Legal Terms for VCs with Ariana Shaffer
Investing in a startup can be exciting and potentially lucrative, but it’s important to understand the legal terms involved in the process. While many emerging venture capitalists and angel investors have a general understanding of these terms, it’s crucial to have a deeper understanding in order to avoid costly mistakes. Ariana Shaffer, Founding Attorney at Tome, dives into four key legal terms and why they are important for investors to understand.
- Option Pool
- Liquidation Preference
- Pro Rata Rights
Economics & control
As we go through these key terms, keep in mind these 2 terms: economics & control.
Knowing there is high risk involved in early stage investing, it is essential to be able to capture some of the downside as well as the upside when negotiating the terms of deals. When negotiating term sheets and looking at deals, consider the risk and have provisions in place that will allow you to mitigate any losses.
Another key factor to consider when investing in startups is control. Typically, control is split between the company and the investors. The founder usually has control and ownership over the company, but investors should also have provisions in place that allow them to have input into certain company decisions and to veto decisions they don’t agree with.
Valuation refers to the value of a company. When it comes to VC, valuation is often split into two categories: pre-money valuation and post-money valuation.
Pre-money valuation refers to the value of the company before any investment is made. In the early stages of a company’s development when there are no financial statements or earnings to analyze, this can be difficult. In these cases, VC investors often rely on other factors, such as the size of the market, the competition, and the potential growth of the industry, to estimate the value of the company.
Post-money valuation, on the other hand, is the value of the company after the investment has been made. It is calculated by adding the pre-money valuation to the amount of the investment. For example, if a company has a pre-money valuation of $10 million and a VC investor invests $5 million, the post-money valuation would be $15 million.
Why does valuation matter? As an investor, the amount you invest divided by the post-money valuation determines the percentage of the company that you own. In the above example, the investor would own 33% of the company post-financing. This percentage can affect your potential return on investment if the company is successful.
It’s important to note that there are different methods for valuing a company, and the process can vary depending on the stage of the company’s development, the industry, and other factors. It’s not an exact science, and valuations can change over time as the company grows and evolves.
One key negotiation tip when it comes to valuation is to be clear about whether you are discussing pre-money or post-money valuation. This can make a big difference in the ownership percentage and potential return on investment. Being clear and upfront about the valuation can save time, confusion, and potentially costly legal fees down the line.
The option pool is a set of shares that is reserved for future advisors, employees, and consultants of a company. Startups often incentivize people to leave high-paying jobs by offering a combination of cash and shares in the company. As the company grows and becomes more successful, these shares can become very valuable. The option pool is also a way for companies to bring on advisors that they can not afford to hire full-time at the moment. Typically, the option pool is between 10 and 20% of a company’s total outstanding shares and is set up at the beginning of the company. When a company does a financing round, they will often raise their option pool or increase the number of shares in the option pool. This is usually done with the approval of investors, and sometimes investors will even request that the option pool be a certain percentage of the post-money capitalization. Tthe option pool is a crucial tool for startups to attract and retain talent, and it’s important for investors to consider when evaluating a company.
Investors typically do not want the option pool to dilute their ownership percentage in the company. They want to ensure that their investment gives them the expected percentage of ownership in the company. Typically, investors may ask that the option pool be a percentage of the post-money capitalization of the company. This ensures that the option pool is taken into account when calculating the ownership percentage.
Investors request that the option pool be calculated in the pre-money valuation to avoid dilution. Including the option pool in the pre-money valuation means that the company is effectively valued at less than what would technically be the pre-money valuation. For example, if a company has a pre-money valuation of $10 million and a desired option pool of 20%, the effective pre-money valuation would be $8 million.
It’s crucial to understand whether the option pool is calculated in the pre-money or post-money valuation. Most founders and VCs in Silicon Valley assume that the option pool is included in the pre-money calculation, so it’s essential to make sure this is the case when looking at a pro forma.
