VC explained: essential fundraising terms for founders and investors

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Navigating the complexities of a Venture Capital (VC) term sheet can be a daunting task for both founders and investors. The document is often filled with industry-specific jargon and intricate legal terms that are crucial in defining the future relationship between the startup and its investors. Understanding these terms is vital, as they dictate key aspects of the partnership, including control, financial returns, and the distribution of power.

In response to this challenge, Antler in Iberia has committed to demystifying the VC fundraising process. We have curated a comprehensive guide to break down and explain the terms commonly found in VC term sheets, providing clear definitions and our unique insights based on years of experience in the startup ecosystem.

Our goal is to empower founders and investors to navigate these agreements confidently, fostering a transparent and knowledgeable fundraising environment. The following are some of the most important terms used in VC investing:
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Equity 

Equity ownership refers to the ownership stake that a venture capital firm acquires in a company in exchange for its investment. The equity ownership is typically expressed as a percentage, representing the proportion of the company that the VC firm owns. For example, if a VC firm invests $1 million in a company with a post-money valuation of $10 million, the VC firm would receive a 10% equity ownership in the company ($1 million / $10 million).

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An equity round refers to the process of investors acquiring shares of a company. This process requires defining a price per share and investors acquire a certain amount of shares in exchange for their investment.  

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🎯Key Terms:

• Total investment
• Pre-money valuation: Value of the company before receiving investment
• Post-money valuation: Value of the company after receiving investment 
• Fully diluted ownership: Percentage of equity the investors will own once the investment is done 

Our view: 

When devising a fundraising strategy, the post-money valuation and fully-diluted ownership are crucial to understand how the founders’ ownership will be affected by the equity round. We recommend that founders build a model to ensure clarity on every step of the round.

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Convertible securities

Convertible securities are financial instruments that allow investors to invest in companies with the promise that that investment will convert into shares in the future. The two main types of convertible securities are SAFE’s (“Simple Agreement for Future Equity”) and Convertible notes. The main rationale for using these instruments is to be able to cover the need to raise capital in a faster and agile manner, specially for early-stage companies. 

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The most simple security is using a SAFE. This are standardized documents that have become popular thanks to Y Combinator (see this link for more reference)

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Convertible notes on the other hand is a quasi-equity instrument since it also has debt components such as paying an interest on the principal amount and a maturity date, and the right, but not an obligation, for converting into equity.

💡Rationale:

1. Secure financing in an agile manner and reduce the cost in external advisors (e.g., lawyers).
2. Early stage startups often choose using SAFEs for delaying decisions that require further clarity, such as setting up the valuation of the company that is needed in an equity investment.

Our view: 

A SAFE is a great instrument for the initial stages of a startup since you can save time and resources while securing investment. However, be mindful of terms and conditions that are not market standard that could potentially impact your chances for further equity rounds. Examples of non-market terms include charging an interest rate in the principal or having a major valuation discount on the next rounds.  

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Lead investor

It’s the main investor in an equity round that sets the terms of the equity round from a startup. Typically, the lead investor gets to set the main terms of the transaction because is the investor with the highest ticket from the investor pool.

For example, if your startup raises €2M and an investor decides to invest half of that ticket, they get the right to set the terms of the equity round. Typically, the rest of the investment needs will be spread across different investors with smaller ticket sizes and hence will accept the terms set by the lead investor. 

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💡Rationale:

• Lead investors can set the main terms of the transaction (e.g., valuation) since they are investing the largest ticket from the equity round.
• In early stages, when the investment is scattered across different small investors, there could be a case when there is no lead investor. In this situation, the founders would have to set the terms themselves. For earlier stages remember that a convertible note could help you secure the funds without a lead investor. 

Our view: 

The lead investor could create a chicken-and-egg situation. In some cases, investors are waiting for someone to set the terms and will not invest until a lead investor joins the equity round. When talking to investors, it is useful to understand if they are comfortable with leading rounds. 

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Capitalization table (cap table)

The cap table is a visualization that shows how the equity ownership capitalization is distributed across a company’s shareholders. This table shows how much ownership each individual/investor owns as founders, investors, employees or advisors. 

Follow this link to Carta’s standard cap table template.

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🎯Key Terms:

• Pro-forma Cap Table: a projected description on the ownership of the company, given a potential new investment. This allows you to perform several scenarios for fundraising to understand how much ownership you’ll have to give away in further equity rounds. 

