Module 2 · Equity Capital · Lesson 5
Equity terms defined
How to read a term sheet
A term sheet is easier to read once you sort its contents into three groups rather than reading top to bottom.
Price terms set what the investment is worth: valuation, the amount raised, the option pool and its treatment. Control terms set who decides: board composition, consent rights over fundraising, hiring, acquisitions and sale. Queue terms set who is paid, in what order, when the company is sold: liquidation preference, participation, anti-dilution, drag and tag.
Founders routinely negotiate the first group hard and accept the other two as boilerplate. That is the wrong emphasis. Price determines the outcome in a good scenario; control and queue determine it in every other scenario, which is precisely why they are in the document.
The second habit: ask of every unfamiliar clause what it does if things go badly. Most terms are inert when a company succeeds and decisive when it does not.
Terms that behave differently in African markets
Liquidation preference is often more aggressive here than the 1x non-participating standard common in deeper markets, because investors are pricing thinner exit routes. It is negotiable, and it is worth negotiating.
Put options appear far more frequently than founders elsewhere would expect. Where trade sales are the only realistic exit and the buyer population is small, investors seek a contractual route to get their money back — usually a right to require the company or its founders to repurchase their shares after a set period. Understand who is obliged to fund that repurchase before signing it.
Valuation carries an unstated currency assumption. A number agreed in rand and a number agreed in dollars are different deals, and which one governs at exit is a term to settle explicitly rather than discover later.
Vesting is sometimes resisted by founders as a sign of distrust. It is closer to the opposite: it protects a founding team from a co-founder who leaves in year one keeping a third of the company.
Index of terms
- Anti-dilution provision
- A term adjusting an investor's shareholding if a later round is priced below the one they invested in. Full-ratchet versions re-price the earlier investment entirely; weighted-average versions adjust more moderately.
- Cap table
- The record of who owns what in a company, including shares, options and any instruments convertible into shares.
- Carried interest
- A fund manager's share of profits, conventionally 20%, usually payable only after investors have received their capital back plus a preferred return.
- Common shares
- Ordinary shares, typically held by founders and employees, ranking behind preference shares for payment on a sale.
- Convertible loan
- Debt that converts into equity on a future event, usually the next funding round, often at a discount to that round's price.
- Down round
- A funding round priced below the previous one, which triggers anti-dilution provisions and usually shifts ownership away from founders.
- Drag-along right
- A provision allowing majority shareholders to compel minorities to join a sale, preventing a small holder from blocking an exit.
- Dilution
- The reduction in an existing shareholder's percentage ownership when new shares are issued.
- ESOP
- An employee share ownership plan — shares reserved for issue to employees, usually as options vesting over time.
- Follow-on investment
- Further capital invested by an existing investor into a company already in their portfolio, funded from reserves set aside for that purpose.
- Fully diluted
- A share count including all options, warrants and convertible instruments as though already exercised. The basis on which percentages should always be checked.
- General partner (GP)
- The manager of a fund, responsible for raising capital, selecting and executing investments, and returning proceeds.
- Hurdle rate
- The minimum return, often around 8%, that a fund must deliver to investors before the manager earns carried interest.
- Limited partner (LP)
- An investor committing capital to a fund but taking no part in its investment decisions — typically pension funds, insurers, endowments, DFIs and family offices.
- Liquidation preference
- A term determining who is paid first when a company is sold, and how much, before remaining proceeds are shared.
- Management fee
- An annual fee, conventionally around 2% of committed capital, paid to a fund manager to run the firm regardless of performance.
- Option pool
- Shares reserved for future employees. Whether it is created pre-money or post-money determines who bears the dilution.
- Participating preference
- A liquidation preference where the investor receives their money back AND then shares in the remaining proceeds, rather than choosing the greater of the two.
- Post-money valuation
- The agreed value of a company immediately after an investment — the pre-money valuation plus the new capital.
- Pre-emption right
- An existing shareholder's right to participate in a new issue of shares to maintain their percentage, before the shares are offered elsewhere.
- Pre-money valuation
- The agreed value of a company immediately before an investment is made.
- Preference shares
- Shares ranking ahead of common shares for payment on a sale, and usually carrying additional rights such as consent over major decisions.
- Ratchet
- An aggressive form of anti-dilution that re-prices an earlier investment as though it had been made at the lower valuation of a later round.
- Reserves
- Capital a fund holds back from new investments to fund follow-on rounds into existing portfolio companies.
- SAFE
- A simple agreement for future equity — an instrument converting into shares at a later priced round, without being structured as debt.
- Tag-along right
- A minority shareholder's right to join a sale on the same terms when a majority holder sells, preventing them from being left behind.
- Vesting
- The schedule over which shares or options are earned, commonly four years with a one-year cliff, so that equity reflects time actually served.
- Vintage
- The year a fund began investing. It indicates how much time remains in the fund's life and therefore how patient it can afford to be.
Questions, answered
What does fully diluted mean?
A share count that includes all options, warrants and convertible instruments as if already exercised. Percentages should always be checked on a fully diluted basis, because the headline figure can otherwise flatter.
What is the difference between participating and non-participating preference?
Non-participating means the investor takes the greater of their money back or their percentage share. Participating means they take their money back and then also share in the remainder, which is materially more expensive to founders on a modest exit.
What is a SAFE, and how is it different from a convertible loan?
Both convert into shares at a later priced round. A convertible loan is debt, carrying interest and a repayment obligation if conversion never happens; a SAFE is not debt and has no repayment right, which makes it simpler but riskier for the investor.
Why do investors ask for vesting on founder shares?
To protect the remaining founders as much as the investor. Without it, a co-founder who leaves early keeps their full stake while others carry the work — vesting ties equity to time actually served.
What is a put option in a funding agreement?
A right allowing an investor to require the company or its founders to buy back their shares after a set period. It is common in African deals because it creates a contractual exit where market exits are uncertain.