Author: Ilya Strebulaev

Translated by: Deep Tide TechFlow

Deep Tide Introduction: This is the first publicly released lecture note from the VC course at Stanford Business School, where the author has taught for many years. Of the over 1300 students, 500 went on to start their own businesses, and 600 entered the VC industry.

He decided to open up the entire course content, starting with the most fundamental and easily overlooked cash flow terms—convertible preferred stock, liquidation preference, conversion rights—these terms determine how much founders can really take home upon exit.

This is essential foundational material for founders who plan to raise funds or are currently negotiating.

The full text is as follows:

This article will introduce how cash flow terms work, how liquidation preference affects your returns, and how convertible preferred stock can give investors an edge.

These are fundamental knowledge that entrepreneurs should understand.

Welcome, and my motivation

I have been teaching a venture capital course at Stanford Business School for many years. During this time, over 1300 students have taken the course, about 500 of whom later founded startups, and around 600 entered the venture capital (VC) and broader private equity industries as investors. I keep in touch with many students and often receive emails or messages saying, "I pulled out your lecture notes and slides again, professor, while negotiating terms."

I have always wanted to share my knowledge and experience widely, especially since the world of VC and entrepreneurship is often shrouded in mystery and widely misunderstood. This is also why I started posting VC research findings almost daily on LinkedIn. But sharing the details of a complex and challenging course—where concepts build layer upon layer—requires different media. So, here I am.

After reading each article, you should have a fairly deep understanding of how investors make decisions, how entrepreneurs and investors negotiate cash flow allocation and corporate governance, and countless other matters routinely encountered in the startup world.

In the initial few articles, we will dive directly into the core, primarily discussing cash flow terms in the first round of VC financing. Cash flow terms are essentially rules about "who gets what when splitting the cake." We will become acquainted with the most commonly used financial security in VC financing—convertible preferred stock. We will cover all major contractual terms that determine the allocation of returns between founders and investors. After covering the first round of VC financing, we will continue to introduce subsequent rounds. Only after that will we be ready to discuss pre-VC rounds, including securities such as SAFE and convertible notes. Many students have asked me why not start with SAFE—after all, it’s the security many founders issue first now. But the key feature of SAFE is that it converts into securities that the startup will issue later, making it difficult to truly understand SAFE without knowing about those later securities. After covering cash flow terms, we will discuss control, corporate governance, and conflicts of interest in startups. These are absolutely critical discussion points. As I repeatedly tell my students, "You can only lose control of the startup once. Once lost, it is lost forever."

Typical Case

When explaining the cash flow theme, I will use a consistent typical case and modify and expand it as content increases. Ann Zhao and Matt Smith are the co-founders of SoftMet, a tech startup. During the fundraising process, they encountered Rob Arnott, a partner at the top venture capital firm Top Gun. Rob later invited Ann and Matt to present their startup idea to all the partners at Top Gun. A week later, the founders received Top Gun's term sheet. The term sheet proposed:

Top Gun will invest 10 million dollars in SoftMet.

Top Gun will receive Series A preferred stock from SoftMet, with an issue price (original issue price) of 4 dollars.

Series A preferred stock has a 1x liquidation preference.

1 share of Series A preferred stock can be converted into 1 share of SoftMet common stock.

Series A preferred stock comes with various additional terms and conditions.

The founders hold 7.5 million shares of common stock.

The post-money valuation of the company is 40 million dollars.

Ann and Matt need to understand what this term sheet means: What exactly is Series A preferred stock? What is the post-money valuation? What is liquidation preference? What is conversion? What features in this proposal should they particularly focus on? Which terms among all may have important financial implications that they might want to renegotiate? Which are the more founder-friendly terms?

We need to make some simplifying assumptions to introduce all concepts

To keep things clear, we will start with some simplifying assumptions. We will relax all temporary assumptions in subsequent lecture notes, so stay tuned! Don’t leave just because you think, "This ivory tower professor doesn’t know that founders are not 'shareholders' but have 'vesting' and so on." I know, and we will return to all of these at the appropriate time.