Our view: 

Having a simple cap table will help you align incentives across co-founders and investors. Typically, you should seek to give away between 10% to 20% in a seed round and have the rest of the ownership distributed among co-founders.
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Term sheet

It’s a non-binding agreement between the investor and the company where the investor commits to invest a certain amount of capital given at a defined price per share. Besides the economic terms of the transaction, term sheets usually also include certain rights and governance obligations.  

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🎯Key Terms:

• Investment amount
• Company valuation
• Price per share
• Corporate Governance: Terms may include board of directors composition, liquidation preference, pre-emption rights, Right of first refusal, Tag along, Drag along, Non-compete, Founder exclusivity, Founder lock-in, Board of Directors, Reserved matters, Information rights, among others.
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Our view: 

Understanding term sheets is crucial for executing a successful fundraising strategy. We always recommend checking with an expert or legal advisor to review all the terms and conditions before committing to the next steps.  
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Vesting period

Vesting is a method for restricting the ownership of a company until certain milestones have been reached, typically solely based on time in the company. Until a defined time is completed, the person’s right to own shares is conditional. The most common vesting period is to receive the 100% of your shares until four years have passed. The vesting schedule refers to how you will earn your shares over the passing of time. Typically, you have one minimal period for having the right to receive any share at all, referred to as “Cliff”.

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The most typical terms are:

• Standard vesting over four years
• One year cliff, for having the right to receive shares
• 25% of the total package shall vest vest after one year,
• And the remaining 75% will vest linearly on a quarterly basis over the following three years.

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💡Rationale:

• Founders "earn" their relative stake over time - usually with a cliff (a period of typically 12 months) that would render an early termination in 0 stake - and after the cliff in equal parts over the span of 36 months.

Our view: 

At Antler, we believe that Founders are the #1 factor for a startup to succeed. We want to prevent cases where founders start the business then leave at an early point (e.g., six months after incorporation), still keeping all their shares. This will dramatically thin out the remaining shares. Vesting is placed on founders’ equity to make sure they stick around and work to earn the full value of their shares.  
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ESOP (employee stock option pool)

An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock.
The traditional expectation for the ESOP is to assume the existence of a fully diluted 10% notional employee share option pool. This option pool will give you the opportunity to distribute 10% of the equity of your company to key employees and advisors and will also include a vesting schedule. 

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💡Rationale:

• Since ESOP shares are part of the employees’ remuneration package, companies can use ESOPs to keep plan participants focused on corporate performance and share price appreciation.
• By giving plan participants an interest in seeing the company’s stock perform well, these plans supposedly encourage participants to do what’s best for shareholders, since the participants themselves are shareholders.
• Employees, meanwhile, are presented with a way to make more money, increase their compensation, and essentially be rewarded for their hard work and commitment. Having a stake in the company should make employees feel more appreciated and perhaps make going to work more exciting.
• In order to ensure employees (besides founders) have access to company equity, an ESOP (employee stock option pool) is issued, as the round is executed. 
• A stock option is a contract that gives you the right, but not obligation, to buy a stock at an agreed-upon price and date. The price at which you can purchase the stock is called the exercise price, or strike price.
• ESOP typically has a vesting period with similar conditions as the one explained before. 

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Conditions precedent

This refers to all the events/conditions that must be met to ensure the execution of the contract. This refers to all the things that need to happen before the transaction becomes a binding agreement. Some examples related to early stage investment of these conditions could be:

1. Completion of due diligence to the satisfaction of the investors;
2. Negotiation and execution of definitive agreements customary in transactions of this nature;
3. Receipt of all required authorizations, approvals and consents;
4. Delivery of customary closing certificates

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💡Rationale:

• This clause states the legal mechanism (typical from most contracts) and defines the events which need to occur (in parallel) for the investment to be made. 
• If any of the events isn't concluded the clause is not fulfilled, the legal documents can't be released by the lawyers and the funding isn't released to the company.

Our view: 

The conditions precedent should be actions-oriented to the investment, such as understanding the business in a due diligence or getting approval from key members. It’s important to also understand the conditions that the investors will have to do on their side in order to have a complete overview of the process from both sides.

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Liquidation preference

A common feature of preferred stock is the preferential right to receive distributions upon certain events. These liquidation preferences apply to distributions related to a sale of the company (e.g., exit). The market standard for this clause is establishing a 1x non-participating liquidation preference. This means that if your company is sold or wound up, the investors receive the higher of:

1. Initial investment amount, and
2. Investor’s share of the proceeds based on the ownership percentage at the time. If the sale proceeds are less than the initial investment, all the proceeds will be distributed directly to investors.

