đ Educational Resource Disclaimer
This glossary provides general explanations of common equity terms. These definitions and examples are for educational purposes only and do not constitute legal, financial, or tax advice.
Equity structures vary significantly between companies, and your specific situation may have unique terms and conditions. For guidance on how these concepts apply to your individual situation, please consult with a qualified legal, financial, or tax professional.
Anti-Dilution Protection
A provision that protects investors from dilution if the company raises money at a lower valuation than their round (a âdown roundâ). The investorâs shares convert into more common shares to maintain their economic stake.
Types:
Full Ratchet (most investor-friendly, rare):
Investorâs conversion price adjusts to the new, lower price
Example: Investor bought preferred at $2.00/share. Next round prices at $1.00/share. Investorâs shares now convert as if they paid $1.00/share, doubling their share count.
Weighted Average (more common, more balanced):
Adjustment is proportional to the size and price of the down round
Broad-based: Uses all outstanding shares in calculation (more founder-friendly)
Narrow-based: Uses only common stock in calculation (more investor-friendly)
Example (Broad-Based Weighted Average):
Series A investor paid $2.00/share for 1,000,000 shares
Down round at $1.00/share for 500,000 new shares
New conversion price: ~$1.60/share (weighted based on round size)
Series A shares now convert to ~1,250,000 common shares instead of 1,000,000
Why it matters: Anti-dilution provisions transfer dilution from investors to founders and employees in down rounds. Understanding the terms helps to model downside scenarios.
Catch-Up Provisions
Contractual terms in investment or founder agreements that allow certain parties (typically founders or early investors) to receive additional equity distributions until they achieve a specified ownership percentage or return threshold, compensating for dilution from later financing rounds.
Key characteristics:
Restores ownership after dilution
Triggered by specific events (usually exits or milestones)
Can be percentage-based or dollar-based
Negotiated protection for key parties
Sometimes called "kicker provisions"
Common structures:
Founder catch-up:
Founders diluted from 60% to 35% through funding rounds
Catch-up provision: At exit, founders receive additional proceeds until they own 45%
Benefits founders while investors still get their returns
Investor catch-up:
Early investor gets 1x liquidation preference
After preference paid, catch-up to 20% ownership before common shares participate
Protects investor from heavy dilution in down rounds
Example scenario:
Founders start with 80% ownership
After Series A, B, C: Own 25%
Catch-up provision in founder agreements
Company exits for $100M
Investors take $40M (liquidation preferences)
Founders receive additional $15M to reach 40% of remaining proceeds
Then final $45M split pro-rata among all shareholders
Why it matters: Catch-up provisions protect founders and early investors from excessive dilution, ensuring they maintain meaningful ownership despite multiple funding rounds. Important to understand when negotiating founder agreements or investment terms.
Common Stock
The basic ownership class in a company. Common stockholders have voting rights and participate in the companyâs success, but theyâre last in line to get paid if the company is sold or liquidates (after preferred stockholders).
Key characteristics:
Voting rights (typically 1 vote per share)
Residual economic rights (get paid after preferred)
Subject to vesting (for founders and employees)
Often subject to repurchase rights
Who typically holds common stock:
Founders
Employees (after exercising options)
Early advisors
Sometimes angels (in very early rounds)
Example: You founded the company and own 5,000,000 shares of common stock. An investor later buys preferred stock with a 1x liquidation preference. If the company sells for $10M and the investor put in $2M, they get their $2M first, then you split the remaining $8M based on ownership percentages.
Preferred Stock
A class of stock with special rights and preferences, typically issued to investors during fundraising rounds. Preferred stock usually has liquidation preferences, meaning preferred holders get paid before common stockholders in an exit.
Common preferred stock features:
Liquidation preference: Get paid first in an exit (1x, 2x, etc.)
Conversion rights: Can convert to common stock (usually at 1:1 ratio)
Anti-dilution protection: Protects against down rounds
Voting rights: Sometimes enhanced voting power
Board seats: Often includes right to appoint directors
Dividend rights: Rare in startups, but possible
Series naming:
Series Seed / Seed Preferred: First institutional round
Series A, B, C, etc.: Subsequent rounds, numbered alphabetically
Example: A VC invests $5M at a $20M post-money valuation and gets Series A Preferred Stock with a 1x liquidation preference. If the company sells for $30M, they get their $5M first, then everyone shares the remaining $25M pro-rata.
Why it matters: Preferred stock terms significantly impact founder and employee outcomes in an exit. Understanding liquidation preferences, participation rights, and conversion terms is critical.
Liquidation Preference
The right of preferred stockholders to get paid before common stockholders when the company is sold or liquidates. Usually expressed as a multiple (1x, 2x) of the investment amount.
Types:
1x Non-Participating (most common):
Investor gets the greater of (a) 1x their money back, or (b) their pro-rata share as if they converted to common
Example: Invested $5M for 25% ownership. Company sells for $30M.
Option A: Take $5M (1x liquidation preference)
Option B: Convert to common and take 25% Ă $30M = $7.5M
Investor chooses Option B ($7.5M)
1x Participating (less common, more investor-friendly):
Investor gets 1x their money back PLUS their pro-rata share of remaining proceeds
Example: Same scenario above. Company sells for $30M.
Investor gets $5M first
Then gets 25% of remaining $25M = $6.25M
Total: $11.25M (nearly half of proceeds despite owning 25%)
2x or Higher:
Investor have more negotiation power.
Example: Invested $5M with 2x preference. Sale at $8M means investor gets all $8M, founders/employees get $0.
Why it matters: Liquidation preferences can dramatically affect founder and employee outcomes, especially in modest exits. A $20M sale might be great or terrible depending on preferences.
Profits Interests
A form of equity compensation used primarily by LLCs and partnerships that grants recipients the right to share in future profits and appreciation of the company, without providing any claim to the current value. If issued at fair market value, profits interests typically have no value at grant (no immediate tax), making them similar to stock options but with more favorable tax treatment.
Key characteristics:
Only participate in future appreciation
No claim to current equity value
Common in LLCs, uncommon in C-corps
Can convert to capital interests over time
Favorable tax treatment if structured properly
How they work:
LLC determines current fair market value
Grants profits interest at that threshold
Recipient shares in appreciation above threshold
Receives distributions and exit proceeds on future growth only
Example:
LLC valued at $20 million
Key employee receives 5% profits interest
Profits interest threshold: $20 million
Five years later, company sells for $50 million
Employee receives: 5% Ă ($50M - $20M) = $1.5 million
Gets nothing from first $20 million in value
Tax advantages:
No tax at grant (if structured properly under IRS safe harbor)
Can be taxed as long-term capital gains if held 1+ years
Avoids ordinary income treatment of NSOs
Profits Interests vs. Stock Options:
Feature | Profits Interests (LLC) | Stock Options (C-Corp) |
Tax at grant | None (if at FMV) | None |
Exercise cost | None | Yes (strike price) |
Tax at exit | Capital gains | Depends (ISO vs NSO) |
Common structure | LLCs, Partnerships | C-Corporations |
Why it matters: Profits interests are the LLC equivalent of stock options, often with better tax treatment. Critical to understand if joining or operating an LLC-structured startup.
Treasury Stock
Shares that were previously issued and outstanding but have been bought back by the company. Treasury shares donât have voting rights and donât count toward outstanding shares, but they remain authorized.
Example:
Company repurchases 100,000 shares from a departing founder
These become treasury stock
Can be reissued later without increasing authorized share count
Often retired (cancelled) rather than held as treasury stock
Why it matters: Treasury stock gives flexibility for future issuances without amending a charter. However, many startups simply retire repurchased shares.