Below is a glossary for venture capital and merger and acquisition transactions. Users are encouraged to submit additional words for inclusion and suggestions for improved definitions. Once updating starts, the most up to date version of the glossary will be maintained at this link: Current Venture Capital and Merger and Acquisition Glossary.

Accredited investor

A person or entity that meets certain requirements under the federal securities laws for investment purposes. For example, a natural person is an accredited investor if he or she has a net worth (with spouse) that exceeds $1 million at the time of the purchase of securities, or has income either individually that exceeds $200,000 in each of the two most recent years or jointly with spouse that exceeds $300,000 for the two most recent years.

Angel investor

A wealthy individual (accredited investor) who provides seed or early-stage financing from his or her own funds in return for equity. Angel investors sometimes provide industry knowledge and contacts and sometimes play a direct role on the board, but infrequently participate in management. Angels invest either as individuals or in groups.

Anti-dilution provisions

An adjustment mechanism for preferred stock, options, or convertible securities that provides the holder the right to receive additional securities in the event of a future financing in which securities are sold at a lower price than originally paid by the holder of the right. Typically, anti-dilution provisions come in two types: full ratchet and weighted average. There are typically exceptions for the adjustment mechanism that carve out situations such as the issuance of certain employee options or existing convertible securities.

Assignment of inventions agreement

An agreement that states who owns the rights to intellectual property that is developed. An assignment of inventions agreement typically makes clear that an entity owns the relevant intellectual property developed by its employees, contractors, and agents.

Blank check preferred stock

Unissued class of preferred stock of a company, the terms and conditions of which (such as liquidation, voting, dividend, and conversion rights) may be expressly determined by the company’s board of directors without further shareholder approval. An issuer will typically use blank check preferred stock to simplify the process of creating new series of preferred stock to raise additional funds from sophisticated investors without obtaining additional shareholder approval.

Bridge financing

Interim financing used to meet a short-term, cash-flow need until more permanent financing (typically larger amounts) is secured. For example, bridge financing can be used to carry a firm to an initial public offering, a venture round of financing, or long-term debt.

Burn rate

The rate at which a company that is not profitable uses available cash to cover expenses that exceed revenues; the figure is usually expressed in monthly terms, as in a $100,000/month burn rate.

Business issue

An area that is traditionally negotiated between the clients, rather than attorneys (or in some cases, an area that one or both lawyers don’t want to negotiate for whatever reason).

Call right

A right that enables one person (or the issuer) to purchase securities held by another, usually at a fixed price and after a specified date or the occurrence of a certain event.

Capitalization

The combined sources of equity capital, consisting of convertible debt, common stock, and preferred stock.

Cap table

Short for capitalization table, it is a summary of a company’s issued and outstanding securities.

Common stock

A type of security representing the residual ownership rights of a corporation. Usually, company founders, management, employees, and some angel investors own common stock, while other investors own preferred stock. In the event of a liquidation of a corporation, the claims of secured and unsecured creditors, debt holders and holders of preferred stock take precedence over holders of common stock.

Convertible debt

A debt instrument (such as a promissory note) that can be converted to equity of the issuer (either as common stock or preferred stock).

Co-sale or tag-along rights

These rights enable the holder to participate in a sale of stock from another shareholder to a third party, typically in proportion to the number of shares the holder holds in the company. Co-sale rights are usually designed and intended to protect the holder if a founder or a majority shareholder decides to sell his, her, or its interest in the company. The co-sale rights holder can participate in the sale, usually on the same terms and conditions as the founder or majority shareholder.

Covenant

A contractual obligation to do or not do something in the future. For example, an affirmative covenant could be to provide quarterly reports to investors and a negative covenant could be to not enter into another financing without enabling existing investors to participate.

Cram-down financing

A financing that results in significant dilution of non-participating existing shareholders, usually reducing the value of the inon-participating existing shareholders’ original investments or the rights held by such non-participating existing shareholders.

Cumulative dividends

Dividends that accrue when unpaid and must be paid out before dividends are paid to subordinate classes of stock.

Deal flow

The amount of potential investments that an investor reviews in a given period of time.

