Cap Table Glossary
A form of vesting that takes place at a faster rate than the initial vesting schedule in a company's stock option plan. This allows the option holder to receive the monetary benefit from the option much sooner.
Some employees negotiate vesting acceleration in the event of an acquisition. For example, the employee might earn an extra six or 12 months of vesting at the close of the deal. The logic behind this benefit is the employee didn’t sign up to work for the acquirer, so they should be compensated for having to accept a significant change in environment. Acceleration upon merger is typically only offered with what is known as a double trigger. This means that two events are required to trigger the acceleration: acquisition and a change of role post acquisition (i.e. you have a lesser job).
Most companies don’t like to offer acceleration of vesting upon acquisition to anyone other than executives. The reason executives are able to command the acceleration benefit is because ironically they are the ones most likely to lose their job in an acquisition.
The purchase of one corporation by another, through either the purchase of its shares, or the purchase of its assets .
There's only one way for a company to achieve massive growth literally overnight, and that's by buying somebody else's company. Acquisition has become one of the most popular ways to grow today. Since 1990, the annual number of mergers and acquisitions has doubled, meaning that this is the most popular era ever for growth by acquisition.
Angel investors invest in small startups or entrepreneurs. Often, angel investors are among an entrepreneur's family and friends. Typically, angel investors are focused on helping startups take their first steps, rather than just the possible profit they may get from the business.
Angel investors must meet the Securities Exchange Commission's (SEC) standards for accredited investors. To become an angel investor, one must have a minimum net worth of $1 million and an annual income of $200,000. Angel investors typically use their own money, unlike venture capitalists who take care of pooled money from many other investors and place them in a strategically managed fund.
An anti-dilution clause is a provision in an option or a convertible security also known as an "anti-dilution provision." It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid. These are common with convertible preferred stock, which is a favored form of venture capital investment.
In venture capital investing in particular, dilution is a concern for preferred shareholders, as a later issue of stock at a price lower than their current shares would dilute their total ownership. Anti-dilution clauses prevent this from occurring by adjusting the conversion price between preferred stock and common stock. These clauses are also known as preemptive rights, subscription privileges or subscription rights.
Convertible notes are designed to convert into equity when the company raises more than $1M dollars in new capital. Without a cap or discount, the notes would typically convert at the same price as the equity issued in that financing.
A “valuation cap” entitles note holders to convert into equity at the lower of the valuation cap or the price in the subsequent financing. It is designed to protect seed stage investors from dilution if the size of the round is greater than the cap amount.
A capitalization table (or cap table) is a table providing an analysis of the founders' and investors' percentage of ownership, equity dilution, and value of equity in each round of investment.
Early stage startups typically have a simple capital structure and more limited stakeholder accounting requirements. In the earliest stages of their development, startups may track their shareholders in a simple document or spreadsheet. As more complexity is added there is increased risk of errors or omissions and the use of a dedicated tool such as captable.io becomes neccessary.
Cap tables are widely used by entrepreneurs, venture capitalists, and investment bankers to model and to analyze events such as ownership dilution, issuing employee stock options, or issuing new securities. After several rounds of financing, a cap table can become highly complex.
Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.
There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.
For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity.
A discount in a convertible note sets a percentage reduction at which the note will convert relative to the next qualified priced round. Effectively this permits an investor to convert the principal amount of their loan (plus any accrued interest) into shares of stock at a discount to the purchase price paid by investors in that round. Discounts range from 0% to as high as 35% with 20% being common.
An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings. If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1,000,000 plus 5% of gross sales over the next three years.
A section 83(b) election is a letter you send to the Internal Revenue Service letting them know you’d like to be taxed on your equity, such as stock options, on the date the equity was granted to you rather than on the date the equity vests. Put simply, it accelerates your ordinary income tax.
Filing an 83b election is part of the process of purchasing your stock options early, to avoid significant tax bills later after your options have gained in value.
Entrepreneur in Residence is a kind of position in Venture Capital firms that is usually temporary and not formal. This is when an institution brings in an entrepreneur, who is usually in the process of starting or expanding his/her new company.
In the Venture Capital firm the entrepreneur is funded to work with some of the investment team of the company as well as being exposed to business-building processes, where he/she can assist the firm with any existing portfolio. In addition he/she is expected to help the company evaluate new potential investments, especially if it is an area of the E.I.R's experience. On the other hand, the company usually benefits from this by getting significant access to the new company started by the E.I.R. This is due to the fact that the company gets to, usually, be the first investor in E.I.R's new company, giving them a chance to influence some company decisions.
Equity compensation is one way to attract and retain employees to a startup company. Since most companies lack the initial funds to get high quality employees, they use equity compensation to fulfill this need. Equity compensation is a non-cash compensation that represents a form of ownership interest in a company.
