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.
Cancellation
When a security or agreement is terminated and removed from the cap table. Common with forfeited options or cancelled convertible instruments.
Examples:
Option forfeiture: Employee leaves before cliff, unvested options are cancelled
SAFE cancellation: Investor and company mutually agree to cancel SAFE
Expired warrants: Warrants expire unexercised and are cancelled
Why it matters: Cancellations clean up the cap table by removing securities that will never convert to shares.
Earnout Provisions
Contractual arrangements in acquisition agreements where a portion of the purchase price is contingent upon the acquired company achieving specific performance milestones or financial targets post-acquisition. Earnouts bridge valuation gaps between buyers and sellers and incentivize continued performance after the deal closes.
Key characteristics:
Deferred payment based on performance
Specific metrics and timeframes
Typically 10-40% of total deal value
Creates ongoing alignment
Can be individual or collective
Common metrics:
Revenue targets
EBITDA or profit thresholds
Customer retention rates
Product development milestones
User growth targets
Structure types:
Cliff earnout:
All-or-nothing based on hitting target
Example: $5M if revenue exceeds $20M, $0 if below
Graduated earnout:
Sliding scale based on performance
Example: $1M per $5M in revenue between $15M-$25M
Time-based earnout:
Paid over time if key employees stay
Example: $2M per year for 3 years if founder remains employed
Example scenario:
Company sells for $40M upfront + earnout
Earnout: $15M if company generates $25M revenue within 24 months
Results: Company achieves $27M revenue
Sellers receive: Additional $15M earnout payment
Total deal value: $55M
Example with sliding scale:
Base purchase: $30M
Earnout structure:
$5M if EBITDA reaches $10M
Additional $5M if EBITDA reaches $12M
Additional $5M if EBITDA reaches $15M
Maximum deal value: $45M
Common disputes:
Definition of metrics (what counts as revenue?)
Buyer's operational control affecting targets
Changes to business affecting earnout achievability
Accounting methods
Why it matters: Earnouts reduce buyer risk but create uncertainty for sellers. Founders should negotiate clear metrics, protection against buyer decisions that harm earnout potential, and shorter earnout periods when possible. Common in acquisitions of earlier-stage companies with uncertain future performance.
Escrow Arrangements
A mechanism in acquisition transactions where a portion of the purchase price is held by a neutral third party (the escrow agent) for a specified period to cover potential indemnification claims, working capital adjustments, or dispute resolution. Protects buyers against breaches of representations and warranties or undisclosed liabilities.
Key characteristics:
Neutral third-party holds funds
Specified time period (typically 12-24 months)
Covers indemnification claims
Released if no valid claims
Standard in M&A transactions
Common escrow types:
Indemnification escrow:
Covers breaches of reps and warranties
Typical amount: 10-20% of purchase price
Period: 12-18 months (survival period for reps)
Working capital escrow:
Adjusts for final working capital calculations
Released after final numbers determined
Usually 60-120 days
Specific indemnity escrow:
Covers known risks or pending litigation
Held until specific matter resolved
Can extend beyond general escrow period
How it works:
At closing, buyer withholds portion of purchase price
Funds deposited with escrow agent (often law firm or bank)
During escrow period, buyer can make claims
Valid claims paid from escrow to buyer
After escrow period, remaining funds released to sellers
Example:
Acquisition: $60M total purchase price
At closing: $54M paid to sellers
Escrow: $6M (10%) held for 18 months
Indemnification cap: $6M
Month 8: Buyer discovers $2M undisclosed liability
Buyer makes claim, proven valid
Escrow agent pays $2M to buyer
After 18 months: Remaining $4M released to sellers
Sellers net: $58M total
Negotiation points:
Sellers want:
Lower escrow percentage (5-10%)
Shorter periods (12 months)
Higher claim thresholds
Clear release mechanisms
Buyers want:
Higher escrow percentage (15-20%)
Longer periods (18-24 months)
Easier claim process
Broader indemnification coverage
Why it matters: Escrow arrangements delay final payment but are standard M&A practice. Sellers should negotiate for reasonable escrow amounts and periods while ensuring clear, objective release mechanisms. Missing escrow deadlines or failing to properly document claims can result in forfeited proceeds.
