2006-04-10 Randall Lucas
It’s been just over half a year that I’ve been working on the “other side of the table,” as a VC analyst at one of Seattle’s leading venture firms. Something that was helpful to me in my first days on the job was reading blog postings from Brad Feld and Fred Wilson, explaining terms of art in the VC world, like “participating preferred,” “liquidation preference,” and the like.
Both as a personal reference tool, and in order to help out folks (be they new analysts / associates at a venture firm, or entrepreneurs) who are faced with rapidly coming up to speed on the jargon of the industry, I’m preparing this miniature glossary of VC terms. I’m targeting the reader who’s responsibility is actually modeling the effect of these terms once in place, rather than negotiating them ex ante, so commentary is biased accordingly.
A right of preferred stockholders to increase their effective number of shares in the event of a subsequent dilutive (lower per-share price) sale of stock. AKA “the (full or partial) ratchet.”
For preferred stock, antidilution protection is usually effected by an adjustment in the conversion price (or ratio). For example, if you bought at $1.00 per share, you would normally convert to common at $1.00 per share (1:1 ratio). For reasons of antidilution, your conversion price might be adjusted to $0.75 per share (1.5:1 ratio). How this is calculated depends upon the type of protection.
Antidilution protection is usually either “broad-based” or “narrow-based” — these represent the “partial” ratchet, and are based upon a weighted average. In broad-based antidilution protection, you would typically reduce the conversion price using a factor derived as follows:
Old share count (CSE) + (New money / Old per-share price) Factor = --------------------------------------------------------- Old share count (CSE) + (New money / New per-share price) (Broad-based antidilution conversion price factor calculation)
For narrow-based protection, the factor is derived similarly, but instead of CSE for the old share count, a much smaller number may be used (such as only the then-outstanding common shares). Investors naturally prefer narrow-based to broad-based when choosing a weighted average antidilution clause.
However, the rational investor will prefer most of all the “full ratchet.” This clause simply adjusts the conversion price on the old shares to the new share price. In the event of a “down round,” this jacks up the prior investor’s percentage ownership in a major way.
In fact, however, the “full ratchet” is not aggressively pursued by many VCs these days. Although it is theoretically favorable to him who holds it, it paradoxically may turn off a subsequent “down round” investor and wash out management’s skin in the game at a time when that capital and talent are most needed.
A distribution upon liquidation which is set aside (“carved out”) for the management team, often at the discretion of the Board of Directors and ahead of equity distributions.
One purpose of a carveout is to ensure that management stays motivated to effect an orderly wind-up of a company even when their equity compensation is likely to be modest or nonexistent.
Other sources: Gray Cary
Common Stock Equivalents (CSE)
The number of common stock shares for which a given security may be exchanged or converted; includes things like preferred shares as-converted, options, and warrants. However, it behooves the analyst carefully to read the documents in question; varying types of calculations calling for the fully diluted share count may have differing rules (e.g. for options, one might count all authorized, only granted, or only “above water”).
Preferred stock often has a dividend clause; a typicaly amount and character of dividends I’ve seen is “8% annual, non-cumulative, in preference to junior stock, when, as, and if declared.” The last part — if declared — is the key issue here, since dividends rarely if ever are declared by startups.
The consensus I’ve gotten in this part of the country is that dividends are typically a non-issue, but that a dividend clause is added to block shenanigans such as a dividend to common shareholders to circumvent the liquidation preferences.
Sometimes, preferred stock will have a mandatory dividend associated with it as well; this is more likely to be seen in mature companies than in startups, and I have never had to model it. This might also be different in different regions.
The right to compel other shareholders to approve a liquidation transaction (“drag them along” with you). Usually afforded to a supermajority of preferred shareholders (either a specific class, or preferred holders voting together).
(Update 2006-06-19: Brad Feld introduces his readers to a variant of a drag-along right, termed a “compelled sale right,” in which the right is attributable to a particular minority shareholder rather than a majority or supermajority. Shockingly, in Feld’s example term sheet, this compelled sale right is given to a 10% CSE owner.)
A right of holders of a series of preferred stock to receive, before any other distribution, a specified payment, typically a multiple (such as 2.0x) of the original purchase price. AKA “two times money out first.”
Liquidation preferences are either paid in rank order (e.g., Series D preference first, then Series C, then Series B, etc.) or pari passu (according to each series’ percentage of the total preference amount). Once all the preferences are paid, then the rest of the proceeds are split among the holders of common stock (but see Participating Preferred, below).
The choice of converting to common vs. taking a preference, in a multiple-series capital structure, can lead to some pretty hairy financial models; caveat Excelor. One big thing to remember is that the decision of one series can “cascade” to others, since the first series’ decision, by definition, will be changing the amount of proceeds available to others.
Very rarely, common stock has a “liqudiation preference” as well (no joke — I’ve seen it with my own eyes!).
Other sources: Brad Feld on liquidation preferences;
A series of preferred stock which, in addition to any liquidation preference, gets to participate in the distribution of proceeds to common stock on an “as-if converted (to common stock)” basis. AKA “double dip.”
In non-participating preferred, a preferred investor must choose either to receive his liquidation preference, or to participate on an as-converted basis. For small exits, the preference is better; for large exits, the participation is better. Participating preferred is known as the double dip, because the investor gets both.
Sometimes, this clause is combined with a “cap” on the participation amount, which is, in a tricky way, equivalent to non-participating preferred with a big “invisible preference” included (because the investor still faces a “tipping point” where it is better to convert to common; it’s just a much higher number).
Other sources: Brad Feld on participating preferred;
of a stockholder to require the company to buy back his shares. Like with dividends, this is almost always present, but very rarely invoked for startup deals.
Typically, the redemption right specifies the price of redemption and a timeline (e.g. 1.0x, monthly over two years). Most often, this right requires some kind of supermajority of preferred holders for its exercise.
In conjunction with another financing, the issuance of warrants to purchase stock in a quantity usually specified by a percentage of a principal amount (e.g., 10% coverage on a $5 M bridge loan would be a warrant to purchase $500k of stock). The actual price for the warrant exercise might be the then-current price, or it might be dependent on the conversion price of a convertible note.
Warrants are usually “sweeteners” added onto debt rounds by venture lenders; chances are awful good that if you look at the warrants section of a few cap tables you’ll come across “SVB” before long (Silicon Valley Bank, one of the usual suspects in venture lending).