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.

Series Seed, Series A, Series B, Series C or even Series A-2, Series B-2 or Series Pre-seed, etc. You have probably heard about these classifications associated with financing rounds, but it can be challenging to understand them all. There is no legal definition. Sometimes there is also no clear distinction between rounds. The following therefore provides you with an overview of the most common financing round classifications:

1. Pre-seed: The Pre-seed round is the earliest stage of fundraising for start-ups, typically taking place before the start-up has a viable product. It involves raising small amounts of capital mostly from founders, friends and family to validate the idea, conduct market research and develop a prototype or minimum viable product (MVP).
2. Seed: The Seed round is the next stage of fundraising after the Pre-seed round. At this stage, start-ups have typically developed an MVP and have an initial market presence. Seed rounds are often used to refine the product, scale the team and acquire early customers. Seed round investors can include angel investors, venture capital (VC) firms and strategic partners. The amount raised in a Seed round can vary widely, but it is generally higher than the Pre-seed round.
3. Series A: The Series A round is typically the first institutional funding round for start-ups. At this stage, the company has achieved a significant presence in the market and is looking to scale its operations. Series A rounds are usually led by VC firms and involve larger investments compared to Pre-seed and Seed rounds. Series A funds are used to scale operations, invest in marketing and sales, and further develop the product or service.
4. Series B, C, D and beyond: Once a start-up has successfully raised a Series A round, it can continue to raise additional rounds of funding, such as Series B, C, D and so on. These subsequent rounds are often used to further accelerate growth, expand into new markets or make strategic acquisitions. The size of the rounds and the valuation of the company typically increase with each subsequent round as the start-up progresses towards maturity.
5. Other financing rounds: Apart from the common Pre-seed, Seed and Series A, B, C and D rounds, there are other financing instruments that may be relevant, such as convertible loans or SAFEs (simple agreement for future equity). These allow investors to provide capital in exchange for equity in the future, typically at the next priced financing round, and are commonly used in early stages when valuations may be uncertain and/or as bridge financing between two priced rounds.

In principle, each financing round has its own purpose, characteristics and implications. Classifications should be aligned with the stage of development of the start-up. Some start-ups want to avoid going down the alphabet too far and so they sometimes decide to name a new round an extension of the preceding round. Typically, this happens when a new financing round is done on the same terms and mostly with the same investors as the preceding round but with a different share price. In such cases a Series A-2 may follow a Series A instead of a Series B, for example.

What to remember: classifications of financing rounds help to discuss how early or late stage a company is.

Start-up investing has become increasingly popular in recent years as more people seek to get in on the ground floor of innovative companies with high growth potential. There are several types of investors that participate in start-up funding, including angel investors, venture capitalists, corporate investors, crowdfunding platforms, accelerators, incubators, and even family and friends. Each type of investor has their own set of criteria and expectations, but they all share a common goal: to identify and support promising start-ups that have the potential to disrupt industries and generate significant returns. Below you will find a summary of the most common investor types in the start-up ecosystem:

