Do You Really Understand the Venture Capital Terms—or Are You Just Afraid to Ask?
In our education programs at Two Step Software, we provide basic training for those who do the difficult work of tracking and creating capitalization tables and offer other courses that focus on equity compensation accounting. However, for a change, we thought it would be useful to take one step back and help those who are responsible for basic cap table tracking (but aren’t "deal gurus") understand some of the deal terms that may not relate to cap table tracking at first blush.
While sometimes it’s the tracking that matters most, it’s also critical to understand the terms that relate to the investment side. If you’re responsible for tracking the equity in your company's capitalization table, you should be familiar with this terminology in order to understand how all the pieces fit together. This understanding will serve you well as new stock is being issued—or as more complicated equity instruments become involved, such as preferred stock, stock options, or warrants.
Once the big numbers are determined -- such as valuation and how much the new investor will get of the company -- the details must be implemented: How many shares is the new investor going to get? How many shares of preferred will be issued for the agreed portion of the common stock? How do they convert? How does the increased option pool fit into the total capitalization? Will the liquidation preference increase over time? How do the investors participate in future rounds?
I recently came across a set of blog posts from four years ago, written by an early-stage investor, Brad Feld, Managing Director of the Foundry Group and formerly of Mobius Venture Capital. His blog, worth reading, is full of outstanding writing and insightful commentary. Despite their age, these posts provide the equivalent of a half-day seminar on understanding venture capital terms for a stock plan administrator, junior finance department member, young corporate attorney, or corporate paralegal. If you've ever found yourself on a conference call where the discussion sounded like a foreign language, take a few minutes to read these articles.
The four blog post titles are (click to view):
“Venture Capital Deal Algebra” discusses the basic concepts of "pre-money" and "post-money" valuation and how to calculate the shares to be issued. Among the information it shares are some very simple formulas that could be extremely helpful for deal novices, such as:
Pre-money Valuation = Share Price * Pre-money Shares
Share Price = Pre-money Valuation / Pre-money Shares
Post-money Valuation = Pre-money Valuation + Investment
Investment = Share Price * Shares Issued
The other three posts are self-explanatory based on their titles. They cover areas that many non-lawyers, non-CFOs and non-venture capitalists don't really understand (and in the sophisticated world of VC and private equity investing, few are bold enough to raise their hand and ask). Judging by the reader comments in these posts, it's also clear that even some investors and founders don't understand the terms completely.
It’s possible that these individuals have avoided the second tier of negotiation that is required to flesh out what a term means under specific circumstances (see: What Does Pro Rata Mean?). For every investor who has done a few deals in the past, it seems like these terms should be obvious based on the way they were used in those unique deals. But as these articles suggest, there are probably many other investors who have used them differently in their own deals.
If you are new to venture capital terms, read these blog posts and you’ll greatly increase the chances that you can actually understand what the terms mean on the Term Sheet and spend a little less time hoping no one asks.