partners' capital commitments to the fund, designed to cover the basic costs of running and administering a venture capital fund. The management fee is not intended to work as an incentive compensation for the General Partner—that is the purpose of the carried interest.
Qualified IPO; QPO
An initial public offering that meets certain contractually defined criteria (e.g., a minimum gross proceeds amount and/or a minimum share price multiple vs. the original investment amount). The criteria is usually designed to ensure a sufficiently robust IPO such that the IPO shares will trade on a major securities exchange (e.g., NASDAQ or New York Stock Exchange). The occurrence of a QPO may trigger certain events (e.g., automatic conversion of preferred stock into common stock and/or loss of certain preferred stock holder rights).
Small Business Investment Company
An investment firm licensed by the US Small Business Administration (SBA) to obtain matching federal loans for its venture capital/private equity investments. An SBIC will generally have access to $2 in credit (in the form of low-interest-rate loans, drawn down on a deal-by-deal basis) for every $1 that it invests in a portfolio company meeting certain requirements.
Staged Investing
An investment in a company structured to be funded in stages (or installments), with the initial installment at the first closing and then subsequent installments if the company meets certain specified milestones (e.g., hiring key managers, reaching a revenue hurdle, meeting project development deadlines, landing a specified number of customers) or if an agreed time period lapses. Also referred to as milestone-based investing.
Ten Bagger
An investment that returns to its investors (at least) 10 times the initial amount of capital invested.
Round
An investment transaction (or financing event) in which a private company receives funding from outside investors. Venture-backed companies typically receive more than one round of venture capital funding. The term "first-round funding" does not necessarily mean that the company has received no previous outside capital (particularly if from one or more angel investors). The first round typically refers to the first investment transaction involving participation by one or more venture capital funds or institutional investors. See also "A" Round and "B" Round.
Club Deal
An investment transaction in which several fund investors invest side by side in the same round. Although this term is most commonly used in private equity fund/buyout deals, it is also used in multi-fund venture capital transactions.
Tag-Along Rights
Contractual right of a minority investor/shareholder (typically provided in a shareholders' agreement) to sell its stock (on a pro rata basis) along with and at the same price as the founder or majority shareholder, if either the founder or majority shareholder elects to sell stock to a third party. In this way, the minority investor/shareholder is permitted to "tag along" with the selling shareholders. Also referred to as co-sale rights.
Drag-Along Rights
Contractual rights (typically provided in a shareholders' agreement or investor rights agreement) that allow one or more investors/shareholders (often those holding a majority or a specified percentage of the outstanding shares) to force (or "drag") all other shareholders to agreement to and/or participate in a specific action, such as the sale of the company, alongside the initiating investor/shareholder. This provision operates to prevent minority shareholders from blocking a sale of the company (approved by the majority) by refusing to sell their shares.
Strategic Investors
Corporate or individual investors that add strategic value to their equity investments through industry experience, expertise, and contracts. These investors can assist companies in operations, finance, marketing, sales, intellectual property, acquisitions and other disciplines, as well s in raising additional capital and effecting exit strategies.
Subordinated Debt
Debt that is subordinated (and thus inferior) in right of payment to other more senior debt in the event of liquidation, insolvency, or bankruptcy. Subordinated debt is sometimes also called "high-yield debt" (given the high interest rate it bears).
Pari Passu
Equally; ratable; without preference. Generally used to describe securities that are to be treated as being of equal priority.
Sweat Equity
Equity ownership received (typically, by founders, employees, and consultants) as a result of and in exchange for work, deliverables, or expertise (the "sweat"), as opposed to a cash investment.
Carried Interest; Carry
In a venture capital fund organized as a limited partnership, the general partner's share of the profits generated through the funds performance. Typically, a fund must return the capital invested in it by limited partners plus an agreed hurdle rate (or preferred return) before the general partner can share in the profits of the fund. The general partner will then receive its agreed carried interest (also known as its "carry" or "promote"), which is the agreed share or split (with the limited partners) of the remaining profits. The carried interest, rather than the management fee, is the general partner's principal incentive to perform well and generate strong fund returns.
Gatekeepers
Intermediaries (e.g., attorneys, accountants, bankers, and consultants), whom venture capital funds use as sounding boards and advisors in sourcing and gaining introductions to potential portfolio company investments.
Institutional Investors
Large, asset-rich organizations that invest their funds in a variety of investments and asset classes and in an ongoing, professional basis; typically banks, insurance companies, pension funds, investment companies, mutual funds, and endowments. Together with high-net-worth individuals, these comprise the most significant investors (and limited partners) in venture capital funds.
Redeemable Preferred Stock
Preferred stock which, by its terms, enables the stock holder to require that the issuer redeem (or repurchase) the preferred stock for a specific amount within or following a specific time period. The redemption feature is also referred to as a put option or put right.
