You need to know these key terms to understand Silicon Valley start-up funding

Silicon Valley is full of sad tales of founders who were intimidated or confused by all the jargon in their term sheets, and eager to get funded agreed to something that wasn’t in their best interest.

Just as in any negotiating situation, the more knowledge you have the better. You need to be able to know if the deal you are being offered is really the right one for you. The problem is, the vocabulary used in the world of start-up investing is unique, and includes things that would be unfamiliar even if you have an MBA.

Drawing on the information in our new book Valley Speak: Deciphering the Jargon of Silicon Valley, here are some of the key terms you need to know to understand start-up funding will help you decipher that term sheet and negotiate with confidence!

What you need to know about the term sheet

The term sheet sets forth all the terms and conditions of an investment. It is not, however, the definitive or legally binding document that an entrepreneur might ultimately sign, but rather a statement of intent.

In particular, after the term sheet is signed, the deal is still subject to a due diligence review by the investor, in which the investor will do a deep-dive search for risks related to the company, its operations, its accounting, its customers, its staff, and so on, so that it can go into the investment with eyes wide open.

The initial term sheet will normally be proposed by the lead investor and negotiated with the entrepreneur. This complex document will likely specify the following items, among others:

• The amount of money that will be invested.

• The full amount to be invested may not be released all at once, but rather be divided into portions, called tranches. Additional tranches after the first are only released if the company achieves certain milestones, such as sales, user counts, entrance into new markets, or release of product features.

• How much the company is assumed to be worth under the deal, the valuation. This typically is specified as a pre-money valuation – the value prior to the funding, as opposed to the post-money valuation after the funding.

• A schedule for vesting – accumulation of control of their share of the equity over time – that will be imposed on the members of the founding team. This may be included even if they had been fully vested prior to the funding. Vesting assures that the founding team sticks around to build the company rather than leaving with their equity.

• Designation of the stock held by the investor as being preferred stock, rather than common stock. Preferred stock differs from common stock in that it can give the holder a claim to additional dividends as well as the right to receive dividends and proceeds of liquidation or sale before common shareholders receive similar distributions.

• The liquidation preference: a multiple of the amount invested that the investors insist on receiving upon liquidation or sale of the company, prior to payments to other stockholders. This is basically a guarantee to the investors that they will, if at all possible, get their money back and more no matter what happens.

• Definition of participation — when, upon liquidation or sale and after the liquidation preference payment, preferred shares should continue to be paid alongside those of other investors—either immediately (fully participating), after other investors are given a chance to “catch up” (simple participating), or never (non-participating).

• An anti-dilution clause, which protects the investor from new shares being issued at a lower price (a down round) by requiring that in that circumstance, additional shares be issued to the investor. The most extreme form of anti-dilution, full-ratchet protection, preserves the investor’s ownership percentage.

• A no shop clause, which prohibits the founder from entering into negotiations with other investors (but not necessarily from continuing existing negotiations) for a fixed time period during due diligence. However the investor will be under no such constraint!

• A definition of the voting rights of the preferred stock, possibly at a multiple of common.

• A redemption right, which would allow the investor to reclaim their funds (through the company purchasing their shares) after a certain period of time. This of course is considered dangerous for founders.

Rochelle Kopp and Steven Ganz are co-authors of Valley Speak: Deciphering the Jargon of Silicon Valley, a new book dedicated to defining the startup ecosystem’s vocabulary in a way that is both rigorous and entertaining.