Guest post provided by: Joseph Shanley, Esq.
At a certain point on their startup journey, founders may require outside investment to grow their business. Some even get lucky enough to receive a term sheet from a prospective investor who believes in their product or service. Upon reviewing the term sheet, excitement turns into anxiety as the founding team sifts through all of the legal gobbledygook. Security types? Liquidation Preference? What does all of this mean? While these definitions are complicated and require attorney analysis, it is helpful to understand basic investment concepts before moving forward with a deal. In this article, we’re going to discuss some common startup financing terms you might encounter, but in plain English.
A “security” is a financial asset or instrument that holds monetary value. Super vague, right? In fact, the Securities Act of 1933 identifies more than 25 separate financial instruments as securities. Securities fall into two broad categories as it relates to startup financing, equity and debt. Keep in mind that these categories can intermingle, but for now we’ll keep it simple.
An issuer is a legal entity that registers or sells securities. In our case, the issuer would be a startup company. Issuers are obligated to report financial conditions, developments, and operating activities to investors as required by federal and state regulations.
A shareholder is an individual or entity that owns one or more shares of a company. These folks get a piece of the pie and are looking for the big win.
A dividend is a sum of money paid by a company to its shareholders out of its profits or reserves. It is important to note that it is not mandatory for a company to pay regular dividends. In fact, some companies don’t pay dividends to defer tax liability but that’s a whole different can of worms.
Equity is a security that entitles the equity holder to a share of ownership interest or capital stock in a company. Remember that piece of the pie, it’s just delicious. Depending upon the issuance, equities may or may not have voting rights in the company. Equity holders also may or may not receive regular dividends (taxes anyone?). In the event the company liquidates its assets or dissolves, equity holders have lower priority claims than debtholders to the company’s assets. However, after the debtholders have been paid, equity holders will capture any residual value or upside from the business. In short, equity holders are risk takers looking for a bigger return because there is a chance that there won’t be any residual value left after the debtholders are paid. Examples of startup equity include common stock or preferred stock, which we’ll discuss in a bit.
Debt is a security that entitles the debtholder to payments of principal and accumulated interest along with other contractual rights from the company. Most consumers are familiar with debt, especially those pesky credit cards (at least you get air miles, right?). Debt is generally a fixed investment that is redeemed by the debtholder at the end of the term, or maturity date. Debtholders generally don’t have an ownership interest or voting rights in the company. In the event the company liquidates its assets or dissolves, debtholders do have higher priority claims than equity holders to the company’s assets. It’s good to think of debtholders like your grandparents. They are more risk averse and are looking for more stable returns than the young equity whippersnappers. Examples of startup debt include promissory notes or bank loans.
Preferred shares are stocks with dividends that are paid before common stock dividends when a company declares a dividend. Preferred shareholders may or may not have voting rights in the company. In the event the company liquidates its assets or dissolves, preferred shareholders have higher priority claims than common shareholders to the company’s assets. Always remember though, grandma and grandpa (debtholders) still have higher priority claims than the preferred shareholders to the company’s assets.
Common shares are stocks that have the right to share in the profits of the company and possess ownership in assets that are shared, or common, property of all the investors. Common shareholders also have voting rights. In the event the company liquidates its assets or dissolves, common shareholders have the lowest priority claims to the company’s assets. They are the brave and noble, but will they be victorious?
Promissory notes are debt instruments containing a written promise from the company to pay principal and accumulated interest to the debtholder over a period of time until the maturity date. Side note for all you startup enthusiasts. Promissory notes can also be structured as convertible notes, where the investor converts the note’s principal & accumulated interest into equity in the company at a pre-determined valuation and time.
Valuation is the process of valuing a business to determine what a prospective equity holder’s position is worth in a company. There are several techniques used by investors and companies to determine what a business is worth that are beyond the scope of this article.
A liquidation preference is an economic term in an investment contract that determines an investor’s claims on dividends or distributions from the company. The preference establishes that the investor will receive their money back before common shareholders and defines the amount of their preference (e.g. 2X of their initial investment, etc.). The investor may also choose to “participate” in the remaining liquidation proceeds after receiving their preference at a set conversion rate to common stock.
A No-Shop provision is a clause that prevents a company from soliciting purchase proposals from other parties for a period of time while in negotiations with a prospective investor.
There you have it, a few common startup financing terms that you may encounter when talking to investors. While it is great to have an idea of what these terms mean, it is crucial that you seek the help of an experienced business attorney to negotiate the best possible deal for you and your company.
About the Author: Joseph Shanley is a licensed attorney and serial entrepreneur based in the Greater Detroit Area. He currently serves as principal attorney and founder of Awen Innovations. Awen Innovations is a law firm and business consultancy dedicated to serving startups and small businesses. Click here to learn more.
DISCLAIMER. This article is purely informational and not intended to be legal advice. Readers should consult a licensed business attorney for more information on the topics discussed as it relates to their facts and circumstances.