As a general rule, all stock option grants need to have an exercise price at or above the fair market value of the company’s common stock on the date such grant is made. This requirement, and its many related complexities, generally comes from Section 409A of the Internal Revenue Code and the related Internal Revenue Service (“IRS”) regulations (collectively, “Section 409A”). Section 409A was enacted several years ago in response to perceived abuse of deferred compensation arrangements brought to light during various high-profile corporate scandals.
An initial public offering (IPO) is the first time that the stock of a private company is offered to the public. IPOs are often issued by smaller, younger companies seeking capital to expand, but they can also be done by large privately owned companies looking to become publicly traded.
An investment banker is an individual who works in a financial institution that is in the business primarily of raising capital for companies, governments and other entities, or who works in a large bank's division that is involved with these activities, often called an investment bank.
A lead investor is a company's principal capital provider. Lead investors play a much more critical role than that of any other investor. Regardless of what round, whether that be the angel round, venture round or hedge fund, finding a lead investor can be invaluable to a company.
Used in most major business transactions, a letter of intent (LOI) outlines the terms of a deal and serves as an “agreement to agree” between two parties. An LOI is similar to a term sheet in its content, but differs in structure (one formatted as a letter; the other, as a list of terms).
The real utility of a letter of intent is that it formalizes a preliminary agreement on a topic before negotiations get underway, it outlines what can and can't be talked about outside of that negotiation, and it provides a roadmap that describes how things will proceed.
LPs or Limited Partners serve as the primary source of capital into a venture fund, and GPs or General Partners serve to manage the fund and execute investments with the capital in order to return that capital to the LPs.
What that means is that if a VC fund were a startup, the LPs are sort of like the VCs for the fund. Just like VCs watch over the investment by being board members and active participants in the growth of a startup, LPs watch over their investment in a VC fund by certifying investment choices and overseeing the fund's growth in hiring new partners, selecting other critical members of the investment team, etc.
A liquidity event is a typical exit strategy of a company, since the liquidity event typically converts the ownership equity held by a company's founders and investors into cash. A liquidity event is not to be confused with the liquidation of a company, in which the company's business is discontinued.
A liquidation preference is one of the primary economic terms of a venture finance investment in a private company. The term describes how various investors' claims on dividends or on other distributions are queued and covered.
Read a clear, diagramatic explanation of Liquidation preferences here.
In its most basic form, a nondisclosure agreement is a legally enforceable contract that creates a confidential relationship between a person who holds some kind of trade secret and a person to whom the secret will be disclosed.
Confidentiality agreements typically serve three key functions:
- NDAs protect sensitive information. By signing an NDA, participants promise to not divulge or release information shared with them by the other people involved. If the information is leaked, the injured person can claim breach of contract.
- In the case of new product or concept development, a confidentiality agreement can help the inventor keep patent rights. In many cases, public disclosure of a new invention can void patent rights. A properly drafted NDA can help the original creator hold onto the rights to a product or idea.
- Confidentiality agreements and NDAs expressly outline what information is private and what's fair game. In many cases, the agreement serves as a document that classifies exclusive and confidential information.
An option pool consists of shares of stock reserved for employees of a private company. The option pool is a way of attracting talented employees to a startup company - if the employees help the company do well enough to go public, they will be compensated with stock. Employees who get into the startup early will usually receive a greater percentage of the option pool than employees who arrive later.
Post-money valuation is a company's value after outside financing and/or capital injections are added to its balance sheet. Post-money valuation refers to a company's valuation after funds, such as investments from venture capitalists or angel investors have been added to the balance sheet.
A pre-money valuation is a term widely used in private equity or venture capital industries, referring to the valuation of a company or asset prior to an investment or financing.
Pro rata is the term used to describe a proportionate allocation. It is a method of assigning an amount to a fraction according to its share of the whole. While a pro rata calculation can be used to determine the appropriate portions of any given whole, it is most commonly used in business finance.
Right of first refusal (ROFR or RFR) is a contractual right that gives its holder the option to enter a business transaction with the owner of something, according to specified terms, before the owner is entitled to enter into that transaction with a third party.
If the founders ever want to sell any of their shares to a third-party, the right of first refusal requires them to give the company the first opportunity to purchase the shares on the terms offered by the third-party. If the company doesn’t exercise its right of first refusal, the venture capital investor then has the opportunity to purchase the shares on the same terms. If both the company and venture capital investor forego their rights of first refusal, then the founders may proceed to sell their shares to the third-party. A right of first refusal is designed to control which parties may own a significant number of shares in the company and give the venture capital investors the first opportunity to purchase shares if they desire to do so.
