IRS Section 409A sets the rules governing the granting stock options and other equity-based compensation. Granting stock options at a price below fair market value can lead to significant tax consequences. To avoid these issues, before granting stock options or other equity-based compensation, a company should have the fair market value of its stock evaluated by a third-party firm. This process is referred to as the Section 409A valuation safe harbor or simply a “409A Valuation.” Once complete, a valuation is valid for 12 months, so long as nothing occurs during that period that would materially affect the valuation.
506 Offering or Rule 506 Offering
SEC Rule 506 lists the requirements for issuing private placement securities offerings without registering those securities with the SEC. To be exempt, the securities can be offered and sold only to up to 35 non-accredited investors who meet sophistication requirements and satisfy other disclosure and offering requirements. There is no limit on the size of the offering.
506(b) Offering or Rule 506(b) Offering
Under this version of an exempt offering, the issuer cannot use any general solicitation or advertising to find investors. Essentially, in a Rule 506(b) offering, the issuer must have a pre-existing relationship with each investor.
506(c) Offering or Rule 506(c) Offering
Under this version of an exempt offering, the issuer can use general solicitation or advertising to find investors, but offerings may be made only to accredited investors. Generally, solicitations are conducted online, using a funding platform website that can qualify investors before they are given access to any potential investments.
Accelerator
A company that provides early-stage startup companies with access to a variety of resources, including mentors, classes, workshops, investor networks, co-working space and/or small investments of capital in exchange for a grant of equity. Accelerators (or “incubators”) usually provide services for a term of several months. Well-known accelerators include Y Combinator, Dreamit and TechStars. See also “Incubator.”
Accredited Investor
According to SEC rules, to be an “accredited investor” an individual must certify that he/she has an annual income of at least $200,000 as an individual (or joint income of at least $300,000 with a spouse) or has a net worth of at least $1 million (not including the value of a primary residence). Entities may qualify under a variety of different standards, including corporate entities with assets of at least $5 million or partnerships in which all the partners qualify as individual accredited investors. Under SEC rules, accredited investors are eligible to invest in certain companies that are required to provide less disclosure than companies open to non-accredited investors.
Acqui-Hire
The practice of acquiring a company for its talent rather than its products or services, also known as a “talent acquisition.” In an acqui-hire, the buyer acquires all of the target company’s assets as in any other acquisition, then reassigns employees to buyer-led projects, usually abandoning the work of the target company. Entrepreneurs wanting to stay on good terms with their previous investors or maintain their reputation in the investing marketplace often “deflect” the acquisition proceeds to investors and stakeholders, rather than take all the gains with them as they leave a startup.
Advisor or Advisory Board
Startups may select an individual or a group of individuals who can provide advice, expertise and introductions. These advisors are not like a formal board of directors and have no authority to act for the startup. Advisors are generally compensated by the startup with equity-based compensation such as restricted stock or stock options.
Angel Investor
A wealthy individual investor (or a group of wealthy investors) who provides early-stage financing to startups before venture capital firm involvement. Typically, angels invest seed financing of up to $1 million in exchange for common stock or convertible notes. Angel investors may work together to share information about possible investment opportunities, spread risk and increase their funding base.
B2B
Startup businesses that market or sell products or services to other businesses are called B2B.
B2C
Startup businesses that market or sell products or services to individual consumers are called B2C.
Benchmark
A performance-based goal. Achieving set benchmarks may trigger payment of additional compensation to individuals or investment in the startup.
Board of Directors
A group of people elected by the stockholders of a corporation (or members of a limited liability company) to provide oversight. A board of directors is not involved in the day-to-day operations (aside from board members who are also executives of the company), but guides broad strategy and major decisions.
Bootstrapped
A startup that is financed by one or more founders using only their own financial resources and without any outside capital or financing is said to be bootstrapped.
Bridge Loan
A short-term, relatively high-interest loan provided to help a startup meet current obligations until a pending or committed round of more permanent financing becomes available. Generally, a bridge loan will be rolled into or repaid out of a subsequent round of larger financing.
Burn Rate
The rate at which a startup is using cash to finance its operations and a measure of how quickly a startup will run out of cash.
