We both spend most of our days with start-ups and have realised we often get asked the same questions – what does this legal word actually mean? Sometimes legal terminology becomes its own language and so we want to demystify that and make it clear.
We are starting with 10 words that we often explain to people when we are involved in legal transactions for start-ups raising capital. Let’s dive in!
- Vesting – this is a mechanism which means that the founders and key people of a start-up don’t get all of their shares at once, but instead receive a little bit every month or year. A “vesting schedule” sets out the timeframe over which their ownership rights to shares are earned. Also, if they leave prior to their shares vesting, they forfeit a portion of their ownership rights and if they don’t contribute in the way agreed, they might not get their shares. Vesting is used as a way to keep the founders and key people committed to the start-up’s success.
- SAFE – an acronym for: ‘Simple Agreement for Future Equity’ this is a financing tool which allows early-stage investors to provide funding to start-ups in exchange for the promise of future equity in the company, but without determining the exact ownership stake at the time of investment. This offers start-ups a way to access early-stage capital without having to immediately determine the value of the company, while investors get the promise of future equity on potentially more favourable terms compared to later investors.
- Tag & Drag – Drag-Along rights allow a majority of shareholders to compel a minority of shareholders to participate in the sale of the start-up. This prevents minority shareholders from blocking a beneficial exit and ensures that if a favourable sale opportunity arises all shareholders can participate. Tag-Along rights are designed to protect minority shareholders and mean that if a majority shareholders intends to sell their shares to a third party, then a minority shareholder has the option to include their shares in the same transaction.
- Indemnity –A “legal promise” where one party agrees to compensate another party for any loss, damages, or liabilities coming from a specific event or circumstances. In venture capital deals, the legal promise is by the start-up to compensate the investor for any losses, damages, or liabilities arising from certain events. This is typically included in the investment documents and relates to unforeseen matters such as legal disputes, IP issues, tax or undisclosed obligations. Generally the indemnity is limited to the investment amount which the investor has made.
- Warranty –A legal statement by the start-up regarding the accuracy and truthfulness of information and representations made about the business. Warranties typically cover areas like the company’s financial statements, IP, and legal compliance. Warranties provide a level of protection in case the start-up’s provided information is incorrect or misleading.
- Liquidation Preference – specifies the terms under which preferred shareholders will be paid if the start-up is sold, dissolved, or undergoes any other form of liquidation. Liquidation preferences are designed to protect the investors’ downside risk and ensure that they have a certain level of financial security in the event of a less-than-ideal exit for the start-up. These can be “non-participating preferred” or or “participating preferred” (the difference relates to whether after being preferred they also have rights to participate as shareholders after getting their preference amount).
- Anti-Dilution– a start-up might issue new shares at a lower price per share than what the investor paid, so anti-dilution protection adjusts the investor’s share price or conversion rate, ensuring they maintain their ownership level and are less likely to be diluted. Dilution refers to the reduction in the ownership percentage of existing shareholders when a company issues additional shares, often during subsequent financing rounds as more shares being issued means the number you hold amounts to a lower percentage.
- Valuation – The price used to determine the start-ups market value, which is critical for setting investment terms like the share price and conversion rate. Investors use valuation to assess the equity they will receive for their investment, a higher valuation typically means investors will get a smaller ownership stake in the company for their investment, while a lower valuation offers them a larger stake. Accurate valuation is essential to strike a fair deal for both the start-up and investors.
- Due Diligence – this is usually undertaken by the lead investor and involves the investor thoroughly investigating a start-ups financial, legal and operational aspects of their business to assess any risks before investing. The depth and scope of due diligence can vary depending on the specific deal and the investors risk tolerance.
- Term Sheet – a document outlining the key terms and conditions of the proposed investment deal. It is a preliminary (but non-binding) agreement that creates the base for further negotiations, it is also used for the drafting of the final investment documents. It’s the ‘getting to know you’ stage in the relationship. The term sheet helps both parties to understand the key terms and expectations of the investment and includes matters including (but not limited to) the investment amount, valuation, investors rights, conditions, governance and decision making, board structure and confidentiality requirements.
We hope this initial list of 10 key terms is helpful and would like to create another list in the future– what terms or concepts have confused you that we should unpack next time? Drop us a line…
This article is general in nature and is not a substitute for legal advice. You should talk to a lawyer about your specific situation. Reproduction is permitted with prior approval and credit being given back to the source.
Elise O’Halloran, Senior Legal Counsel at Icehouse Ventures – elise@icehouseventures.co.nz
Steven Moe, Partner at Parry Field Lawyers and host of Seeds Podcast– stevenmoe@parryfield.com