Demand registration rights

Rights that enable a holder to demand that the company register the stock held by such holder under the Securities Act of 1933 in order to enable the holder to sell the stock in the public market without restriction.

Dilution

The reduction in the ownership percentage of shareholders caused by the issuance of new securities or the conversion of convertible securities of the issuer, typically with the connotation that the new securities are issued at a lower price than that paid in the previous round of financing.

Discounted cash flow

A valuation method in which the present value is calculated of anticipated future company cash flows.

Dividend

Payment made by a company to the owners of one or more of its types of securities.

Down round

A financing in which the new securities are issued at a lower price than the previous round of financing.

Drag-along rights

Rights that enable a shareholder or group of shareholders (usually those who own a controlling interest in the company) to compel other shareholders to sell their stock in the event a purchaser desires to purchase more than what the controlling shareholder(s) own(s).

Due diligence

A prudent and proper investigatory process to assess a company and the viability of a potential transaction.

Earn out

An arrangement in which sellers of a business may receive additional future payments if certain financial performance metrics are met.

Exit strategy

The method or plan for enabling shareholders to sell their shares and earn a return on investment. Typically, it refers to either the sale of the company or a public offering.

Founder

A person who participates in the creation of a company.

Founders’ stock

Nominally priced common stock issued to founders, officers, employees, directors, and consultants at or around the time a company is formed.

Full-ratchet, anti-dilution protection

Rights that enable investors to reduce the share price at which they can convert their earlier investment or debt to the lower price per share that the company subsequently sells or issues its securities.

Fully diluted basis

The total number of shares of common stock issued by a company, assuming all warrants, options and other rights are exercised and all preferred stock and other convertible securities are converted to common stock.

Initial Public Offering (or IPO)

The first registered offering of securities to the public that is in compliance with the Securities and Exchange Commission requirements.

Inside round

A round of financing in which the investors are the same or a subset of investors that invested in a previous round.

Institutional investor

Large, licensed entities that invest capital on behalf of companies or individuals.

Investment banker

A firm that raises capital, trades in securities, or facilities or brokers mergers and acquisitions (or a combination of some or all of the above).

Issuer

Refers to the company that issued or sold its securities.

Joint venture

An agreement or understanding between two or more companies in which the companies work together for a particular business undertaking.

Lead investor

The investor who manages the negotiation, documentation, and closing of a round of financing, and typically makes the largest investment in such round.

Liquidation preference

The amount of assets holders of preferred stock are entitled to prior to any distribution of assets to holders of common stock upon a liquidation event, such as the dissolution or sale of the company. The preference amount is often based on the original purchase price paid by the holders of preferred stock, or a multiple thereof (e.g., a 2x liquidation preference).

Living dead

Refers to investors who go through a few down rounds of financing, are unwilling or unable to invest any more, and for whose interests in the company there is no liquidation event on the horizon. When the term is applied to a company, it means that the company continues to operate, even though the company is insolvent or has little chance of thriving.

Lock-up provision

A contractual requirement that for a period of time (such as 180 days) a shareholder is restricted from selling such shareholder’s securities following a public offering.

Mezzanine financing

Typically a hybrid of debt and equity financing that is used to finance the expansion of an existing company. It is generally subordinated to debt provided by senior lenders, such as banks

No-shop requirement

A contractual requirement that prevents a company from soliciting or negotiating other deals for a specified period of time, while it is exclusively negotiating with a potential investor, group of investors, or acquiror.

Outstanding stock

Shares of stock that have been issued and are not held by the issuer

Participation right

A right that enables the holder to purchase the holder’s pro-rata percentage of the company’s equity securities in future rounds, enabling the holder to maintain his, her or its percentage ownership in the company.

Participating preferred stock

Preferred stock that entitles the holder not only to holder’s stated liquidation preference, but also allows the holder to participate in liquidating distributions to holders of common stock after the initial liquidation preference is distributed to the holders of preferred stock.

Payment in-kind dividends

A dividend paid in equity rather than cash.

Pari passu

A Latin term referring to the equal treatment of two or more parties in an agreement. For example, an investor may want to have a certain right that is pari passu with investors in a previous financing round.