Liquidation Preference determines the order in which proceeds are paid out after a liquidity event, such as an acquisition of the company. Typically, investors are paid out first, followed by the preferred stockholders, and then the common stockholders. The rights we’re discussing today are given to preferred stockholders, who have certain rights, privileges, and preferences that the common stock does not have.
When looking at liquidation preferences, there are a few key components to consider. The first key component is the multiple, which can be 1x, 2x, 3x, or any other multiple. The most common multiple in Silicon Valley and USBC markets is 1x, but in down rounds or challenging economic times, more aggressive liquidation preferences may be seen. It’s important to be prepared to negotiate any type of multiple.
If you invested $500,000 in a company with a 1x multiple, on an exit, you get your 500,000 back. If you had a 2x Multiple, you’d get a million back, and so on and so on.
The next component is participation which can get tricky but something common. Right now, we’re seeing that most liquidation preferences are non participating. Sometimes you will see participating or cap participation. This type of preference allows the investor to not only receive their initial investment back but also participate in the remaining proceeds. This is essentially double-dipping, and it’s not common because it can leave founders and employees with nothing. It’s important for investors to be cognizant of their reputation as a VC and to be founder-friendly. Being seen as a VC who takes all the money in an acquisition could make it difficult to score the best deals.
There are also different levels of seniority in liquidation preferences. As you start to invest in later stage deals, this will become more relevant. Pari passu means that all series are equal and paid out at the same time. Series-specific seniority means that the series B investors get paid out before the series A investors who get paid out before the seed investors. Typically, last money in gets paid out first.
Pro Rata Rights
Pro rata rights are an important tool for investors, particularly for those who invest in early-stage or angel investments. As companies grow and require more capital, they issue more shares to new investors in order to raise funds. This dilutes the ownership percentage of existing investors, which is why pro rata rights are so valuable. With pro rata rights, investors have the option to purchase additional shares in future financing rounds in order to maintain their current ownership percentage.
This is particularly important for early investors, who are often the most vulnerable to dilution as the company grows and raises more money. By negotiating for pro rata rights, investors can ensure that they have the opportunity to participate in future financing rounds and protect their ownership stake. Pro rata rights can be included in investment agreements such as a safe, and can be negotiated separately as an optional side letter. Overall, pro rata rights are a crucial tool for investors to protect their interests as companies grow and evolve.
Pro rata rights are commonly found in the National Venture Capital Association (NVCA) documents, available on the NVCA’s website. These documents discuss pro rata rights as a major investor right, available only to the top two or three investors based on a threshold investment amount.
While it is common for early-stage investors to have pro rata rights, whether they are granted or not depends on the context of the deal. If the investor is not the largest check writer or not among the top two or three investors in a Series A round, they may not be granted pro rata rights.
When negotiating for pro rata rights, it’s important to look for a couple of key provisions. One of these is an overall allotment or “gobble up” rights, which means that if another investor with pro rata rights doesn’t take theirs, you can take their share. Another provision to watch for is a “use it or lose it” provision, which means that if you don’t exercise your pro rata rights when offered, you lose them for the future. Companies often use this to incentivize investors to use their rights.
It is worth noting that pro rata rights can be waived by a majority of the investors who hold them. When a company seeks approval for financing, they may request that pro rata right holders waive their rights in case there is not enough room for them in the funding round. This means that if there is no space for pro rata rights, they will not be honored, but if there is enough room, the investors will be allowed to participate. In some cases, larger investors may be able to waive these rights on behalf of minority investors without seeking their approval. Minority investors could be affected negatively in a situation where they want to exercise pro rata rights but the company determined there was no room. Pay close attention to this language in legal documents.
Ariana is the Founding Attorney at Tome a seed-stage startup that uses AI to summarize common venture documents, including SAFEs and NVCA financing documents. Tome recently launched their Venturepedia, a curated knowledge base of venture capital and legal terms for emerging VCs.