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🎯Key Terms:

• Non Participating: The investor receives the greater amount of 

1. either their invested amount back in the case of an exit,
2. or the percentage -amount of the valuation of the total sale price;

• Participating: The investor, in case of an exit, receives both

1. the investment amount back and,
2. the percentage-amount of their holding stake of the remaining amount of valuation minus initial investment.

Our view: 

The liquidation preference protects the investors on the downside potential in case the exit of the company is not higher than their initial investment. It’s important to review this clause with a lot of caution; a participating liquidation preference will give the investors more proceeds in the exit and could significantly impact the proceeds for the founding team. Overall, it’s a fair and common clause to have a 1x non-participating liquidation preference since the expectations of the founders and investors should be to use the investment to create value and surpass that amount in terms of valuation.    

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Pre-emption rights

Give the investors the right, but not the obligation, to buy additional shares in any future financing of the company before the shares are made available to new investors.

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💡Rationale:

• It provides shareholders the right to acquire shares before they can be offered to a third party (i.e., a new investor) on either an issue of new shares or a share transfer by an existing shareholder.
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Our view: 

Investors typically want to keep their fully-diluted percentage of ownership while new investors enter in new financing rounds. The initial investors will acquire stocks in the class being issued with said round (with all rights and obligations associated) and at the same value as the remaining investors.

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Right of first refusal (ROFR)

ROFR states that if any shareholder wants to sell their shares to someone else, the company and investors have the right, but not the obligation, to buy those shares on the same terms.

💡Rationale:

• Generally, the sale to the ROFR holder, should they choose to exercise the ROFR, must be on the same terms as the original third-party offer.
• In venture investing, ROFR can be held by either the venture investor(s) or the company itself. They are considered to be a “standard” request by venture investors.

Our view: 

The idea behind ROFO is to give the current shareholders—both investors, founders, and employees—the right to acquire the shares that are being sold. Since they have been in the company for more time, it’s a good practice to give them the benefit for acquiring more ownership. 

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Tag along

In the case of any sale of shares by a founder, investors have the right to sell the same proportion of our shares on the same terms.

💡Rationale:

• Tag-along rights, also referred to as "co-sale rights," are contractual obligations used to protect a minority shareholder, usually in a venture capital deal.
• This term typically assures "co-sale" rights to smaller scale investors. 

Our view: 

Tag-alongs effectively oblige the majority shareholder to include the holdings of the minority holder in the negotiations so that the tag-along right is exercised. If only a proportion of the company's shares are sold, let's say by the majority owner, the equal participation chance must also be given (a proportional allotment) to the smaller investors so that they get a chance to exit parts of their shares, as well.

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Drag along

Drag along rights are provisions that allow the majority shareholders to compel the minority shareholders to participate in the sale of the company. Sometimes known as “bring along rights” or “drag rights,” these provisions are usually found in the term sheet and subsequent shareholder's rights agreement, if included in a deal.

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In venture capital, the majority shareholders can either be the investors or the founders - it typically depends on the company's stage. The earlier the stage, the more likely it is that the founders are the majority shareholders.

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💡Rationale:

• Drag along rights are provisions that allow the majority shareholders to compel the minority shareholders to participate in the sale of the company.
• Usually, the economics and mechanics are well defined (such as minimum threshold of valuation, etc.)

Our view: 

This refers to a "forced" sales provision, e.g., in the event of a majority sale (such as an acquisition by another company). The majority shareholder can force all other shareholders to sell their shares at equal economic conditions, so that the entirety of the control of the company can be handed over. In simple terms, the big investors "drag" the small investors along on this deal. 

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Non-compete

The obligation of the founding team not to compete with the company’s business in the territory (segment, market or industry) defined by the agreement for a set period of time. These restrictions apply while you are either:

1. employed by the company, or
2. hold (directly or indirectly) any shares in the company, and for twelve months afterwards. These provisions can be waived by the investors.

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💡Rationale:

• This clause guarantees that the founders will not be able (in the 12 months after leaving the company) to engage in any activity deemed directly competing, or recruit any of the company staff/personnel, without the investors previous approval. 
• Standard non-competition and non-solicitation provisions are usually included.

Our view: 

Non-compete often have a one year duration, although it could be defined for two years or more. You can negotiate which key people would be included in this clause and it is typically limited to the founding team. 