Pay-to-play

A requirement that in order retain a right, the holder must do or pay something in the future. In the venture capital context, if a holder of preferred stock desires to maintain certain rights as a preferred stockholder, he, she, or it must participate and invest pro rata in future financings or lose those rights.

Piggyback registration right

A right that enables an investor to force an issuer to register the investor’s previously issued, but unregistered shares of the issuer in the event the issuer decides to register some of its other securities.

Placement agent

An individual or firm that assists with identifying investors to purchase securities.

Portfolio company

A company that has received an investment from a venture capital fund is said to be a portfolio company of that venture capital fund.

Post-money valuation

The value of a company after investors invest in a given round of financing.

Pre-emptive right

The right of an existing shareholder to purchase such shareholder’s pro rata share of any new stock that is being issued by the company prior to that stock being offered to new investors. Pre-emptive rights are similar to participation rights.

Pre-money valuation

The value of a company before investors invest in a given round of financing.

Preferred stock

Stock that gives its holders certain rights, preferences, and privileges over holders of common stock and other securities.

Private placement memorandum (PPM) or offering memorandum

A document explaining the details of an investment opportunity related to the sale of unregistered securities to potential investors.

Put right

A right that enables the holder to force the company or another investor to purchase the holder’s securities, usually for a prior agreed upon price, after a specified date or the occurrence of a specified event.

Qualified public offering (QPO)

A public offering that meets certain requirements, as agreed between investors and an issuer, such as a minimum amount or a specified return for holders of preferred stock.

Reg D or Regulation D

Refers to certain alternative rules promulgated by the Securities and Exchange Commission that enable an issuer to sell its securities with certain restrictions, without registering them, to a limited number of people, most or all of whom must meet certain standards of sophistication or wealth (see “accredited investor”). Each rule under Reg D has different requirements, such as those relating to the size of the offering, the number of investors, and the types of required disclosures.

Redeemable preferred

Preferred stock that can be redeemed by its holder in exchange for a prior agreed upon price.

Rights offering

An offering of securities only to current shareholders of an issuer.

Road Show

A series of presentations made in several cities to potential investors.

Securities and Exchange Commission (or SEC)

The federal agency that is in charge of enforcing the federal securities laws and regulating the securities industry (including the stock exchanges).

Stripped down preferred

A type of preferred stock that carries only the very basic rights of preferred stock (e.g., a liquidation preference), but does not carry the variety of other rights (contractual or otherwise) frequently associated with the issuance of preferred stock.

Syndicate

A group of investors that participate in a round of financing or a group of investment banks that participate in a public offering.

Term sheet

A document that outlines the key terms of a proposed transaction. The term sheet is typically non-binding, except for certain provisions.

Underwater option

An option is underwater when the current fair market value of the underlying shares is less than the option exercise price to purchase those shares.

Veto rights

Negotiated rights that enable the holder to prevent a company from taking certain actions or cause it to take certain actions.

Warrants

A derivative security that gives the holder the right to purchase securities (usually common stock) from the issuer at a specific price within a certain time frame.

Weighted average anti-dilution protection

Adjusts the investor’s conversion price downward based on a weighted average formula reflecting the number of new shares sold and the new price per share at which the additional shares were issued. It can be a narrow-based, weighted average or a broad-based, weighted average. Compare to full-ratchet anti-dilution protection.

The 2009 second quarter MoneyTree™ Report from PricewaterhouseCoopers (PwC) and the National Venture Capital Association (NVCA) came out earlier this week. As expected, the news was generally not good, but there were some rays of hope. Total amount invested nationwide was up some (15%) over last quarter but the number of deals was flat compared to the anemic numbers from the first quarter. In comparing last quarter to the 2008 second quarter figure, the number of deals was down by more than 40%.

Life Science Sector Leading the Way

By sector, life sciences faired the best. The report defines life sciences as biotechnology and medical device. According to PwC, investments in life science companies accounted for the highest percentage of total venture capital investments since the inception of the report. While the figures are not staggering, life science investments are proving to have slow but continuing exits for investors while exits for other industry have mostly stalled. With the increasing number of drugs coming off patent for large, cash rich pharma in the next few years, acquisitions of biotech companies are anticipated to increase. Many drug development companies (and investors) plan to take advantage of this as part of their exit strategy and long-term capitalization plan.