Capital
The common and preferred stock a corporation can issue, or the units/interests that a limited liability company can issue.
Capped Notes
Notes issued by a startup to early investors that convert to equity (usually preferred stock) in the next round of financing. The conversion occurs at a discount and includes a stated cap on the price to be paid in the next round. If equity is priced higher than the cap in the next round, the conversion occurs at the capped amount. Essentially, the cap sets a ceiling on the maximum price investors holding those notes have to pay for equity in the next round, even if the startup is successful and other investors are willing to pay a significantly higher price.
Co-Sale Rights
Contractual rights given to certain investors that enable them to sell their stock in the same proportion and for the same terms as other investors. Co-sale rights ensure that founders and other significant stockholders cannot sell their stake without allowing minority holders similar opportunity to liquidate their investment.
Common Stock
Common stock is a form of equity security issued by a startup corporation without any special rights and preferences. Founders, managers and employees are typically issued common stock as compensation or invest in common stock.
Convertible Debt or Convertible Notes
A form of debt financing startups often use to raise seed capital. A startup issues promissory notes equal to an initial investment that convert to equity (common or preferred stock) at some point in the future. In most cases, convertible notes will include an automatic mechanism that triggers conversion upon the achievement of a specific milestone and according to a set price formula, but they may also be convertible at the option of the investor holding the notes.
Convertible Stock
A form of equity security (typically preferred stock) that is convertible into another form of equity (typically common stock) upon the achievement of a specific milestone. Convertible stock may also be convertible into another equity security at the option of the investor holding the stock.
Crowdfunding
A strategy for raising seed capital from a crowd of investors, usually through an Internet-based platform. Well-known crowdfunding websites include Kickstarter and Indiegogo. Crowdfunding for sales of company securities (so-called “equity crowdfunding”) is not yet legal in the United States, but many companies are using 506(c) offerings and crowdfunding platforms to crowdraise equity or debt financing. (The SEC is required by the JOBS Act to pass regulations that will eventually make equity crowdfunding legal.)
Crowdfunding Platform
An Internet-based platform that provides startups with access to potential capital providers. Crowdfunding platforms help startups identify and vet prospective investors; assess whether an investor would be considered “accredited;” and provide 506(b) or 506(c) offering capabilities. Investors also use crowdfunding platforms to find new startup investment opportunities.
Crowdsource
Soliciting input from a large, undefined group of people, usually via the Internet. Startups use crowdsourcing to make business decisions or conduct research and development into product design, use, distribution or marketing. Input may be offered gratis or for a stated fee, depending on the nature of the request.
Debt Financing
A means of financing a company using loans rather than equity. Debt financing may be in the form of bank loans or investor debt (called bonds). Debt generally has a stated maturity date when the loan must be repaid and accrues interest at a stated rate. Interest may be paid during the term of the loan or at maturity. When a company is liquidated, debt must be paid off before the equity holders receive any returns.
Disruptive
When a technology or business meaningfully transforms its market space, it is said to be disruptive.
Down Round
A round of financing in which the valuation of the company is lower than it was in a preceding round. Down rounds dilute the value of stock held by existing investors because it effectively lowers the stock price. Some investors seek and obtain contractual protection against down rounds. Down rounds generally occur in the context of financial challenges and are sometimes the only alternative to dissolution.
Drag-Along Rights
Contractual rights that allow majority shareholders to force minority shareholders to sell their shares to a new investor, usually in the context of a company’s sale. The minority investors must receive the same price, terms and conditions on their securities as any other investor.
Due Diligence
Research conducted by prospective investors before investing in a startup. Due diligence includes reviewing the company’s organizational documents, prior rounds of financing, products, technology and other material aspects of the company’s business. The purpose is to assess the viability of the business and truthfulness of information provided by its owners.
Early Stage
A new company with high potential for growth that is just beginning its development is an early-stage company. The term can also refer to funding provided to such a company.
Entrepreneur
An innovative person who founds, structures, and manages a new business and is subject to the vast potential risks and rewards.
Equity Financing
In general, equity shareholders receive a return in the course of a liquidation only after all debts are paid. Preferred stockholders get paid before common stockholders."
