In this title, we are going to be discussing some key terms that every entrepreneur must know in the context of fundraising
Introduction
Investment terminologies and concepts that are often thrown around in negotiations and during meetings with Venture Capitalists (VCs) can be quite confusing for first-time entrepreneurs. For anyone looking at raising the first round of funding for their startup, and desirous of familiarizing themselves with basic investment terminologies and concepts before negotiating a term sheet with investors, below is a glossary of various terms and concepts that would be useful before approaching the investors for fundraising.
Term Sheet
A term sheet is a non-binding document that lays out the important terms under which the VC or angel investor will make an investment in a company. A term sheet is used as a framework for discussion, negotiations and clarifications before the final shareholders’ agreement are drafted. A shareholders’ agreement (SHA) is a binding document which legally formalizes the transaction.
Since the term-sheet is the basis of the final SHA, it covers critical aspects like valuation of the company, control over decision making, exit options and how the investor’s capital would be protected against the potential downside.
Valuation
Valuation is the process of determining the current (or projected) worth of a company. There are many techniques used for doing a valuation. An analyst placing a value on a company looks at the business’ management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets, among other metrics. Analysts may use various methods to arrive at a company’s valuation.
In simple terms, the valuation is reflective of what a buyer is willing to pay a seller. For example, if an investor proposes to purchase 10% of the equity shareholding of a company for INR 10 Lakh (after taking into account relevant metrics), he is valuing the company at INR 1 Crore.
Equity Shares
An equity share, commonly referred to as ordinary share, represents the form of part ownership of the company. The holders of such shares are members (shareholders) of the company and have voting rights in proportion to their shareholding.
Convertible Debt
Investors may use convertible debt instruments such as convertible debentures which are in the nature of a debt, but can be subsequently converted into a predetermined amount of the underlying company’s equity. The primary reason for issuing convertible debentures is that investors demand security that protests their principal amount from the downside, but also allows them to participate in the upside (capital appreciation) should the underlying company succeed help in the Fundraising for startups.
A startup or relatively new company, for example, may have a risky project that loses a great deal of money on one end but may lead the company to profitability and outsize growth. A convertible debenture investor can get back some principal upon failure of the company but can benefit from capital appreciation by converting the debentures into equity if the company is successful.
Preference Shares
Preference shares are shares which enjoy preferential rights as to dividend and repayment of capital in the event of winding up of the company over the equity shares. In simple terms, preference shareholders receive their payout first, ahead of equity shareholders, in the event of payment of a dividend or winding up of the company.
Compulsorily Convertible Preference Shares: Preference shares which are compulsorily to be converted into equity shares at a subsequent period in time.
Dilution
Dilution is a result of a reduction in the ownership percentage of a company, or percentage of shares of stock, due to the issuance of new equity shares by the company. Dilution can also occur when holders of stock options (such as company employees) exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable. For example, if Shareholder A holds 100 shares representing 10% shareholding of Company X as on 1st January 2019, and Company X issues 1000 new shares to a new investor on 1st February 2019, the shareholding of Shareholder A is now diluted down from 10% to 5% of the shares of Company X from 1st February.
Anti-dilution Clause
An anti-dilution clause is a provision which protects an investor from the dilution of an equity position – something that occurs when an owner’s percentage stake in a company decreases because of an increase in the total number of shares outstanding. As has been mentioned above, total shares outstanding may increase because of new shares being issued due to a round of equity financing or perhaps because existing option owners exercise their options.
One way in which dilution can be avoided is by incorporating an anti-dilution clause in transaction documents, which adjusts the conversion price between preference stock and common stock. To elaborate further, investors may keep a certain number of convertible preference shares which, in case of a dilution event, can be converted into equity shares at a price which will nullify the dilution.
Liquidation Preference
The liquidation preference sets out how various investors’ claims on dividends or on other distributions are queued and covered. Liquidation preference establishes that certain investors receive their investment money back first before other company owners in the event the company is sold, goes public, pays dividends, or has another liquidation (payout) event for Fundraising .
Right of First Refusal (RoFR)
Right of first refusal is a contractual right, but not the obligation, to enter into a business transaction with a person or company before anyone else can for Fundraising . If the entity with the right of the first refusal declines to enter into a transaction, the owner of the asset who offered the right is free to open the bidding up to other interested parties. For instance, an existing investor in a company may insist on a right of first refusal on the purchase of shares in case of a subsequent round of investment. In such a case, if the company is desirous of raising further investment Fundraising , the right to subscribe to the new shares to be issued for this purpose vests with the existing investor. It is pertinent to note that the existing investor may or may not exercise this right.
Pre-emption / pro-rata rights
A pre-emption/pro-rata rights clause essentially reserves the right of the investor to participate in the future financing rounds (similar to RoFR).
For instance, if an investor owns a 20 percent stake in a company which is about to receive additional INR 50,00,000 investment, a pro-rata right allows the investor to invest INR 50,00,000 * 20 percent = INR 10,00,000 at the same terms as the rest of the investors by Fundraising .
Veto Rights: Veto rights are rights that may be included within the shareholders’ agreement to grant any party to the agreement the final decision making power with respect to specified matters pertaining to the internal governance of a company.
Drag-Along Rights
Drag-along rights give the company the right to force all shareholders to participate in and vote for a sale of the company if the sale has been approved by specified groups (who have such rights). For a Series A financing, the drag-along is typically triggered if approved by the Board of Directors, the holders of a majority of the common stock, and the holders of a majority of the preferred stock by Fundraising . The idea is not that one group can force another to sell, but rather that if all major constituencies of the company want to sell, all shareholders are required to participate in the sale. This prevents small shareholders from creating a roadblock to an acquisition by objecting or exercising appraisal or dissenters’ rights under applicable law.
Tag-along Rights
Tag-along rights, also referred to as “co-sale rights,” are contractual obligations used to protect a minority shareholder, usually in a venture capital deal. If a majority shareholder sells his stake, it gives the minority shareholder the right to join the transaction and sell his minority stake in the company (on the same terms). Tag-alongs effectively oblige the majority shareholder to include the holdings of the minority holder in the negotiations if the tag-along right is exercised Fundraising .
Conclusion
The terms defined above constitute merely a first-level indicative list of the broad concepts that would be of use to the reader in entering into negotiations with investors.
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