venture capital glossary

There is hardly any way around signing a term sheet when seeking financing for a start-up. A term sheet outlines the basic terms and conditions of a financing round (such as the amount of investment, valuation mechanics, share classes, anti-dilution protection, liquidation preferences, board composition, etc.).

Although a term sheet is typically not legally binding (with only a few exemptions, such as clauses on confidentiality and exclusivity), it is perhaps the most important document in the financing process. A signed term sheet serves as a blueprint for negotiating and finalising the definitive long-form legal documents and it demonstrates the commitment of the parties to closing the deal on such terms. Requests for substantial deviations from the term sheet are mostly not accepted (or traded against other requests) when negotiating binding long-form documents and a requesting party risks losing credibility vis-à-vis the other party and ultimately the contemplated investment. Thus, be careful when signing a term sheet, even if it is legally not binding.

A term sheet typically refers to a broad variety of venture capital concepts without defining them in detail. Considering the importance of the term sheet, it is crucial to be familiar with such terms and concepts before signing one. For example, it may have a huge economic impact on the founder whether the term sheet refers to "full ratchet" or to "broad-based weighted average" anti-dilution protection.

Of course, not every clause in a term sheet needs to be negotiated and fought for. Engaging an experienced VC lawyer at an early stage of a financing round can help founders focus on the important aspects of the term sheet and avoid common pitfalls.

Note: the principal difference between a term sheet, a letter of intent (LoI) and a memorandum of understanding (MoU) is only the document style. While a term sheet is the most widely used document type in the venture capital world, key terms of a financing round can also be agreed in a non-binding way in an LoI or MoU.

Anti-dilution protection is a mechanism designed to protect an investor's ownership percentage in a company from being diluted in a future share issuance. Typically, the protection applies only in case of a so called "down round", i.e. a share issuance below the valuation that was agreed with the protected party.

When an investor invests in a company, they typically receive a certain number of shares or ownership percentage in exchange for their investment. However, if the company issues more shares in the future to raise additional capital or as part of an acquisition, the investor's relative ownership decreases, even though they haven't sold any of their shares. Commonly, each shareholder has a right to participate in each share issuance (subscription right or pre-emptive right). However, for down-rounds, investors often seek protection beyond subscription rights.

Anti-dilution protection can help prevent down-round dilution by adjusting the investor's ownership percentage to account for any new shares issued in the future. This can be done in a few different ways, but common methods are called "weighted average anti-dilution" and "full ratchet anti-dilution".

These anti-dilution protection methods have in common that investors only pay the nominal amount of the anti-dilution shares (rather than the full subscription price).

Weighted average anti-dilution

The basic concept of weighted average anti-dilution is calculating a weighted average share price that ends up somewhere in between the share price that was paid by the investor (usually the share price in the last financing round) and the share price that will be paid in the down round. Essentially, the investor's initial purchase price is adjusted downwards to reflect the fact that the company is now worth less per share due to the new shares being issued. This means that the investor will receive additional shares to compensate for the dilution. The actual number of shares issued to the investor in the anti-dilution financing round depends on the application of the agreed formula. Commonly, one of the two formulae is applied: "broad-based" or "narrow-based" weighted average. The difference between these formulae essentially lies in the number of shares to be weighed against the shares to be issued. "Broad-based" is typically more founder-friendly.

Full ratchet anti-dilution

The basic concept of full ratchet anti-dilution offers investors the most protection. Essentially, the investor's initial purchase price is effectively "reset" to the new lower price for the purpose of calculating their ownership percentage in the company. In other words, the investors are put in a position as if they had invested at the lower share price.

Full ratchet anti-dilution protection is less common than weighted average anti-dilution protection. It is typically applied only in specific situations, e.g. if the valuation agreed with the investor is (from the investor's perspective) too high and is to be adjusted in certain circumstances (e.g. if an agreed minimum financing volume is not reached within a certain time).

If you are seeking financing as a start-up founder, the valuation of your company that is agreed upon with the investor will determine the percentage of the company that you are selling (i.e. your dilution). Understanding the concepts of "pre-money valuation" and "post-money valuation" is crucial.