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Founder exclusivity

The founder can not hold another full time position during the tenure as operating manager of the venture. Any other form of employment, also part-time employment, needs to be approved by the board and at least by one investor. 

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💡Rationale:

• This clause has the purpose to ensure that founders are fully committed to the company and if not, the investors need to be informed and need to approve it.

Our view: 

This clause benefits the founding team and investors as it is focused on limiting their skills and capabilities to building the business.

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Founder lock-in

A lock-up agreement is a contractual provision preventing founders of a company from selling their shares for a specified period of time. It is usual for investors to request such a provision in a shareholders’ agreement when negotiating an investment transaction. 

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💡Rationale:

• This ensures that the founders need the approval of a majority of stockholders to sell their shares and the investors also need to agree.
• It is usual for investors to request such a provision in a shareholders’ agreement when negotiating an investment transaction.

Our view: 

This clause aims to align incentives between founders and investors. Investors expect that founders will be working with a long vision as they continue building their company. By including this clause founders show commitment and build something for a couple of years before starting to think of selling the company. 

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Board of Directors

The board of directors is a group of individuals elected by the shareholders of a company to oversee the management of the company and make strategic decisions. 

💡Rationale:

• VC firms often have the right to appoint one or more members to the board of directors of the companies in which they invest, giving them a say in key business decisions and providing them with greater visibility into the operations of the company.
• This ensures that the founders need the approval of a majority of stockholders to sell their shares and investors also needs to agree

Our view: 

The board should be composed of members with a voting right and observers that provide value with their input in discussions. Investors often have the right to appoint a board observer only (and not a director). A solid board of directors composed of people with complementing skill will be a valuable asset on the strategic decision making process of a startup and will provide founders with valuable advice on value creation in their entrepreneurial journey. 

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Reserved matters

The reserved matters set out a list of actions or items which the company cannot carry out without special approval by a certain number of people or even by a single person approved at the board or shareholder level.

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In other words, reserved matters are an additional level of approval above that may be needed by the existing companies law. It gives further control and protection for those shareholders that may have a smaller minority stake in a company that may not be able to veto or influence decisions on those items if the approval threshold is only applicable under the usual companies law.

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💡Rationale:

• Reserved matters is a (negotiable) list of items which, in case it were to happen stockholders should approve. These are specific to each location but refer to extreme situations, i.e. not business as usual.

Our view:

Investors request a customary list of reserved matters (important decisions) relating to your company that will need their consent. Those decisions will include (among other things) issuing new shares, paying dividends, selling your company, winding up your company, and materially changing the nature of your company’s business.

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Information rights

An information rights provision in a term sheet outlines the information a company must deliver to investors beyond what state law requires. Generally, this includes a commitment to deliver regular financial statements and a budget to investors. A term sheet’s information rights typically terminate in the event of an IPO and often gives investors access to the company’s facilities and personnel.

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💡Rationale:

• While the default reporting period is quarterly, investors may ask for financial statements on a monthly basis early in a company’s life. Many companies elect to provide monthly financials to major investors for a long time.

Our view:

Generally, this clause includes a commitment to deliver regular financial statements and a budget to investors. A term sheet’s information rights typically terminate in the event of an IPO and often gives investors access to the company’s facilities and personnel. The information should be everything related to the business and will allow the investors to monitor the company evolution and provide you with feedback on key metrics.

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Law

Every term sheet will be governed in all respects by the laws of a specific country in order to become legally binding. 

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💡Rationale:

• This clause indicates the laws governing the agreement and should be aligned with jurisdiction in which the company is incorporated and/or where the investment will occur (depending on the situation).

Our view:

It’s important to understand the scope and enforcement of all the clauses set in a term sheet given the law that will be governed by. Legislations could be very different when comparing legislations.

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“No-shop” restriction

Investors will sometimes require companies to agree to an exclusive negotiation period (sometimes referred to as a “no-shop” period). Given that it may have expended significant time and effort in conducting due diligence and negotiating deal terms, an investor will not want the company to immediately turn around and use the term sheet to leverage better deal terms from other investors.

💡Rationale:

• Investors want to have time for making a decision after conducting their due diligence. This clause assures them that the founders will not engage with other investors while they are analyzing the transaction more closely. 
• Note that “no shop” doesn't imply an obligation for the investor to proceed with the investment.

Our view:

Agreeing to a “no shop” too early in the process may prevent better opportunities. Founders need to be careful when agreeing to this, especially if the company has a limited runway. With no guarantee of securing the equity round, the company may be left with no options or bad options at the end of the “no shop” period.

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