Exit
A transaction in which the founders and investors sell their equity in a startup, usually through the sale of the company, private placement of securities or an IPO. See also “Liquidity Event.”
Finder
Intermediaries who introduce startups to potential investors. Finders are typically paid a fee based on the amount raised for the startup when a transaction closes. Finders must comply with all federal and state broker-dealer laws.
Founder
A person(s) who starts, organizes and manages a new business venture. As the startup grows, a founder may continue to act as the managing officer or may hand over daily management in order to play a different role (for example, as chief technology or chief marketing officer). See also “Entrepreneur.”
Founder’s Stock
Shares of common stock issued to a founder of a company (as well as early-stage employees and angel investors) at a low valuation. Founder’s stock is usually issued in exchange for services or technology rather than cash. Founder’s stock may be subject to restrictions, such as time-based vesting, but it also may be issued without restriction.
Friends and Family Round
A round of investment financing where common stock is sold only to the friends and family of the founders of a startup. If done, it is usually a first round and generally raises relatively low levels of capital. The equity sales are structured as private placement offerings and may be done as a 506 offering.
Incubator
A company that provides business support services to startup companies, including work space, utilities and other services. Some incubators also provide accelerator services such as access to mentors, classes, workshops and networks of potential investors. See also “Accelerators.”
Institutional Investor
A large organization such as an investment bank, investment fund, pension fund or insurance company that pools money to make substantial investments in securities.
IPO
An initial public offering is the first sale of common stock by a private company to the general public. In filing an IPO, a company must register with the SEC and becomes subject to heavy regulation by the SEC and other securities administrators. Companies will generally hire an investment bank to serve as the underwriter of an IPO, which means that the investment bank will be responsible for helping to price the stock and market the offering to potential investors. The underwriter typically bears the risk of being unable to sell the stock. Institutional investors usually cannot sell their holdings during an IPO, but must wait for some period to either sell stock on the open market or register the shares for sale in a subsequent public offering.
JOBS Act
The Jumpstart Our Business Startups Act, signed into law in April 2012, was designed to encourage investment in small business by easing specific securities regulations.
KISS Instrument
Keep It Simple Security (or the KISS instrument) is a set of legal documents that guide startups in how to issue convertible notes or convertible equity. These documents were designed and are made available for free by 500 Startups, a global venture capital seed fund and startup accelerator. 500 Startups touts the fundraising method and documents as opening a simpler and less expensive pathway for startups to access capital than using traditional preferred stock or other investment vehicles.
Lead Investor
The investor who contributes the largest amount of capital (and also often who commits capital first) in a given round of financing. A startup will typically negotiate the price and terms with the lead investor and the other investors will simply join the round under the same terms and conditions. Securing a lead investor is the most critical task; once a lead is in place, a funding round is usually completed successfully.
Letter of Intent or LOI
A non-binding agreement between parties that lists the principal terms of an expected agreement between two parties. The LOI must be written with a good faith intention to enter into a binding agreement that essentially follows those terms. See “Term Sheet.”
Leveraged Buyout
A transaction in which the target company is acquired, often by a private equity fund or other institutional investor, with a limited equity investment and a significant amount of debt that is financed by using the target company’s assets or operating income as collateral.
Liquidation
A startup sells all its assets and ceases operation. In a liquidation, debt holders are repaid in full before the equity holders of the startup receive any return of their investment.
Liquidation Preference or Preference
The rights of certain investors to be paid before other investors in the event of a liquidation or liquidity event. Typically, preferred stockholders have a contractual right to be paid a set proportion of their original investment before any payouts to other stockholders. Liquidation preference is noted as a function of the amount invested. So, for example, an investor with $5 million in preferred stock and entitled to $5 million before payments to other shareholders has a “1X preference.” That same investor entitled to $10 million before payments to other shareholders has a “2X preference.”
Liquidity Event
When the owners of a startup liquidate their equity holdings, typically through a merger or acquisition, private sale of securities, IPO or bankruptcy. See also “Exit.”
Milestones
Specific targets or events that must be achieved by a startup to secure additional financing. Some investors, often venture capital investors, will divide (or tranche) their investment into several rounds of financing that will be provided as the startup meets targets within a specified timeframe. See also “Benchmark.”