Pre-money valuation

Pre-money valuation is the estimated value of a company before it receives any external investment. For example, if a start-up has a pre-money valuation of EUR 3m and an investor invests EUR 1m, the post-money valuation would be EUR 4m. The investor now owns 25 % of the company (1/4) and the founder or founders still own 75 %.

Post-money valuation

Post-money valuation is the value of a company after it receives external investment. It is simply the pre-money valuation plus the amount invested by the investor. In the above example, the post-money valuation of the start-up after the investment is EUR 4m. If the investor had invested EUR 1.5m, the post-money valuation would be EUR 4.5m. The investor would now own 33.33 % of the company (1.5/4.5), and the founders would own 66.67 %. In such a scenario, the founders sell more shares in the company and thus get more diluted.

Why pre- and post-money valuation matter and employee option pool

Knowing the pre- and post-money valuation is important because it affects the ownership percentage of the investor and founders after the investment. Always clearly communicate whether you are talking about pre- or post-money valuation and request the investor to be clear and transparent about this. If founders talk with an investor about a EUR 3m investment at a EUR 10m valuation, it is a significant difference whether EUR 10m is meant pre- or post-money. If pre-money is meant, the founders would sell only 23.08 % of the company (3/13). However, if post-money is meant, the founders would sell 30 % of the company (3/10). This is a huge difference.

Side note: Sometimes founders will come across a pre-money valuation, but an investor will at the same time request a new employee option pool (i.e. virtual equity that is reserved to incentivise employees). Let's look again at our previous example: if you agree on a EUR 3m investment at a EUR 10m post-money valuation, but the investor additionally requests a 10 % employee option pool, the founders would end up with an ownership of only 60 % (instead of 70 % without the employee option pool). Although the post-money valuation for the financing round will remain the same (in the above example EUR 10m) the requirement for a 10 % employee option pool will have a significant impact on the valuation and the ownership of the founders.

Price per share (nominal amount vs. contribution)

The price per share in a start-up financing round tells you (at least in relation to an Austrian limited liability company) how much EUR 1 of a fully diluted share capital of a company costs (see separate definition of fully diluted share capital). The price per share can be calculated by dividing the pre-money valuation by the fully diluted share capital of the company. For example, let's say a start-up has a pre-money valuation of EUR 4m and a fully diluted share capital of EUR 50,000. To calculate the price per share, we divide EUR 4m by EUR 50,000, which results in a price per share of EUR 80 (i.e. EUR 1 of the fully diluted share capital costs EUR 80). If an investor now wants to buy 20 % of the company, they must in total invest EUR 1m to get 20 % of a EUR 5m post-money valuation. At the same time the fully diluted share capital of the company needs to be increased by EUR 12,500 to EUR 62,500 (12,500 is again 20 % of 62,500). 

In Austrian VC deals, the payment of the investment amount (EUR 1m in the above example) is typically split as follows:

In a first step the nominal amount is paid (in the above example: EUR 12,500) and in a second step the remaining amount (in the above example: EUR 987,500) is paid as a shareholder contribution. Here it is often a matter of negotiation whether the shareholder contribution is due immediately or only upon registration of the capital increase. Ultimately, it is a question of risk bearing, since in Austria shares are only created upon registration in the commercial register.

In an Austrian limited liability company, the legal share capital and the fully diluted share capital represent various aspects of the company's ownership structure.

Legal share capital

The legal share capital refers to the total amount of capital that has been subscribed by the shareholders, paid into the company's account and registered with the commercial register. It is also the amount that is stated in the company's articles of association and it is fixed, meaning that it cannot be changed without amending the articles. The legal share capital reflects the legal ownership percentage of each shareholder in the company.

Fully diluted share capital

On the other hand, the fully diluted share capital refers to the total number of all outstanding (virtual) options, warrants, phantom shares or other rights convertible into shares. This considers any potential dilution of ownership that may occur because of these instruments. The fully diluted share capital is used to calculate the company's market capitalisation and to determine the economic ownership percentage of each shareholder in the company.

In summary, the legal share capital represents the fixed amount of capital that has been paid into the company by shareholders, while the fully diluted share capital considers the potential dilution of ownership that may occur because of outstanding instruments.