Seed capital is the initial capital used when starting a business, often coming from the founders' personal assets, friends or family, for covering initial operating expenses and attracting venture capitalists. This type of funding is often obtained in exchange for an equity stake in the enterprise, although with less formal contractual overhead than standard equity financing. Because banks and venture capital investors view seed capital as an "at risk" investment by the promoters of a new venture, capital providers may wait until a business is more established before making larger investments of venture capital funding.
A Series A round is the name typically given to a company's first significant round of venture capital financing. The name refers to the class of preferred stock sold to investors in exchange for their investment. It is usually the first series of stock after the common stock and common stock options issued to company founders, employees, friends and family and angel investors.
An employee stock option (ESO) is a stock option granted to specified employees of a company. ESOs offer the options holder the right to buy a certain amount of company shares at a predetermined price for a specific period of time.
Employees that receive stock options get the right to buy stocks at a predetermined price, or strike price. You “exercise your options” when you purchase the underlying stocks at strike price. The company is legally bound to set your strike price at what is deemed fair market value of the company stock when the options are granted to you. When the strike price is equal to fair market value, the options are considered “in the money.”
So, if you were granted “in the money” stock options with strike price of $1, and you were to exercise your options on the same day, you would pay $1 for each stock, and own that stock valued at exactly $1. You would have a net gain of $0. As company grows over time, the value of stock would rise.
A syndicate is an investment vehicle that allows investors (backers) to co-invest with relevant and reputable investors (leaders) in the best startups in the market.
Syndicate leaders are business angels with vast experience in selecting investment opportunities and investing in then, in various technology sectors and with dealflow that most investors don’t have access to. They tend to be angels -or successful startup founders- who have been part of the industry for many years and know its ins and outs.
A term sheet is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made. A term sheet serves as a template to develop more detailed legal documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is then drawn up.
A term sheet lays the groundwork for ensuring that the parties involved in a business transaction agree on most major aspects of the deal, thereby precluding the possibility of a misunderstanding and lessening the likelihood of unnecessary disputes. It also ensures that expensive legal charges involved in drawing up a binding agreement or contract are not incurred prematurely.
Term sheets are not generally considered legally binding and are therefore seen as unenforceable in a legal sense. In that regard, a term sheet may seem similar to a letter of intent when the action is predominately one-sided, as in acquisitions, or a working document to serve as a jumping-off point for more intensive negotiations.
Venture capital (VC) is a type of private equity, a form of financing that is provided by firms or funds to small, early-stage, emerging firms that are deemed to have high growth potential, or which have demonstrated high growth (in terms of number of employees, annual revenue, or both). Venture capital firms or funds invest in these early-stage companies in exchange for equity–an ownership stake–in the companies they invest in. Venture capitalists take on the risk of financing risky start-ups in the hopes that some of the firms they support will become successful. The start-ups are usually based on an innovative technology or business model and they are usually from the high technology industries, such as Information technology (IT), social media or biotechnology. The typical venture capital investment occurs after an initial "seed funding" round. The first round of institutional venture capital to fund growth is called the Series A round. Venture capitalists provide this financing in the interest of generating a return through an eventual "exit" event, such as the company selling shares to the public for the first time in an Initial public offering (IPO) or doing a merger and acquisition (also known as a "trade sale") of the company.
Vesting means that at the very beginning each founder gets his or her full package of stocks at once to avoid getting taxed for capital gains; but, the company has the right to purchase a percentage of the founder’s equity in case he or she walks away. This means that if your partner walks away after a couple of months, he or she will not be able to claim those 100 million dollars because the company purchased his or her equity when he or she left the company. In essence, vesting protects founders from each other and aligns incentives so everybody focuses towards a common goal: building a successful company.
Standard vesting clauses typically last four years and have a one year ‘cliff’. This means that if you had 50% equity and leave after two years you will only retain 25%. The longer you stay, the larger percentage of your equity will be vested until you become fully vested in the 48th month (four years). Each month that you actively work full time in your company, a 1/48th of your total equity package will vest. However, because you have a one year cliff, if one of the founders leaves the company before the 12th month, then he or she walks away with nothing ; whereas staying until day 366 means you get one fourth of your stocks vested instantly.
Warrants represent an option to purchase a certain number of shares (common or preferred) at a future date at a fixed price, which can be the price of the current round of financing or set at a premium to the current price per share.
Warrants tend to be used in earlier-stage deals to compensate an investor helping you to raise startup financing (in lieu of or in addition to cash). Warrants can also be used in later-stage deals or strategic rounds to provide upside potential value to investors to encourage participation in a round of financing.
Unlike stock options, warrants tend to provide an option to purchase the most recent class of shares (rather than common shares). Warrants can also be issued to third parties while stock options are limited to employees, directors, consultants and advisors engaged in the business.
Zone of Insolvency
A startup has entered the Zone of Insolvency when it is very close to being insolvent and no longer has enough money or assets to pay off all of its liabilities. This can impose certain duties on the startup’s board and/or officers.