NDA or Non-Disclosure Agreement
Also known as a confidentiality agreements, NDAs allow a startup to make proprietary and non-public information about its company and operations available to an outside party under the stipulation that the recipient will keep all disclosed information confidential and not use it for any purpose other than those in the agreement. Prospective funders will typically sign a NDA before a due diligence investigation.
Pivot
When a company fundamentally changes course after determining that its original business plan, direction or idea is not viable or not capable of producing the growth that the company seeks.
Portfolio Company
Any company or entity that has venture capital firm, investment firm or private equity firm investment. Every company currently backed by a venture capital, investment or private equity firm is part of the investment company’s portfolio.
Post-Money Valuation
The valuation of a company after a proposed round of financing.
Pre-emptive or Pro Rata Rights
Contractual rights provided by a startup to an investor that allow the investor to purchase the investor’s pro rate share of any new stock that is being issues by the company prior to that stock being issued to new investors. By exercising pre-emptive rights, an investor is protected against dilution during future rounds. An investor can choose to waive pre-emptive rights and not purchase its proportionate share in a new round of funding, in which case the investor will experience dilution.
Pre-Money Valuation
The valuation of a company prior to a proposed round of financing.
Preferred Stock
A form of equity issued by a startup that comes with special rights and preferences, including priority payment upon liquidation of the company. Other features may include the right to a dividend or the right to nominate one or more members of the company’s board of directors. Typically, outside investment firms, institutional investors and later-stage investors will invest in preferred stock.
Private Equity
Investment (equity and debt) in operating private companies that are not public reporting and whose securities are not publicly traded on a stock exchange.
Private Equity Firm
A company that makes investments (often using debt) in the equity and debt securities of operating companies that are not public reporting companies and whose securities are not publicly traded on a stock exchange. Private equity firms typically invest in growth or later-stage companies with positive cash flow, in contrast to venture capital firms.
Private Placement
A non-public offering of securities to investors without registering the offering with the SEC. To get an exemption, a startup will typically offer a private placement through SEC Regulation D under rules 504, 505 or 506.
Proof of Concept
A prototype or pilot that is designed to demonstrate that a product, technology or idea has validity and can be successful.
Put Right
An investor’s right or option to sell securities back to the company or seller at a specified price (or based on a stated formula) before a specified date. A put right protects an investor in the event that the value of the security drops below the price at which the investor can sell the asset back to the company or seller.
Recapitalization
A corporate reorganization in which a company’s underlying capital structure (usually the ratio of debt to equity) changes significantly. For example, a company could sell equity securities and use the proceeds to pay off debt. Or a potential investor in a poorly performing company could agree to provide new financing on the condition that existing investors give up certain rights and preferences. Recapitalization can take many forms.
Redemption
When an issuer buys back a security from a stockholder at a previously agreed-upon price or formula.
Reg D or Regulation D
A set of SEC rules that govern when and how issuers may conduct private placement securities offerings without registering the securities for public sale under federal or state securities laws. Rule 506 is one rule under Regulation D. See also “506 Offering.”
Restricted Stock
Stock that is issued by a company in a private placement and that is not freely transferable or publicly traded on any securities exchange. Restricted stock may not be traded by the holder unless the holder complies with certain legal requirements under federal and state securities laws.
Return on Investment or ROI
A metric used to measure the financial return on or profitability of an investment.
Right of First Refusal or RoFR
Because RoFR makes it more difficult and time consuming for a third party to purchase a security, these rights can make company securities less attractive."
Round
Startups typically raise capital in a series of transactions over time, each of which is known as a round. The company’s first series of significant outside funding (excluding a seed round or friends and family financing) is typically referred to as an “A” round, its second series is a “B” round and so on. See also “Series.”
Sector
The economic area in which a company operates.
Series
Startups typically raise capital in a series of transactions over time, each of which is known as a round. The first round of preferred stock issued by a company is named “Series A Preferred Stock” and comes with certain rights and preferences. Subsequent rounds of outside financing will typically be sequentially lettered as Series B, Series C, etc. Each series of preferred stock will come with unique rights and preferences as negotiated by investors in that series.