1. Business angels: These are wealthy individuals who invest their own money into early-stage start-ups. They typically invest between EUR 25,000 and EUR 100,000 in exchange for equity in the company.
2. Venture capitalists (VCs): VCs are professional investors who manage funds that invest in start-ups. They typically invest larger amounts of money (from EUR 1m to EUR 10m) in exchange for equity in the company. However, within VC investors, there is again a variety of funds focusing on different stages of start-ups and financing rounds:
   1. Pre-seed investors: These VCs focus on investing in start-ups at the very earliest stages of development, often before a product or service has been fully developed. Pre-seed investors provide funding to help start-ups get off the ground and begin building their team and product. They typically invest smaller amounts of money (up to EUR 1m) and take a high risk in exchange for a potentially high return.
   2. Seed investors: Seed investors focus on investing in start-ups that have developed a prototype or have launched a product or service but are not yet generating significant revenue. They provide funding to help start-ups expand their team, develop their product further and begin to scale. Seed investors typically invest between EUR 1m and EUR 3m.
   3. Series A investors: Series A investors focus on investing in start-ups that have achieved some level of traction and are generating significant revenue, but still require additional funding to continue growing. Series A investors provide funding to help start-ups expand their team, develop new products and features, and scale their customer acquisition efforts. They typically invest between EUR 3m and EUR 15m.
   4. Series B investors: Series B investors focus on investing in start-ups that have achieved significant traction and are poised for rapid growth. Series B investors provide funding to help start-ups expand into new markets, acquire new customers and scale their operations. They typically invest between EUR 15m and EUR 50m.
   5. Series C and later stage investors: These VCs focus on investing in start-ups that have achieved significant scale and are preparing for a potential IPO or acquisition. Series C and later stage investors provide funding to help start-ups continue to grow, develop new products and features, and expand into new markets. They typically invest larger amounts of money (over EUR 50m) and take a lower risk in exchange for a potentially lower return.
3. Corporate investors: These are large corporations that invest in start-ups in order to gain access to new technology or to form strategic partnerships.
4. Crowdfunding: Crowdfunding involves raising funds from a large number of people, typically through online platforms. This can take the form of reward-based crowdfunding (where backers receive a product or service in exchange for their investment) or equity crowdfunding (where backers receive equity in the company).
5. Accelerators and incubators: These are organisations that provide funding, mentorship and resources to early-stage start-ups in exchange for equity. They typically have a structured programme and take a hands-on approach to helping start-ups grow.
6. Family and friends: This refers to raising money from personal networks, such as family members or close friends. It is important to approach this type of investment with caution, as it can strain personal relationships if the start-up fails to perform as expected.

In the context of venture capital, the terms "runway" and "burn rate" are often used to describe the financial aspects of a start-up or company:

Runway: Runway refers to the length of time a company can sustain its operations before it exhausts its available funds or reaches a point of financial insolvency if no additional revenues or funding are secured by then.

The runway is calculated by dividing the available cash or funding by the average monthly burn rate. A longer runway provides more time and flexibility for the company to reach key milestones, such as product development, market expansion or revenue generation.

Burn rate: Burn rate is the rate at which a company consumes its available funds or cash reserves to cover its operating expenses over a specific period. It is an indicator of how quickly a company is "burning" through its capital.

The burn rate is typically measured on a monthly or quarterly basis and is calculated by subtracting the total operating expenses from the total funding or cash reserves for the given period. It represents the negative cash flow or net loss incurred by the company during that time.

A high burn rate indicates that a company is spending its capital rapidly and may soon require additional funding.

Monitoring the runway and burn rate is crucial for start-ups and companies, as it helps in financial planning and decision-making, and ensures that adequate capital resources are available to support operations and growth.

Liquidation preference is a common provision found in start-up financing documentation. It addresses the risk borne by investors when investing in start-ups. In exchange for assuming this high risk, investors typically require that any proceeds from a company's exit or sale, as well as dividends, be allocated to them before being distributed to founders or employees participating in employment incentive programmes. These provisions ensure that investors recoup their investment before others receive a share of the proceeds.

There are two main types of liquidation preferences: participating (nicht anrechenbare Liquidationspräferenz) and non-participating (anrechenbare Liquidationspräferenz).

1. Non-participating liquidation preference: In a non-participating liquidation preference, investors are entitled to receive a predetermined preference amount (which is in most cases their original investment, or in more investor-friendly agreements also a multiple of their investments) before any other distributions are made. Such non-participating liquidation preference is only relevant in a downside scenario when the pro-rata share of the investor in the proceeds would not at least reach the preference amount. In other words, investors receive either their preference amount or their pro-rata share in the proceeds, whichever is greater.
2. Participating liquidation preference: In this case, investors receive both the preference amount and a pro-rata share of any remaining proceeds, without the preference amount being subtracted. This allows investors to receive a larger return on their investment if the distributed proceeds are higher than the preference amount. Other than in a non-participating scenario, investors receive both their liquidation preference and their pro-rata share, not just the higher of the two.

In cases where multiple investors are involved, the "last in, first out" principle is often applied to prioritise their preferred returns.

A 1x non-participating liquidation preference has been the norm in recent financing rounds of Austrian start-ups. We will see whether this will change under the current market conditions.

