9 Equity Terms You Need To Know
When shares come into play, you bet that everyone will be itching for a slice of the equity pie.
To make sure that equity is fairly distributed and compliant with federal and state law, you will want to:
- hire a good attorney to help you draft an agreement and
- figure out what the agreement actually means.
We’re breaking down a few legal terms we commonly see in the agreement and whether or not you want to see them in the first place:
1. Right of First Refusal
The right of first refusal is, as implied in its name, a partner’s contractual right to enter into a business transaction with you before anybody else can. If your partner declines to enter the business transaction, you can then open the asset up to other parties.
This right serves as a nifty insurance policy, as it puts you at the front of the line to purchase these shares from your partners before anyone else can. You will often hear about right of first refusal when larger investors attempt to buy out a company’s majority stake from the original business owners.
2. Right of First Offer
Similar to the right of first refusal, the right of first offer is the contractual obligation that you have to negotiate the cost of an asset with your partner before you try to sell the asset to other parties.
The right of first offer differs from the right of first refusal because it tends to favor the seller rather than the buyer. However, the seller is only in a stronger position if there is a third party that is willing to purchase the asset at a higher price than the prospective buyer is willing to pay.
3. Call Option
Call option contracts grant holders the right to buy assets (bonds, stocks, etc.) at a specific price within a set time period. When you purchase a call option contract, you can either choose to sell it any time before the expiry date at market price or you will have to deliver on your contract at the market price on the expiry date.
You can either stand to gain or lose depending on how much you bought your initial contracts for, so keep a close eye on your share prices as you determine when’s the best time to let go of your shares.
4. Put Option
The opposite of a call option, put option contracts give holders the right to sell assets (bonds, stocks, etc.) at a specific price during a specific time period. After you pay a premium amount for the put option contract and set a strike price, you will want to aim to buy the shares below your strike price so that you are able to sell your shares at a profit once your contractual expiry date arrives.
5. Tag Along Rights
Ever heard of the majority of the tyranny? Tag along rights, or “co-sale” rights, are contractual obligations designed to protect minority shareholders and allow them to sell their minority stakes in the case that a majority shareholder decides to sell his or her stake.
Since the majority stakeholder typically has more clout when making the deal, minority shareholders will seek to capitalize on that clout and try to negotiate a better deal for themselves as well if they’re not interested in retaining their shares anymore. Tag along rights are especially popular in the startup scene.
6. Drag Along Rights
Of course, majority shareholders need to look after their backs too. In the case that the majority shareholder is planning to sell their stakes, they can invoke drag along rights to ensure that minority shareholders sell their stakes in the same deal. Drag along rights are most popularly used in mergers and acquisitions, since most buyers are looking to control the whole company.
Obtaining equity or investment funds is a huge reason why most people join high-potential startups. It also makes sense that these startups are looking to attain and retain as much talent as possible (since turnover and onboarding are huge costs).
As a result, many companies require their employees to commit to a vesting schedule, which determines how much time an employee needs to spend at the company before acquiring the full asset like 401(k) matching. This helps companies ensure that employees perform well and stay long enough for their work to have visible and helpful impact.
8. Lockup Period
If you are a founder whose company is about to IPO, chances are you have a pretty stash of stock and considerable knowledge of the IPO deal itself. However, a lockup period (usually lasting 90-180 days) will be incurred to prevent you from selling your shares with insider knowledge and from liquidating the company’s assets too fast. This way, sellers won’t immediately flood the market with excessive shares and decrease their value.
9. Right of Repurchase
Similar to how employees have to face vesting schedules to reap the full benefits of working at a company, founders are also provided an incentive to stick it out at their company through the right of repurchase.
If a company has tied the right of repurchase to stock issued to the founders, it grants them the right (but not obligation) to repurchase the stock from a founder should the founder decide to leave the company and usually at the price of the stock’s initial value.
Should the founder stay at the company past the repurchase period, he or she would be able to leave the company while retaining ownership of the shares.