25 Mar Translating the language of capital-raising
Virtually every area of recurring human endeavor has its own lingo. Whether it be at play (like in running, football or racing) or work (think government workers, lawyers, education, military), it seems that when a group of people get together, they develop their own language that few outside of the group can understand. The world of equity capital raising is no exception.
Before I continue in the series that I began with the Mechanics of Raising Capital for Your Business, I thought it would be helpful to translate some of the words and phrases that I frequently hear, and about which my clients frequently ask.
Hopefully, these explanations will take some of the mystery out of “capital lingo.”
Accredited investor – A person or entity that meets certain requirements under the federal securities laws (specifically, Reg. D) 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. There have been some rumblings in Washington that these figures soon may change.
Angel investor – A wealthy individual (accredited investor) who provides seed or early-stage financing from his or her own funds to entrepreneurs 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 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 separate 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.
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 capital, consisting of debt capital (liabilities) and equity capital (capital stock and retained earnings).
Cap table – Short for capitalization table, it is a summary of a company’s issued and outstanding securities.
Convertible notes – Debt instrument (such as a promissory note) that can be converted to equity (either common stock or preferred stock).
Co-sale or tag-along rights – These enable the holder of the rights to participate in a sale of stock from another investor 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.
Cram-down financing – A financing that results in significant dilution of a non-participating existing shareholder, usually reducing the value of that investor’s original investment or the rights held by such investors.
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 paid in the previous round of financing.
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).
Exit strategy – The method 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.
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 shares.
Issuer – Refers to the company who issued or sold its securities.
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 a preferred shareholder is entitled to prior to any distribution of assets to common shareholders 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 preferred shareholder, or a multiple thereof.
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 offers to purchase its securities for a specified period of time while it is exclusively negotiating with a particular investor or group of investors.
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 its stated liquidation preference, but also allows the holder to participate in liquidating distributions on common stock after the initial liquidation preference is distributed to the preferred stock.
Payment in-kind dividends – A dividend paid in equity rather than cash.
Pay-to-play – A requirement that in order for a holder of preferred stock to maintain certain rights as a preferred stockholder, he, she, or it must participate pro rata in future financings or lose those rights.
Piggyback registration rights – A right that enables an investor to register the investor’s shares in the event the company decides to register some of its other securities.
Post-money valuation – The value of the company after investors invest in a given round of financing.
Pre-emptive rights – 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. They are similar to participation rights.
Preferred stock – Stock that gives its holders certain rights, preferences, and privileges over holders of common stock in certain instances.
Put rights – A right that enables the investor to force the company or another investor to buy back the investor’s securities, usually for a particular 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 – 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.
Term sheet – The document that outlines most of the key terms of an investment between an investor and a company. The term sheet is typically non-binding, except for certain provisions.
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. Compare to full-ratchet anti-dilution protection.
Previous articles by Matt Storms
• Matt Storms: Securities compliance is part of raising capital
• Matt Storms: Raising capital through placement agents
• Due diligence and corporate clean-up
• Matt Storms: The mechanics of raising capital for your business
• Sarbanes-Oxley for the Rest of Us
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