Veto Rights
Rights granted to certain shareholders (or to some or all of a class or series of shares) to vote on or approve certain specified actions or transactions by an issuer (e.g., additional equity financings, borrowings or capital expenditures over a specified amount, an IPO, transactions with affiliates, sale or other change of control). Thus, without the vote or consent of the shareholders holding these rights, the action in question may be vetoed or blocked. Veto rights are one type of minority protection. Also often referred to as blocking rights.
Registration Rights
Rights of a holder to have securities registered with the SEC (on a registration statement) in connection with a later public offering by the issuer. Demand rights require (i.e., permit the holder to force) the holder's shares (or a portion thereof) to be so registered. Piggyback rights permit the holder to add (or "piggyback") its shares (or a portion thereof) onto another person's or the issuer's registration statement (and public offering).
Minority Protections
Rights provided to minority shareholders affording protection against actions taken (or potentially taken) by majority or controlling shareholders. May include veto rights, tag-along rights, preemptive rights, etc.
Conversion Rights
Rights under which shares of preferred stock (or other convertible securities) "convert" into (and become) shares of common stock. Can be automatic or mandatory (in certain specified events, such as a qualified sale, qualified IPO, satisfaction of financing performance targets, and/or approval by a specified vote of preferred stock holders), as well as voluntary (i.e., at the option of the holder). These rights are typically protected by anti-dilution provisions.
Founders' Shares
Share of common stock owned by the company's founders upon (and in connection with) the company's organization.
Basket
Specific dollar limitations on indemnity claims or other provisions provided under an agreement (typically an investment or purchase agreement). For example, the agreement may provide that one party may bring indemnity claims against the other only if the aggregate amount of all claims exceeds a specified dollar amount. A "deductible" basket means that the specified dollar amount is exempt from, and only the excess over that amount is subject to, indemnity claims. A "threshold" (or "dollar-one") basket means that once the specified dollar amount is exceeded, the indemnified person can recover the full amount of all claims (from the first dollar).
Bridge Financing
Temporary (and sometimes emergency) limited funding that will eventually be replaced by permanent capital (from equity investors or debt lenders). In venture capital, a bridge loan is usually provided in the form of a short-term note (6 to 18 months) that converts to preferred stock. Typically, the bridge lender has the right to convert the note to preferred stock at a price that is discounted from the price of the preferred stock in the next financing round. The loan is intended to "bridge" the borrower to its next round of financing.
Pre-Money Value
The (agreed-upon, theoretical) value of a company immediately prior to the current investment round. This value is determined by negotiation and is calculated (mathematically) by multiplying the number of outstanding (or fully diluted) shares before the current round, times the agreed (or derived) purchase price per share in the round. For example, if a venture capital fund agrees to invest $5 million in a company with an agreed pre-money value of $10 million and with one million shares outstanding, then the fund would receive 500,000 shares (or shares of preferred stock convertible into 500,000 shares of common stock) at a purchase price of $10 per share. See also Post-Money Value.
Board of Directors; Board
The governing body of a corporation, charged with oversight of the management and direction of the corporation. Individual directors are elected (usually annually) by shareholders to serve on the board, and they owe certain fiduciary duties to the corporation's shareholders. Venture capital funds typically have the right to elect a specified number of board members (and, together with founders/management, to elect one or more independent directors). See also Independent Director and Investor Rights Agreement.
Internal Rate of Return (IRR)
The interest/discount rate (expressed as a return on capital invested) at which a specific amount of capital invested today would have to grow in order to reach a specific value at a specific time in the future. This is the standard, accepted benchmark venture capital funds (and their limited partners) utilize to measure and compare their relative performance.
Exit; Exit Strategy
The means (or plan) by which a venture capital fund (or other investor) monetizes and realizes a return on its investment in a portfolio company. This typically comes when the portfolio company is sold to another person, goes public in an IPO, or recapitalizes (e.g., leverages it balance sheet and pays dividends to and/or purchases securities from shareholders).
Hurdle Rate
The minimum preferred return to limited partners in a venture capital fund (organized as a limited partnership) to be achieved before the general partner's (or manager's) carried interest is permitted. A hurdle rate of 10% means that the venture capital fund must achieve a return of at least 10% per annum on invested assets (for its limited partners) before the remaining profits are shared (with the general partner) according to the carried interest arrangement. Also referred to as the preferred return.
Broad-Based Weighted Average Ratchet
The most commonly used form of anti-dilution provision in venture capital transactions. See also Weighted Average Ratchet.
Option Pool
The number of shares of common stock that are set aside for issuance upon the exercise of options or other equity-based incentives, to be granted by the board of directors in the future to management and key employees (and perhaps others). The amount of the option pool varies (from 7.5% to 25%), but it averages around 15% of fully diluted shares.
Lead Investor
The person or venture capital fund that organizes a round of financing, leads the round (e.g., in such matters as due diligence, valuation, LOI preparation, negotiations, documentation, and closing), and usually contributes the largest amount of capital to the round.