Also in the report, there was an increase in the combined size and number of seed and early stage investments, which coupled with the increasing interest in life sciences, bodes well for the Midwest if the trend continues.

Midwest Figures

In the breakdown of the regional data, the national trends generally hold true here in the Midwest. It is important to remember though that here in the Midwest, the numbers can fluctuate considerably from quarter to quarter because the deal volume is lower. So, an unanticipated quarterly spike of a given statistic (e.g., deal volume, industry investment, deal size, IPOs) in either direction is likely to be an anomaly rather than a material change in the trend line. As an aside, for purposes of the report, Minnesota, Wisconsin, Iowa, North Dakota, South Dakota, and Nebraska make up the “North Central,” while Illinois, Missouri, Indiana, Kentucky, Ohio, Michigan, and western Pennsylvania make up the “Midwest.”

When companies start up, often the first place they look for seed financing is from friends and family. As frequently as they occur, there is very little available on the details of what consists of a “good” friends and family financing. In this post, we will go through some of the considerations for your next friends and family round of financing.

Friends and family financings are frequently the first financing from outsiders of the company. Increasingly though with tough financial times, companies are relying more heavily and for longer periods of time on friends and family support to get them through the early times. So, let us get into some of the details.

Type of Securities to Issue

Almost invariably, when the company is a corporation, the company issues common stock in the friends and family round. For limited liability companies (LLCs), the security issued in the friends and family round is whatever the common stock comparable security is for the LLC—sometimes it is referred to as Class A Units or sometimes it is just a percentage interest or just “units” (if the LLC has only one class of securities). As LLC capital structures are most often a matter of contract per the company’s operating or LLC agreement and the laws vary from state-to-state, there is no single standard name for the type of security.

As later posts will echo, one important point to keep in my mind in terms of deciding on the type of security to issue is the importance of keeping the capital structure simple. In this case, with a friends and family round, it is typically best to issue common stock (or the LLC comparable). While one sees convertible notes, a “stripped down preferred,” or a certain level of warrant coverage, I recommend keeping the capitalization structure as simple as possible, for as long as possible.

Pricing

High Risk and High Price?

Pricing is often a difficult topic for a friends and family round. In my experience, it is often the round least likely where one is to see negotiation on price. It is not uncommon, however, for the friends and family round to be overpriced. How do I know that? Few would argue that of all the rounds of outside investment that companies go through, the friends and family round is likely where there is the most risk (technical and commercial) and there is likely the fewest tangible and intangible assets. I’ve seen some statistics indicate that over 90% of tech startups end unsuccessfully. Yet, it is (1) very common to see seven (or in some cases, eight) figure pre-money valuations for not much more than a skeleton of a management team, a business plan, and a patent application, license right, prototype, or vaporware, and (2) not uncommon to see either a flat round or better terms offered in the first VC or angel deal following the friends and family financing. It is not that entrepreneurs are trying to take advantage of their friends and family. But rather, it is likely because they are overly optimistic concerning their prospects; they are entrepreneurs after all, and a good sense of optimism is essential to success.

Impact of Price on Subsequent Rounds

When pricing a friends and family round, it is also important to consider the impact of the price in the context of the long term capitalization strategy. I talk about the long term strategy in my earlier post, Capitalization Strategy: Begin with the End in Mind. As mentioned in the previous paragraph, a common problem that some entrepreneurs face is having too high of a price in the friends and family round (or subsequent angel round for that matter). How can too high of a price be a problem for a company? After all, a higher price means less stock is issued and therefore less dilution. The reason it can be a problem goes back to your long term plan. Often, a high price in an early round yields problems in later rounds in terms of existing investor expectations. If you understand the likely pricing expectations of later round investors, those expectations should be incorporated in earlier round pricing. Promising companies can sometimes get too aggressive on pricing in early rounds and often stall, not because of their technology or lack of success in their commercialization efforts, but rather because they cannot find financing sources that meet their existing investor expectations. So, after a considerable delay in not getting a timely financing, companies are forced to consider either (a) “down round” pricing to get the amount of financing they need from subsequent round investors or (b) accepting less investment (most likely from existing investors) and prolonging the current share pricing as they hobble along and exist on less than ideal amounts of financing. Also, by accepting down round pricing, it can not only affect morale of existing investors but also employees as well in terms of the perception of the direction and speed of the company’s momentum.

