5 Terms To Learn Before Negotiating Finance

5 Terms To Learn Before Negotiating Finance

It’s imperative to learn investor jargon before taking a place across the table from a potential investor. Here are some commonly used terms:

1. Liquidation preferences

Liquidation preferences are designed to safeguard investors’ capital, by allowing investors to recoup their investment prior to any distribution of cash to common stockholders in the event of liquidation.

“Look for a 1x liquidation preference in the VC term sheet,” says Arpit Jain, co founder and CEO of Splashmath. “Be wary of 2x or 3x liquidation preferences, giving investors the right to that many times their investment.”

Also, insist on a non-participating liquidation preference wherein the preferred shareholders have the option of recouping their initial investment OR the value of their preferred stock as converted to common stock. A variant called participating liquidation preference entitles investors to both these payouts. Capped participating is an intermediary approach wherein the investors’ aggregate returns are limited to the cap.

2. Dividends

A dividend preference clause entitles investors to receive dividends prior and in preference to the dividends paid on common stock. Investors benefit substantially from dividends only when the investment is high and the expected return on investment is low, according to Jain.

He believes that dividends usually don’t happen in startups, and hence, don’t present a financial burden. But if they are to be given, they should be declared after a solvency analysis by the board. Rates usually vary from 7% to 10%.

However, watch out for cumulative dividends, which are declared automatically to be paid every year or are accumulated over several years to be paid in the event of liquidation.

3. Restrictive terms

Restrictive covenants in an agreement for start-up funding are terms that restrict the founders from certain actions if they leave the company. Founders are usually bound by “non-competes” and “non-solicits” terms.

The “non-compete” clause bars founders from working for competitors for a specified duration after he or she quits. “Non-solicit” disallows departing founders from hiring company employees or approaching the company’s customers for work for some time after they leave.

“Be very clear about the restrictive terms that will apply to you, the entrepreneur,” says Shefali Walia, founder of WeTravelSolo.

She recommends trying to associate the covenants with a minimum threshold, which would mean the restrictions apply only as long as that threshold isn’t crossed.

4. Vesting

Vesting per se gives each founder his or her due stocks at the outset. However, building on the notion that founders and other stock-holding employees must earn their equity by contributing towards value creation over a period of time, vesting gives the company the right to purchase a percentage of the founder’s equity if he or she walks away before a specified duration.

 “Vesting may seem like a negative clause but it’s actually a good thing,” explains Aditi Avasthi, CEO and founder of embibe.com.

It mandates commitment to an enterprise, and helps everyone rally round the common goal: building a successful company.

Avasthi recommends not giving in to the temptation to accept higher vesting upfront as that doesn’t reward longevity.

“Lower vesting also makes it easier to hire great people for attractive stock options, because they will see you are in the same boat,” she adds.

5. Right of first refusal

Right of first refusal is a contractual right that gives the start-up founder the option to buy into the company before the majority stakeholder, presumably the investor, enters into a similar agreement with a third party.

Walia recommends keeping the right of first refusal in your hand, to ensure you’re not bound to agree to anything and everything.

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