Repurchase
When the company buys back shares from a shareholder. Common scenarios include buying back shares from departing founders, employees, or early investors who want liquidity.
How it works:
Shareholder and company agree on price (typically fair market value per 409A)
Company pays cash
Shares are retired or held as treasury stock
Repurchased shares no longer count as outstanding
Example:
Departing founder owns 500,000 vested shares
Company repurchases at $2/share FMV
Company pays: $1,000,000
Founderâs shares are cancelled
Other shareholdersâ ownership percentages increase slightly
Common repurchase scenarios:
Departing founders: Often required by shareholder agreements
Early employees: Company offers liquidity opportunity
Unvested shares: Company repurchases at original price if someone leaves
Why it matters: Repurchases provide liquidity but require significant company cash. They also concentrate ownership among remaining shareholders.
Secondary Sale (Secondary Transaction)
When existing shareholders sell their shares to a new buyer (not the company issuing new shares). This provides liquidity without diluting other shareholders.
Primary vs. Secondary:
Primary: Company issues new shares â dilution, company gets cash
Secondary: Existing shareholder sells shares â no dilution, shareholder gets cash
Example:
Early employee holds 100,000 shares
Private equity firm offers to buy them at $5/share
Employee sells: Gets $500,000 cash
PE firm now owns those 100,000 shares
Company doesnât get any money, no dilution to other shareholders
Why companies sometimes restrict secondaries:
Want to control whoâs on the cap table
Worry about valuation implications
Prefer to offer liquidity through tender offers
Why it matters: Secondaries provide liquidity for early shareholders without the company raising new money. Secondary sales may trigger a 409A refresh or impact Common FMV depending on materiality. This is increasingly common for seed-stage startups.
Stock Split
When a company increases its number of shares by splitting existing shares into multiple shares. This doesnât change anyoneâs ownership percentage or the companyâs value, just the number of shares.
Forward split example (1:10):
You own: 100,000 shares
Company does 10-for-1 split
You now own: 1,000,000 shares (10Ă more)
Price per share: $10 â $1 (1/10th)
Your total value: Same
Why companies split stock:
Make per-share price more manageable ($100/share â $10/share)
Create more shares for option pool without changing percentages
Psychological reasons (lower per-share price feels more accessible)
Reverse split example (10:1):
Less common in startups
Consolidates shares to increase per-share price
Often done before going public
Why it matters: Stock splits donât change economics, but they do change your share counts. Make sure you understand what happened when you see your share count change.
Tender Offer
A structured process where a company offers to buy back shares from employees and shareholders, providing liquidity without a full exit.
How it works:
Company (or investor) offers to buy shares at a set price
Shareholders decide whether to sell
Often capped (e.g., âsell up to 20% of your sharesâ)
All sellers get same price
More sellers than capacity â pro-rata allocation
Example:
Company offers to buy back $10M of employee shares
Price: $5/share (based on recent fundraising)
Employees with vested shares can sell up to 20%
Oversubscribed: Everyone sells pro-rata portion
Why it matters: Tender offers provide partial liquidity before an exit, helping retain employees who need cash without selling the company. Tender offers are likely to trigger a 409A refresh and impact the Common FMV.
Transfer
When ownership of shares moves from one person/entity to another. Transfers are typically restricted by right of first refusal (ROFR) or other transfer restrictions.
Common transfer scenarios:
Gifting: Founder gives shares to family trust or spouse
Secondary sale: Early employee sells shares to outside buyer
Estate planning: Shares transfer to heirs
Divorce: Shares transfer to ex-spouse
Transfer process:
Shareholder wants to transfer
Company has ROFR (right of first refusal)
Company declines or exercises ROFR
If declined, company may approve other buyer
Transfer documents executed
Cap table updated
Why it matters: Most shares canât be freely transferred. You need company approval and must give company the chance to buy first.