Here are the assumptions I will always use in the first batch of notes regarding the first round of VC financing (if the following terms are unfamiliar, that’s precisely why we are simplifying them now):

Assumption: SoftMet does not employ any employees. This assumption means that SoftMet does not need to compensate employees with cash or equity, and it also means that we will consider founders purely as owners, not employees. Vesting periods and founder employment terms will be discussed later.

Assumption: Top Gun is SoftMet's first external investor. In reality, most VC rounds precede angel or seed rounds of financing that use different securities.

Assumption: This round of financing will be the only investment raised by SoftMet as a private VC-supported company. In reality, my research shows that the average unicorn company in the U.S. raises over six rounds of VC. We will definitely relax this assumption soon.

Assumption: Only cash flow terms matter. The term sheet also covers corporate governance—control, voting rights, board seats—but we will address these in subsequent discussions.

Investors exchange financial securities for investment returns

Top Gun's 10 million dollar investment is a venture capital round—exchanging cash for securities. The 10 million dollars proposed by Top Gun is called the investment amount.

In return for the investment, Top Gun will receive securities that confer upon it partial ownership of SoftMet. Specifically, as part of this round, a certain number of new securities—Series A preferred stock—will be issued and granted to Top Gun. But how many shares will Top Gun receive? How is Top Gun's ownership percentage after the investment allocated? How will future returns be distributed between the founders and VC investors?

The term sheet provides clues to answer these questions by indicating who gets what in different scenarios. The number of shares that Top Gun receives is determined by the investment amount and the original issue price of Series A preferred stock. The original issue price is the price that investors pay per share upon issuance, usually abbreviated as OIP, and can also be called the original purchase price (OPP).

Note: OIP is different from par value. Par value is the value of stock specified in the company’s articles of incorporation, set arbitrarily upon registration, with little relevance to the company’s actual valuation and no real economic significance. Common par values are $0.001 or $0.0001, or "no par value".

We can use OIP to determine the number of shares Top Gun receives. The investment amount is 10 million dollars, and the OIP is 4 dollars. Top Gun receives the quotient of the two:

Thus, Top Gun invests 10 million dollars in cash in SoftMet, in exchange for 2.5 million shares of Series A preferred stock. More generally, the relationship between OIP, investment amount, and the number of shares acquired by the investors in this round is as follows:

Once you know any two of these three quantities, you can determine the third. In real-world term sheets, there is often significant variation in how proposed investments are described, but you should always be able to deduce these three quantities from the given information. SoftMet's term sheet provides the investment amount and OIP. Alternatively, the term sheet may also provide the investment amount and the number of shares the investor receives.

Example 1: Original Issue Price

The VC fund Great Innovation Partners invested 25 million dollars in the early company Fox Solutions, Inc., obtaining 2 million shares of seed round preferred stock. What is the original issue price of this security?

The original issue price is:

In other words, Great Innovation paid 12.5 dollars for each share of seed round preferred stock.

Founders typically hold common stock

Founders of early companies typically hold common stock, which is the most common form of ownership in publicly listed and private companies around the world. Stock is a form of company ownership that grants certain rights to its holders (i.e., shareholders). In other words, shareholders have a claim against the company. Equity is another term commonly used to describe the claim of stock, and we will interchange "stock" and "equity". The terms "stock" or "equity" also distinguish these securities from another common type of company claim—debt.

Adding "common" to "common stock" only makes sense when the same company has issued other types of securities. If common stock is the only security issued by the company, then each share of company stock is treated equally with any other share—there is only one claim! More generally, each share of common stock is treated exactly the same as any other piece of common stock.

When there is a distribution of earnings, each share of common stock is entitled to receive the same earnings as any other share of common stock. Therefore, earnings are distributed equally among all outstanding common shares. However, if another holder holds a different type of security, the distribution of earnings may be very different. This is almost always the case in VC transactions.