Efficient cap table management is crucial in the world of venture capital and deals involving many small investors can lead to complexities. To tackle this challenge, small investors are often pooled through trustees who hold the investments of the small investors on trust. In doing so, only the trustee becomes the legal shareholder of the start-up and only the trustee has shareholder rights. When exercising these rights, the trustee is usually only bound by the terms of a trust agreement with the small investor. These agreements typically provide protective provisions for the small investor such as consent rights. This approach offers benefits to both investors and start-ups by streamlining the cap table.

1. Simplified cap table: Through the involvement of trustees, small investors can be consolidated into a single entry on the cap table. This simplifies management tasks, reduces administrative burdens and avoids complications associated with handling multiple individual investors.
2. Enhanced communication: Pooling investors via trustees improves communication and interaction between start-ups and their investor base.
3. Efficient decision-making: A streamlined cap table enables faster and more efficient decision-making processes, as the trustee represents the consolidated group of small investors. This helps streamline decision-making within the start-up (e.g. only the trustee needs to cast a vote in a shareholder meeting instead of each small investor).
4. Organisational appeal: Maintaining a small and consolidated cap table makes start-ups more appealing to potential future investors. A cleaner cap table signifies better organisation, less complexity and fewer risks associated with managing many small investors.

An alternative to pooling investors through a trusteeship structure is to form a voting pool in which small investors come together and collectively exercise their voting rights as if they were a single entity. This approach allows for a unified representation of the investors' interests and facilitates decision-making processes within the start-up.

The choice between these two pooling approaches may depend on various factors, including legal considerations, investor preferences, and the specific requirements of the start-up and its investors.

Due diligence is a crucial process in the start-up and venture capital (VC) ecosystem, undertaken by investors to evaluate the potential risks and opportunities associated with an investment opportunity.

During the due diligence process, investors extensively research and examine the start-up and try to understand its business model. The objective is to mitigate risks and make informed investment decisions. Due diligence findings are then reflected in the negotiation of the final deal terms and the assessment of the start-up's valuation.

Key areas of due diligence:

1. Financial due diligence: This aspect focuses on evaluating the start-up's financial health, including its historical and projected financial statements, revenue streams, expenses, profitability and cash flow. Investors assess the accuracy of the financial data provided and analyse key financial metrics to gauge the start-up's financial viability.
2. Legal due diligence: Legal due diligence involves a thorough examination of the start-up's legal framework to assess the legal risks and obligations associated with the investment. During a legal due diligence process, various legal aspects are examined, including corporate governance, contracts, intellectual property rights, regulatory compliance, real estate ownership, litigation history, employment matters, environmental compliance and any other legal documentation or issues relevant to the transaction.
3. Market due diligence: Market due diligence aims to assess the start-up's target market, industry trends, competitive landscape and growth potential. Investors analyse market size, customer segments, competitors and barriers to entry to determine the start-up's market position and long-term prospects.
4. Operational due diligence: Operational due diligence focuses on evaluating the start-up's operational capabilities, including its organisational structure, supply chain, manufacturing processes (if applicable), technology infrastructure and scalability. Investors seek to identify any operational inefficiencies or risks that could impact the company's growth and profitability.
5. Team due diligence: Team due diligence involves assessing the start-up's management team, their experience, expertise and track record. Investors evaluate the team's ability to execute the business plan, their alignment with the company's vision and any potential talent gaps that need to be addressed.

By conducting due diligence, investors can minimise risks, identify potential red flags and gain confidence in their investment decisions. Start-ups benefit from the due diligence process as it helps them identify areas for improvement, enhance transparency and build trust with potential investors.

Note: The due diligence process can vary in its depth and scope depending on the specific requirements and preferences of the investor or VC firm.

Vesting is a crucial concept in the world of venture capital often included in shareholders' agreements and employee participation programmes that aims to align the interests of investors on the one side and founders and other key team members (such as employees) on the other side. In this article, we will explain the key components of vesting such as "good leaver", "bad leaver", "cliff" and "acceleration."

1. Vesting basics: Vesting refers to the process by which founders or key team members earn ownership of their shares in a start-up over a specified period, typically several years, to stay committed to the start-up for such a long term.