Simple Agreement for Future Equity or SAFE Instrument
A set of free legal documents that guides startups in how to arrange investments in convertible securities issued by the startup. These documents were designed and are made available by Y Combinator, a well-known startup accelerator. SAFE is intended to document a transaction in which the investor pays cash and receives company stock at a specified later date. A simple instrument with little to negotiate other than the valuation cap, Y Combinator says this approach lowers the transaction costs for both parties.
Software as a Service or SaaS
A model for delivering a full range of software services on a subscription basis over the Internet, including marketing, accounting, customer management, anti-virus, etc. Because software and service come with the subscription, using SaaS can potentially decrease IT costs for a startup.
Stage of Development
Where a company stands in its growth cycle. The four commonly recognized stages are concept, development (or startup), growth, and mature (or later stage). A concept company has an idea and is exploring its feasibility. A development company has a credible business model, is in the process of developing its business, and has little or no revenue. A growth company is in the process of expanding its business, typically has a solid management team, and brings in revenue of at least $1 million. A mature company is fully operational and has recurring revenue, slowed internal growth, and lower risk. The amount and type of funding a company may be able to attract will depend, in part, on its stage of development.
Startup
An early stage, entrepreneurial company recently launched to pursue a new business.
Stock Options
Contract securities that give the holder the right to purchase the underlying securities (typically common stock) at a stated price during a stated period. Startups typically grant stock options as a form of equity-based compensation to founders and employees as partial compensation for services rendered. Stock options are often subject to vesting conditions. Stock options are similar to warrants in that both instruments give the holder the right to buy underlying securities for a specified price. See also “Vesting” and “Warrants.”
Strategic Investor
A source of funding for a company that adds value to a startup because of its contacts, experience and/or knowledge of the market in which the company operates. In contrast, financial investors (venture capital firms and institutional investors) principally provide cash rather than contacts, experience or knowledge.
Strike Price
The price at which an option or a warrant may be exercised to purchase the underlying security. If the market price of the underlying security exceeds the strike price at the time the option is exercised, the holder profits by the difference between the two prices.
Tag-Along Rights
Contractual rights given to some minority investors that allow them to sell securities in a future transaction on the same terms and conditions as significant/majority investors. Tag-along rights protect minority stockholders in the event that significant/majority holder decides to sell its stake in the startup.
Term Sheet
A document drafted by a prospective investor that outlines the terms upon which an investor is willing to buy a company’s securities. Term sheets are not generally binding, but provide an outline of the terms that are expected to be incorporated into a binding agreement. See “Letter of Intent” or “LOI.”
Tranche
One installment in a series of linked investments. In order to receive each subsequent tranche of investment, a startup must achieve stated targets or benchmarks. See also “Benchmarks” or “Milestones.”
United States Securities and Exchange Commission or SEC
An agency of the federal government with primary responsibility for enforcing the federal securities laws, proposing securities rules and regulating the nation’s securities industry and securities exchanges.
Valuation
The process of appraising the worth of a company. Startups and emerging businesses tend to have relatively few assets and lack an operating history, so the process of valuing these types of companies is more subjective than the process of valuing more developed companies.
Value Proposition
A statement of the goods or services a company will provide, to whom, and how. It should make clear how the company’s solution to a particular problem will be a significant improvement over the status quo. To attract investors, startups need a compelling value proposition.
Venture Capital
A segment of the private equity industry that focuses on buying equity in early stage companies through a private placement offering. This form of investing is both high risk and high reward.
Venture Capital Firm
An investment company that buys equity in early-stage entrepreneurial companies. Venture capital investors may provide their portfolio companies managerial expertise and guidance in addition to cash.
Vesting
The conditions that must be met before receiving a promised security. Startups will often put vesting conditions on stock options granted as compensation. Those conditions may be time based (for example, restricted stock may vest ratably over a period of four years) or performance based (for example, an employee must meet a specified goal to receive the award).
Warrant
A derivative security that gives the holder the right to purchase the underlying securities from the issuer at a stated price during a stated period. Warrants are similar to stock options in that both instruments give the holder a future right to buy underlying securities for a specified price.
