Adrian
Table of Contents
- Introduction
- Why the Terminology Trap Matters
- Common Venture Capital Terminologies and What They Actually Mean
- Pari Passu
- Ratchets
- Stacking
- Participating Convertible Preferred Shares (CPS) with a Cap
- Liquidation Preference
- Cliff and Vesting
- Drag-Along Rights
- Tag-Along Rights
- My Take on the VC Terminology Trap
- Explore More Insights on the VC World
Introduction
Venturing into the world of venture capital (VC) is exciting for entrepreneurs, but it often comes with a side of confusion—especially when it comes to the terminology. Terms like “pari passu” or “participating CPS with a cap” are thrown around like everyday lingo, leaving many founders nodding along without truly understanding what’s going on.
If you’re considering raising venture capital, you’ve probably already encountered some of this jargon. The trap? Not knowing what these terms mean could lead you into making decisions that aren’t fully in your best interest.
Venture capitalists (VCs) speak their own language, and if you’re not fluent, you might end up agreeing to terms that are far less favorable than they sound. In this post, we’ll walk through some of the most confusing VC terms, break them down into plain English, and explain why they matter.
Why the Terminology Trap Matters
Venture capital is designed to fuel your startup’s growth, but the terms and conditions baked into these deals can be complicated. You’re likely eager to get funding, but without a firm grasp of the language, you might not fully understand what you’re signing up for.
Let’s look at some common VC terms you need to be aware of:
Common Venture Capital Terminologies and What They Actually Mean
Pari Passu
What it sounds like: Fancy Latin for… something.
What it actually means: Pari Passu translates to “on equal footing.” It means that different investors (or groups of investors) will be treated equally in terms of payment. For example, if a VC agreement says that certain investors are “pari passu,” they’ll get paid back at the same time and in the same proportion.
Why it matters: If you’re raising money from multiple investors, you need to know who’s getting paid first or whether everyone gets treated equally.
Ratchets
What it sounds like: A tool, maybe?
What it actually means: A ratchet in VC refers to a mechanism that protects investors. It’s designed to adjust the price at which early investors convert their shares if a company raises money at a lower valuation in the future. There are different kinds of ratchets (full ratchet and partial ratchet), but generally, it protects investors from losing too much value if things don’t go as planned.
Why it matters: As a founder, you need to know how much dilution you’ll face if investors exercise these ratchets. It can drastically affect your ownership.
Stacking
What it sounds like: Something to do with Legos?
What it actually means: Stacking refers to the order in which investors get paid when a company is sold or goes public. Investors who are “stacked” on top of each other are paid in layers—some investors will get paid first (senior investors), and others will get paid later (junior investors).
Why it matters: Understanding stacking is crucial because it determines who gets their money back first if things go south. As a founder, you need to know how much is left for you after everyone else gets paid.
Participating Convertible Preferred Shares (CPS) with a Cap
What it sounds like: A complicated insurance policy.
What it actually means: This one is a mouthful, but it’s important. Participating CPS with a cap means investors get the best of both worlds—they get their money back (with dividends) and can also participate in the upside as if they held common shares. The “cap” limits how much extra they can make from this arrangement.
Why it matters: This structure can take a large bite out of the profits founders would see in an exit. It’s critical to understand how this impacts your final payout.
Liquidation Preference
What it sounds like: Who’s getting fired first?
What it actually means: Liquidation preference dictates the order in which investors get paid if your startup is sold, liquidated, or goes public. A 1x liquidation preference, for example, means an investor gets their original investment back before anyone else (like founders or employees) sees any money.
Why it matters: If your startup exits for less than expected, a high liquidation preference can leave very little for you as the founder, even if the sale price seems significant.
Cliff and Vesting
What it sounds like: A dangerous hiking trail.
What it actually means: Vesting refers to how much equity (shares) you or your employees earn over time. A “cliff” means that no one gets any shares until a specific date, often one year. After that, vesting happens incrementally (e.g., monthly).
Why it matters: As a founder, you want to structure equity so that key team members are incentivized to stay long-term, while also making sure you don’t lose all your equity if someone leaves early.
Drag-Along Rights
What it sounds like: A rough ride?
What it actually means: Drag-along rights allow majority shareholders to force minority shareholders to join in the sale of the company. This means if you own a small portion of the company, you could be “dragged along” into selling, even if you disagree with the terms.
Why it matters: It’s important to understand your rights and what could happen if you’re in the minority as the founder in certain deals.
Tag-Along Rights
What it sounds like: A less aggressive version of drag-along rights.
What it actually means: Tag-along rights, also known as “co-sale rights,” allow minority shareholders to join in on a deal if the majority shareholder sells their stake. This gives the minority shareholders the option to sell their shares at the same time and under the same conditions.
Why it matters: If you have tag-along rights, you won’t be left out of a sale if your larger investors decide to cash out. This can protect you from being stuck in the company if the majority shareholder exits.
My Take on the VC Terminology Trap
As an entrepreneur, the VC world can feel like you’ve stepped into a whole new language—one where even small clauses can have significant implications for your business. The truth is, many of these terms are designed to protect investors, not you. That’s not to say raising venture capital is a bad idea, but it’s crucial to understand every word of the contract you’re signing.
Get a lawyer who specializes in startups to explain the fine print. Don’t be afraid to ask your investors to clarify terms until you’re 100% clear. Remember, it’s your company on the line. A misunderstanding over one term could cost you control, profits, or even ownership of your business.
The venture capital game is tough, and understanding the rules—especially the terminology—gives you a better chance of winning.
Key Takeaways:
- Don’t let complicated VC jargon fool you into bad deals.
- Take the time to fully understand key terms like pari passu, ratchets, and liquidation preferences.
- Get professional help from a lawyer or an advisor to decode terms you don’t understand.
- Investors are looking to protect themselves, so make sure you’re protecting your interests too.
Explore More Insights on the VC World
- Understanding the lingo is crucial, but it’s equally important to know how VCs spend their time—learn more in How Venture Capitalists Really Spend Their Time: A Peek Inside the VC World.
- Once you’ve cracked the terminology, explore the more challenging side of raising capital in The Dark Side of Venture Capital: Five Things Startups Need to Know.