Effect of Price on Stock Options

On a related note to employees, one other thing to keep in mind is the impact of your friends and family round pricing on your stock option pricing (or other equity-based incentive), especially if you issue common stock in the friends and family round. The price at which you sell your securities will likely affect significantly your stock option exercise price or the amount that has to be taken into income by employees and contractors if stock or other equity-based securities are issued to them. This is especially true as the ability to issue discounted stock options is no longer the option (pardon the pun) it once was in light of tax code section 409A. This is one area where offering convertible notes (or preferred stock) to friends and family yields a benefit over common stock.

Accredited Investor Status

As a general rule, it is best to limit your friends and family offering to accredited investors only. Many companies want to enable their friends and family who are not well off to “get into the action” early. Ignoring the issue of whether friends and family who are not accredited can bear the risk associated with an investment in a start-up, by including friends and family who are not accredited in an offering can drive up your legal costs to do the transaction and increase the risks of legal problems associated with the entire offering. If you are considering including investors who are not accredited in your offering, have a discussion with your attorney first before announcing the offering. Doing so will help to ensure that you make an informed decision without the pressures of the implications of backing down from an earlier announcement to your friends and family.

Amount of Funding

The amount of financing should be driven by, you guessed it, your long term capitalization plan. Conventional wisdom is that you should raise sufficient money to comfortably get you to the next significant milestone that increases your valuation. However, there are some companies that believe that they should get as much money as they can, as soon as they can. The problem with this latter approach is that, assuming your subsequent round financing is an up-round, you will suffer more dilution by getting the money earlier than what you would otherwise experience by waiting and then selling the securities later at a higher price. Also, some people believe that companies can become less efficient, less “hungry,” and lose their sense of urgency with significant amounts in the bank. On the flip side, a benefit of raising more in an early round is that less time is spent on subsequent fundraising. In addition, as those who adopted this approach a year ago will say, they are not now seeking financing in what is a very difficult time to raise money.

Importance of the Friends and Family Round

While typically not the biggest round of financing to say the least, the friends and family financing is essential for most high growth companies. It is important to do the financing right and not fall into one of the easy traps that create problems later in the company’s life cycle. If there’s interest, I can elaborate on some other traps and pitfalls in a later post.

“Begin with the End in Mind”: what a simple, yet profound concept. It is one of the habits of Stephen Covey’s 7 Habits of Highly Effective People. It is so simple, but too often overlooked.

When entrepreneurs start companies they often have vivid visions of success. Through the business planning process, entrepreneurs often develop and work through the various issues that need to be addressed in order to obtain the commercial success for which they are looking. But, what is the desired end state or exit? Or, is death the only exit? Seriously though, is the exit, sale of the company within 5 or 10 years? Is it working with and growing the company until retirement, with younger management or the next family generation buying out the company? Is it an intellectual property holding company collecting royalties from various licensees? Is it the sale of stock after a public offering? Too often, entrepreneurs dedicate only two or three sentences in the business plan to the intended exit, using almost boilerplate language. Of course, only time will tell how things will end up, but having a vision for a desired outcome will help drive decisions and planning, making your desired outcome more likely to come to fruition.

Backwards Planning Process

With the desired end in mind, the business planning process and capitalization strategy development can truly begin. It is what is referred to as the backwards planning process. Many people do this instinctively as part of their normal planning. Identify what assuredly has to happen in order to get you in position to meet your desired end state. Think of these “have to happen” items as interim objectives. It may be a certain level of sales or EBITDA, successful completion of a lead drug phase II clinical trial, a successful public offering, etc. Then, identify what conditions, tasks, and shorter-term objectives it will take to meet those interim objectives. Continue to repeat that process until you are back in time to the present day.