Exercise Price
The price at which an option or warrant can be exercised (i.e., the purchase price for the shares or securities covered by the option or warrant).
Charter
The principal governing document of a company, as provided under the governing corporate law of the state of organization, prepared and filed when the company is first formed. Typically named the certificate of incorporation or articles of incorporation in the case of a corporation (or, in the case of a limited liability company, the certificate of formation).
Burn Rate
The rate at which a business expends its (net) cash over a defined period (usually a month).
Conversion Ratio
The ratio used to determine the number of shares of stock into which a convertible security may be converted. In a venture capital transaction, this refers to the ratio that determines, at any point in time, the number of shares of common stock into which shares of convertible preferred stock may be converted.
Cumulative Dividends
The right of a holder of preferred stock to receive accrued (and previously unpaid) dividends at a fixed rate in full before any dividends may be paid to the holders of any other, junior classes of capital stock (including common stock). Thus, dividends may accrue and "accumulate" at a fixed rate (e.g., 6% to 9% per annum) or may simply be payable "when, as, and if declared" by a company's board of directors. Because venture-backed portfolio companies typically need to conserve cash (and thus do not pay dividends), employing a cumulative dividend feature means the liquidation preference of the underlying preferred stock increases by an amount equal to the accrued cumulative dividend. Cumulative dividends are often waived if the preferred stock converts to common stock prior to an IPO or other significant transaction, but may be included in the liquidation preference (or as an adjustment to the conversion ratio) for other purposes.
Mandatory Redemption
The right of a security holder (e.g., of convertible preferred stock) to require the redemption (i.e., repurchase by the issuer) of some or all of the security held at a specified (or determinable) price and after a specified period of time has elapsed (a sufficiently long period of time such that the holders of the security, if they have not achieved liquidity by then, are disappointed and require negotiation leverage to cause the company to pursue an exit strategy). The purchase price is usually the original investment price plus any accrued and unpaid dividends. Also referred to as a forced buyback.
Preemptive Rights
The right of a stockholder to participate in future issuances of equity securities by a company, through the purchase of additional equity securities, so as to allow that stockholder to maintain its proportionate ownership interest.
Call Option
The right to buy a security at a specified price (or price range) within a specific time period. See also Option.
Option
The right to purchase equity securities in a company at a specified price (referred to as the exercise price) within or over a specified time period. Primarily awarded to management and key employees, typically awarded in the discretion of (and with the terms and provisions determined by) the board of directors or a board compensation committee, pursuant to a shareholder-approved option (or incentive compensation) plan.
Liquidation Preference
The right to receive a specific value or amount for shares of preferred stock (or equity securities with preferential rights) if the company is liquidated (or deemed to be liquidated) in priority to amounts to be distributed on other (junior) securities. The liquidation preference is usually fixed at a minimum level equal to the original investment amount, and can be increased to a multiple of original cost (multiple liquidation preference).
Put Option
The right to sell a security at a specified price (or price range) within a specific time period. See also Call Option and Option.
Committed Capital
The total amount of capital committed or pledged to a private equity or venture capital fund and available for the purchase of or investment in portfolio companies.
Post-Money Value
The value of a portfolio company immediately after a funding round. The post-money value is the pre-money value plus the amount of funds invested in the current round. For example, if investors in the current round invest $10 million in a company that is valued at $15 million pre-money, the resulting post-money value is $25 million.
Capital Call
When a venture capital fund manager (usually a general partner in a limited partnership) requests or requires (pursuant to a previous pledge or commitment) that an investor in the fund (a limited partner) provide additional capital to the fund. Typically, the limited partners agree to a maximum investment amount, and the general partner makes a series of requests/demands for capital over time to the limited partners as opportunities to invest in portfolio companies arise.
Multiple Liquidation Preference
When the liquidation preference of a preferred stock is fixed at a multiple (e.g., 2x to 4x) of the amount invested (on a per-share basis). See also Liquidation Preference.
Limited Partners
With respect to a venture capital fund organized as a limited partnership, high-net-worth individuals and institutional investors that contribute capital to the fund, are not involved in the management of the fund, and enjoy limited liability with respect to actions by the fund. See also General Partner and Limited Partnership.
General Partner
With respect to a venture capital fund organized as a limited partnership, the person responsible for all aspects of managing the fund, including communicating with limited partners, raising funds, making portfolio investment decisions, nurturing portfolio companies, and assisting with exits. The general partner, which retains liability for the actions of the partnership, earns a management fee as well as an agreed share of the fund's profits (known as the carried interest). See also Limited Partners and Limited Partnership.
Limited Partnership
With respect to a venture capital fund, a legal entity comprised of a general partner, which manages the fund, and limited partners, who contribute capital but have limited liability and are not involved with the management of the fund. The most common form of organization adopted by venture capital funds. See also General Partner and Limited Partner.