Stanford VC Course Highlights: The Basics of Venture Capital Every Founder Should Know

Author: Ilya Strebulaev

Compiler: Deep Tide TechFlow

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This is the first publicly available lecture note from Stanford Business School’s VC course, which the author has taught for many years. Out of over 1,300 students, 500 have gone on to start their own companies, and 600 have entered the VC industry.

He decided to fully open up the course content, starting with the most fundamental and easily misunderstood cash flow terms — convertible preferred stock, liquidation preference, conversion rights — which determine how much the founder can actually take away upon exit.

This is essential foundational material for founders looking to raise funds or already in negotiations.

This article will explain how cash flow terms work, how liquidation preferences affect your returns, and how convertible preferred stock gives investors an advantage.

These are fundamental concepts that entrepreneurs should understand.

Welcome, and my motivation

I have been teaching the venture capital course at Stanford Business School for many years. During this time, over 1,300 students have taken this course, about 500 of whom later went on to start their own companies, and about 600 entered the venture capital (VC) and broader private equity industry as investors. I keep in touch with many of my students and often receive their emails or messages saying, “I pulled out your lecture notes and slides again, Professor,” when they are fundraising or negotiating term sheets.

I have always wanted to share my knowledge and experience broadly, especially because the world of VC and entrepreneurship is often shrouded in mystery and widely misunderstood. This is also why I started posting VC research findings on LinkedIn almost every day. However, sharing the details of a complex and challenging course — in which concepts layer upon one another — 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 distribution and corporate governance, and countless other matters commonly used in the entrepreneurial 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 the rules about “who gets what when dividing the cake.” We will get to know the most commonly used financial security in VC financing — convertible preferred stock. We will cover all the main contractual terms that determine the distribution of returns between entrepreneurs 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 like SAFE and convertible notes. Many students have asked me why I don’t start with SAFE — after all, this is often the first security that many founders issue now. But the key feature of SAFE is its conversion into securities that the startup will issue later, making it hard to truly understand SAFE without knowing about those 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 tell students again and again, “You can only lose control of your startup once. Once lost, it’s lost forever.”

Typical case

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

Top Gun would invest $10 million in SoftMet.

Top Gun would receive Series A preferred stock in SoftMet, with an issue price (original issue price) of $4.

The 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.

The 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.

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 should they particularly pay attention to in this proposal? Which terms among all may have significant financial implications that they might want to renegotiate? Which are more founder-friendly terms?

We need to make some simplifying assumptions to introduce all concepts.

To maintain clarity, we will start with some simplifying assumptions. We will relax all temporary assumptions in future lectures, so stay tuned! Don’t leave just because you think, “This ivory tower professor doesn’t understand that founders don’t ‘hold shares’ but rather ‘vest,’ and so on.” I know, and we will come back to all of this at the appropriate time.

Here are the assumptions I will consistently use in the initial lectures on Series A VC financing (if the following terms are unfamiliar, that’s exactly why we are simplifying now):

Assumption: SoftMet does not employ any employees. This assumption means that SoftMet does not need to compensate employees with cash or stock, and it also means that we will purely view the founders as owners rather than 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 have angel or seed rounds preceding them, using different securities.

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

Assumption: Only cash flow terms are important. The term sheet also covers corporate governance — control, voting rights, board seats — but we will handle those in later discussions.

Investors exchange financial securities for investment returns.

Top Gun’s $10 million investment is a venture capital round — exchanging cash for securities. The $10 million proposed for investment by Top Gun is referred to as the investment amount.

In return for the investment, Top Gun will receive securities that grant 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 will Top Gun’s ownership stake be allocated after the investment? 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 Top Gun receives is determined by the investment amount and the original issue price of the Series A preferred stock. The original issue price is the price the investor pays per share at the time of issuance, often abbreviated as OIP, and can also be referred to as the original purchase price (OPP).

Note: OIP is different from par value. Par value is the stated value of the stock as specified in the company’s articles of incorporation, set arbitrarily at registration, and has little to do with the company’s actual valuation, having no real economic significance. Common par values are $0.001 or $0.0001, or they may be “no par value.”

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

Thus, Top Gun invests $10 million 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 received by the investor in this round is as follows:

Once you know any two of these three quantities, you can determine the third. In practice, term sheets can vary significantly in describing the proposed investment, but they should always be able to derive these three quantities from the given information. SoftMet’s term sheet provides the investment amount and OIP. Alternatively, a term sheet may also provide the investment amount and the number of shares the investor will receive.