At least in Austria, founder vesting is often set up as "reverse vesting" because founders already have their shares when vesting provisions are introduced. In contrast to standard vesting, individuals under reverse vesting have their entire shares upfront, but they must gradually return a portion if a "leaver event" occurs within a specified timeframe. The sooner such an event happens, the greater the proportion of "unvested" shares that must be surrendered.

2. Vesting schedule: The vesting process usually follows a schedule, often spanning four years, with for example a one-year cliff. During the cliff period, no shares are vested. After the cliff, shares vest gradually, commonly on a monthly basis.

3. Leaver event: A "leaver event" refers to a situation that occurs when an individual under vesting provisions leaves the company before all their shares have fully vested in accordance with the vesting schedule. There are various things that can happen with such shares depending on the category of the leaver event. The specific terms and consequences of each leaver event are usually heavily negotiated and agreed in advance, and can vary widely from one company to another. Broadly, leaver events fall into two principal categories:

Good leaver: A "good leaver" is typically someone who leaves the company for valid reasons, such as resignation due to health issues or a family emergency. Good leavers may keep some or all of their vested shares, often calculated based on their time with the company.

Bad leaver: On the other hand, a "bad leaver" is someone who leaves the company for reasons that are not considered valid, like voluntarily quitting for a better job opportunity. Bad leavers often forfeit their unvested shares and may have to sell their vested shares at a reduced price.

Occasionally, a third category known as a "grey" leaver may also apply.

4. Acceleration: Acceleration clauses are provisions that can alter the vesting schedule under specific circumstances. For example, in an exit event (i.e. sale of the start-up), some or all of the unvested shares may accelerate, becoming immediately vested.

Why is vesting important?

Vesting plays a crucial role in protecting the interests of everyone involved in a start-up. Investors use it to ensure founders and key team members stay dedicated, especially during the early phases of the company. Similarly, those under vesting provisions (such as founders and key team members) have an interest in their co-founders and colleagues' commitment to the start-up since collective teamwork is essential for the company's growth.

Disposal of shares refers to the process of transferring ownership or selling shares in a company from one shareholder to another. Several key terms and concepts are associated with the disposal of shares, each with its own implications. The exact terms of the concepts can greatly differ from one company to another, and are typically determined through prior negotiations. Roughly, such concepts are defined as follows:

1. Drag-along right: A drag-along right is a provision in a shareholders' agreement or articles of association that allows majority shareholders to force minority shareholders to join in the sale of the company. This means that if the majority shareholder receives an offer to sell the entire company, they can compel minority shareholders to sell their shares on the same terms and conditions.

2. Tag-along right: A tag-along right is a protective provision that benefits minority shareholders. If a majority shareholder decides to sell their shares to a third party, minority shareholders with tag-along rights have the option to join the sale and sell their shares on the same terms as the majority shareholder. This ensures that minority shareholders are not left behind in the event of a sale.

3. Right of first refusal (ROFR): The right of first refusal is a contractual arrangement that gives existing shareholders the opportunity to purchase the shares of a selling shareholder before they are sold to an external party. If shareholders wish to sell their shares, they must first offer them to the existing shareholders at the same price and under the same terms as the external offer. Existing shareholders can choose to exercise their right to buy the shares or decline, allowing the sale to proceed to the external party.

4. Right of first offer (ROFO): The right of first offer is like the right of first refusal, but it operates slightly differently. With an ROFO, a shareholder who intends to sell their shares must first offer them to existing shareholders before seeking external buyers. However, unlike the ROFR, existing shareholders have the option to make an offer to purchase the shares before the seller can accept external offers. If no acceptable offer is made by existing shareholders, the seller can then proceed with external sales.

5 Pre-emption right: Differing from the aforementioned concepts, a pre-emption right, also referred to as a pre-emptive right, comes into play when new shares are issued as part of a capital increase and not during the transfer of existing shares between individuals. Pre-emption rights grant existing shareholders the opportunity to purchase additional shares of a company before those shares are offered to external investors. This right helps maintain the proportional ownership of existing shareholders by allowing them to participate in new share issuances. If the existing shareholders choose not to exercise their pre-emption rights, the shares can then be sold to external investors.

Understanding these terms and their implications is crucial for shareholders and investors in a company, as they can significantly impact the ownership structure.