Capitalization Strategy

When looking at your capitalization strategy, it is a very similar process. In fact, it should go hand in hand with business planning. You also need to consider though the needs, expectations, and desires of your sources of capital—meaning your prospective investors, bankers, government agencies, customers, etc. Figure out what it will likely take in order for you to get the sources and amount of capital you need to reach your desired end state. When looking at equity capital, think through valuation issues, dilution, capitalization structure, liquidation preferences, etc. Again though, start with the end in mind and work back through time, through each anticipated round of investment, each grant and grant phase, etc. It will help you develop a coherent strategy and identify what needs to be done to get you where you want to be.

Understanding Investor Needs

I’ll go through more on investor needs, expectations, and desires in later posts, but for present purposes I will touch on two very basic ones to illustrate some of the considerations to include in developing your capitalization strategy: the amounts of money that different types of investors invest as well as when in a company’s life cycle those investors invest.

Here are a couple of charts to consider. The first one shows the ranges of investment amount by investor type. The chart contains generalizations. Of course, sometimes investments are outside of these ranges for unique deals or situations or current market conditions. For instance, this year we are in relatively tight markets so both the number of deals and the amount of investments by group are generally down.

This next chart shows the stage of company development that investors generally invest at. As with the amount of investment, one see deals outside of these ranges based on unique opportunities or situations or the general market conditions. Also, there are variations by industry. For example, in therapeutics, the categories on the y-axis would be different: they would likely include positive preclinical animal data, filing a new drug application, commencing the clinical trial, completing phase I of the trial, etc.

 

The point to take from all this is that developing a coherent capitalization strategy is a deliberate process. It should take into account the entire time between today and the day you meet you desired end state, not just where your next grant or equity financing is going to come from. Have a long term strategy will actually help guide you through many decisions and assessments of opportunities that you will likely encounter.

It comes to no surprise to most people that virtually all early stage technology-based companies are in need of more money.  Even after companies raise money, they are often looking quickly for where the next grant or round of financing is going to come from.  High growth companies that are more established often weigh how much cash should be allocated to marketing and sales versus research and development and augmenting their product pipeline. 

Below is a list of some of the traditional sources of capital for high growth companies.  Most companies use at least two of these methods at any given time and it is not uncommon for companies to use all of them at some point in their life cycle.

Equity Capital

This includes investor money from friends, family members, wealthy acquaintances, venture capitalists, hedge and pension funds, and the public at large.  While not viewed this way by many, in most cases, it is the most expensive form of capital for successful companies.

Federal and State Grants and Loans

Probably the cheapest form of capital is federal and state grants.  For small technology companies, SBIR and STTR grants are often their main sources of capital.  Even for early stage tech companies that rely on investor money, they often supplement investor money with grant funds.  For later stage companies, government grants and loans often amount to only a small portion (or no portion) of their incoming capital.

Debt and Equipment Leasing

With the exception of convertible debt, debt obligations issued to insiders, and certain government-sponsored debt, significant debt financing is typically reserved for large companies that are cash-flow positive or that have a significant asset base

Strategic Alliances or Partnership Arrangements

Entering into a strategic alliance or other form of partnering arrangement is a common way for a number of companies to raise capital during the development stage, especially those that are in the pharmaceutical or other high development cost industries.  In exchange for some form of exclusivity or option for exclusivity, these arrangements frequently have a large up-front payment or the costs of development, testing and clinical trials are borne by the larger company.  Most often, continued payments are conditioned upon meeting pre-defined milestones.  Sometimes, these arrangements entail the larger company adopting a technology or platform (at reduced or no cost or in exchange for equity of the smaller company) in an effort to make the technology or platform an industry standard.

We’re going to spend a lot of time on this blog addressing financing issues.  Over the next several posts, we’ll go over some of the details on each of the areas, emphasizing current strategies that companies are using as well as current market terms in light of the tight capital markets.  We’ll also conduct some interviews with industry players and seasoned entrepreneurs to get their perspective and advice.

Welcome to the AlphaTech Counsel blog! In this blog, we’ll address common issues that high growth companies face. We will conduct interviews of seasoned entrepreneurs and investors, identify and comment on market trends, and provide answers to recurring questions.

In the meantime, if you have any areas that you’d like to see us address, drop us a line.