Investors hold convertible preferred stock

The Series A preferred stock received by Top Gun is an example of convertible preferred stock. Convertible preferred stock is the security of choice for most VC investors in the U.S. This security combines characteristics of both debt and common stock. Unfortunately for aspiring entrepreneurs or seed investors, the structure of this security is more complex, especially compared to the two traditional financial securities of direct debt and common stock. Fortunately, we will master it together now.

At its core, convertible preferred stock is a financial security that gives the holder the choice between two potential gain options. The holder can choose to convert the convertible preferred stock into another security, usually common stock (this is called the optional conversion feature). Alternatively, the holder can receive a one-time payment before common stockholders receive any proceeds (this is called the liquidation preference feature). This right usually comes with many additional conditions and depends on many additional contractual terms that we will explore. But the core idea is that this security grants investors the right to choose between the conversion feature and the liquidation preference feature.

A very important point—especially for those with experience in the stock market and investment banking—is that, in traditional financial markets, companies also sometimes issue securities called preferred stock. Although superficially similar, securities issued in VC transactions have many characteristics that distinguish them dramatically from publicly traded preferred stock. If you understand preferred stock from the public markets—that’s different. Don’t skip this section.

Example 2: Preferred Stock Issued by Public Companies

In 2018, the large publicly traded insurance company MetLife issued a new series of preferred stock MET-E, offering 28 million shares to the market. This type of preferred stock functions similarly to debt securities, where investors receive a permanent fixed dividend. MET-E offers investors a coupon rate of 5.63% but provides no voting rights (unlike common stock). Preferred stockholders have priority over the company's income, receiving dividends before common shareholders (but after creditors). MET-E preferred stock typically does not have conversion features.

VC contracts typically refer to this security as preferred stock, but when you see preferred stock in VC contracts or term sheets, you can safely assume it is also convertible. In my analysis of thousands of VC contracts, over 99% of "preferred stock" is actually convertible.

While contracts usually omit "convertible" from the name of the security, there are often additional qualifiers. For example, the security may be named Series A preferred stock, just like in the case of Top Gun’s proposed investment.

Example 3: Series Letters

The ride-sharing company Uber issued seed, Series A, Series B, and so on, all the way to Series G preferred stock during its time as a private VC-supported company. Big data analytics company Palantir issued Series K preferred stock in its 2015 financing round (having previously issued Series A to J). The aerospace company SpaceX is likely to run out of letters before its eventual IPO to name its series of preferred stock (I am writing this in January 2026). Sometimes companies issue securities in non-alphabetical order, for example, when a company is undergoing a restructure. For instance, the online gaming company Zynga issued Series A, B, and C preferred stock, then jumped to Series Z preferred stock before its IPO.

Historically, Series A preferred stock was the designation for the securities issued in the first round of VC financing. In the last roughly fifteen years, the first security is often referred to as seed round preferred stock (as in the case of Uber). This usually means that the structure of this security may be simpler than that of full Series A preferred stock. Founders and investors may also want to convey that this is a very early company. Once a company completes another financing round, Series A preferred stock is typically issued. This means you should not assume that "Series A" necessarily means the first round of VC financing.

So what is the first round of VC financing? The best way to judge is to ask whether this round is a priced round, i.e., whether the securities have OIP. If a company issues SAFE or convertible notes, it is not a priced round; however, seed round preferred stock is a priced round. (Note: The common phrase you hear is that a non-priced round does not set any valuation for the company. This is incorrect, and we will discuss it at the appropriate time.)

Lawyers advising VC investors and startups are quite creative in naming, so there are many other variances in nomenclature. Sometimes these subtle name differences represent specific arrangements. For example, any series can also be followed by or accompanied by additional numbered series (after Series A, there may be Series A-1, A-2, etc.). If a part of the same round, these A-1 shares typically differ only slightly on specific terms from Series A shares; otherwise, they are the same, often because some circulating securities were converted to (virtually equivalent to) Series A. Or they could be part of totally different financing rounds, like when a company thinks it has not reached the milestones that the market expects for a Series B company in that field.