Example 1: Original issue price

The VC fund Great Innovation Partners invested in early company Fox Solutions, Inc. with an investment amount of $25 million to obtain 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 per share of seed round preferred stock.

Founders typically hold common stock.

Founders of early-stage companies typically hold common stock, which is the most common form of ownership in public and private companies worldwide. Stock is a form of company ownership that grants its holders (i.e., shareholders) certain rights. In other words, shareholders have a claim on the company. Equity is another term commonly used to describe the claim on stock, and we will interchangeably use stock and equity here. The terms “stock” or “equity” also distinguish these securities from another commonly used type of company claim — debt.

Adding “common” in “common stock” only makes sense if other types of securities have been issued by the same company. If common stock is the only security issued by the company, then each share of company stock is treated the same as any other share — there is only one claim! More generally, the treatment of each share of common stock is exactly the same as any other share of common stock.

When there are distributions, each share of common stock is entitled to receive the same distribution as any other share of common stock. Thus, distributions are evenly distributed among all outstanding common shares. However, if other holders have a different type of security, the distribution of returns can 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 type of security combines the features of debt and common stock. Unfortunately for aspiring entrepreneurs or early-stage investors, the structure of this security is somewhat complex, especially compared to the two traditional financial securities: direct debt and common stock. Fortunately, we are now going to master it together.

At its core, convertible preferred stock is a financial security that gives the holder the option to choose between two possible return 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 any returns are distributed to common stockholders (this is called the liquidation preference feature). This right usually comes with many additional conditions and depends on many extra contractual terms that we will explore. But the core idea is that this security provides investors the right to choose between the conversion feature and the liquidation preference feature.

An extremely important point — especially for those with experience in stock markets and investment banking — is that in traditional financial markets, companies sometimes issue securities referred to as preferred stock. While superficially similar, the securities issued in VC transactions have many features that differentiate them from publicly traded preferred stock. If you understand preferred stock from the public market — this is different. Do not skip this part.

Example 2: Preferred stock issued by public companies

In 2018, the large public 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, providing investors with 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 a priority claim on the company’s income, receiving dividends before common shareholders (but after creditors). Preferred stock like MET-E typically does not have a conversion feature.

VC contracts usually refer to this type of security as preferred stock, but when you see preferred stock in a VC contract or term sheet, 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 often omit “convertible” in the name of the security, there are typically other additional words. 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-hailing company Uber issued seed, Series A, Series B, and so on, up to Series G preferred stock during its time as a privately VC-backed company. The big data analytics company Palantir issued Series K preferred stock in its 2015 funding round (having previously issued Series A through J). The space company SpaceX will likely exhaust all letters to name its various series of preferred stock before going public (I write this in January 2026). Sometimes, companies issue securities in a non-alphabetical order, for example, when a company undergoes a restructuring. For instance, the online gaming company Zynga issued Series A, B, and C preferred stock, then skipped to Series Z preferred stock before its initial public offering.

Historically, Series A preferred stock refers to the securities issued in the first round of VC financing. Over the past fifteen years or so, the first security has also often been referred to as seed round preferred stock (as in the case of Uber). This typically means that the structure of that security may be simpler than a full Series A preferred stock. Founders and investors may also want to convey that this is a very early-stage company. Once a company completes another round of financing, it will typically issue Series A preferred stock. 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, meaning whether the security has an OIP. If the company issues SAFE or convertible notes, it is not a priced round; but seed round preferred stock is a priced round. (Note: The common saying you often hear is that unpriced rounds do not set any valuation for the company. This is incorrect, and we will discuss this at the appropriate time.)

Lawyers advising VC investors and startups are quite creative in naming, so there are many other variants in naming. Sometimes these subtle naming differences represent specific arrangements. For instance, any series may also be followed or accompanied by additional numbered series (Series A may be followed by Series A-1, A-2, etc.). If part of the same round, such A-1 shares usually differ only slightly on certain specific terms from Series A shares, otherwise they are the same, often because some outstanding securities were converted into (almost equivalent to) Series A. Alternatively, they may be part of entirely different financing rounds, for instance, because the company believes it has not yet reached the milestones expected by the market for a B round company in that field.