Bench to Market: Understanding the Language

Posted by Peter Buck on October 21, 2009

Bench to Market (article) As the first installment of our Bench to Market series of posts, we provide a glossary of certain terms that an entrepreneur is likely to hear in the course of bringing a venture to market. This glossary assumes that many terms commonly used in legal circles will be new to the entrepreneur. The defined terms in this initial list relate primarily to the choice of legal entities that are available to the entrepreneur for development and operation of a business venture. As the series continues, this list will be expanded to include additional terms discussed in subsequent posts.

Glossary of Terms:

C Corporation: A business entity organized under a state statute and taxed as a separate entity under Subchapter C of the Internal Revenue Code. The Corporation is the traditional form of business entity historically used for aggregation of capital, since it limits the potential liability of investors to the amount invested. The Corporation remains the most frequently used investment vehicle, especially for businesses that may eventually effect a public offering of shares. Other forms of business entity, such as S Corporations, Limited Liability Companies, and Limited Partnerships, may be more suitable for certain ventures.
Common Stock: The basic equity or capital ownership unit of a Corporation, which entitles the holder to the residual value of the assets and business of a corporation upon liquidation, after payment of all the Corporation’s indebtedness and liability and redemption of any Preferred Stock of the corporation. Holders of common stock generally have proportionate rights to vote, receive dividends, and receive distributions upon liquidation of the corporation.
Convertible: Either Preferred Stock or a promissory note of a Corporation may be “convertible,” meaning that it is convertible, at the election of the holder, into the capital stock, typically Common Stock, of the Corporation at a fixed conversion price. The terms of conversion would be set forth in the charter of the Corporation or in a loan agreement or indenture.
Dilution: A reduction in the ownership percentage of a Corporation (or other form of business entity) held by an investor that results from the Corporation’s issuance of additional shares of its capital stock to other investors. Dilution can also refer to the reduction in earnings per share of Common Stock that would occur in the event all Convertible Stock or convertible debt of a corporation were converted into Common Stock. “Fully Diluted Shares” means the number of shares of Common Stock that would be outstanding if all Options and Warrants were exercised and all Convertible Stock and Convertible Notes converted into shares of Common Stock.
Limited Liability Company or LLC: A business entity organized under a state statute, typically pursuant to articles of organization or a similar charter filed with the state government, which is not required to pay federal or state income taxes but nonetheless limits the potential liability of investors to the amount invested. Income tax liabilities and attributes of an LLC “pass through” to its members, who are taxed directly on the earnings of the company and receive the tax benefit of any losses by the company. Limited Liability Companies also afford investors and managers great flexibility in arranging their relationships and duties to one another.
Limited Partnership: A business entity organized under a state partnership statute, typically pursuant to a partnership agreement that is not required to be filed with the state government, that has both “general partners” and “limited partners.” General partners typically control the operations of the business but remain personally liable for the debts and obligations of the partnership; limited partners have much less control over the activities of the business but are not liable for obligations of the business except in very unusual circumstances. Limited partnerships afford general partners and limited partners significant flexibility in arranging their relationships to one another, although partners typically owe each other greater fiduciary duties than either stockholders of a Corporation or members of a Limited Liability Company. Limited Partnerships are not required to pay federal or state income taxes; the general partners and limited partners are taxed directly on the earnings of the partnership and receive the tax benefit of any losses by the partnership.
Liquidation Preference: The fixed amount that a corporation must pay to a holder of its Preferred Stock in the event of a liquidation. A Liquidation Preference must be paid prior to any distribution to holders of Common Stock. A typical Liquidation Preference would be equal to the per-share purchase price of the Preferred Stock, and the redemption price of Redeemable Preferred Stock would typically be equal to its Liquidation Preference or a multiple thereof.
Options: Contractual commitments, or securities, of a corporation that enable the holder of an Option to purchase shares of the Corporation’s capital stock for an agreed price, which can be a fixed price, a price determined by application of a formula, or a price determined by an independent valuation procedure. Corporations typically issue Options to founders or key management employees as compensation incentives. Different types of Options are treated differently for income tax purposes. Options may also be issued by a Limited Partnership or Limited Liability Company.
Participating Preferred Stock: Preferred stock of a Corporation that entitles the holder to a stated Liquidation Preference and dividend preference, and in addition to participate proportionally with the holders of Common Stock in the distribution upon liquidation of the residual assets of the Corporation.
Preferred Stock: Equity ownership units of a Corporation that have rights to receive both dividends and liquidating distributions from a Corporation that are “preferred” or prior to the rights of holders of Common Stock, but subordinate to the rights of creditors. For example, the terms of Preferred Stock might provide that no dividend can be paid with respect to Common Stock during any year until holders of Preferred Stock have received a dividend of at least $1 per share and that each Preferred Stock share would have a Liquidation Preference of $10 (the amount is typically the purchase price of a share), which must be paid prior to any liquidating distribution to holders of Common Stock. The rights of holders of Preferred Stock are set forth in the charter of the Corporation and sometimes in other agreements between the stockholders.
Redeemable Preferred Stock: Preferred Stock that can be repurchased, or “redeemed,” by the Corporation from a stockholder, at the option of the Corporation, for an agreed price. Mandatorily Redeemable Preferred Stock must be redeemed by the Corporation at the election of the stockholder, and thus may be considered a debt obligation of the Corporation for certain purposes.
S Corporation: Like a C Corporation, a business entity chartered under a state statute but, unlike a C Corporation, not taxed as a separate entity. An S Corporation is formed under Subchapter S of the Internal Revenue Code. Subject to certain limitations, stockholders of S Corporations are taxed directly on the earnings of the Corporation and receive the tax benefits of any losses by the Corporation. Strict tax rules about the number of stockholders and other matters apply to S Corporations.
Warrants: Like Options, contractual commitments, or securities, of a Corporation that enable the holder of a Warrant to purchase shares of the Corporation’s capital stock for an agreed price, which can be a fixed price, a price determined by application of a formula, or a price determined by an independent valuation procedure. Corporations typically issue Warrants to investors, sometimes in consideration of loans to the corporation.