LookFar Ventures12 August 2016
Demystifying Startup Finance Part I: Glossary
Welcome to the first post of LookFar’s brand new finance breakdown!
This is Part 1 in our Demystifying Startup Finance series. Follow the links to read part 2, part 3, part 4, and part 5.
Over the next several weeks, I’ll be covering a range of startup topics with a particular focus on determining your fundraising needs and getting you in shape to negotiate your first round.
The goal here is to make sure that you understand what you’re getting into when you sign on with an investor and what you’re giving away.
But first, let’s talk language.
Startup finance comes with a dizzying (seriously, sit down before you read this) array of buzzwords, technical terms, and flat-out jargon. For this reason, the first post of the series is going to be a glossary; I would heavily, heavily recommend browsing through it to make sure you’re ready to follow along with future posts. While the articles in this series are meant to be accessible to anyone, not just finance majors, they still stray into some fairly technical territories.
So, enough introduction. Let’s dive right in!
Anti-Dilution: provisions placed in the Term Sheet of an investment by an investor to protect themselves from significant loss due to Dilution. Can be either a Full Ratchet or Weighted Average provision.
Assumptions: values ‘assumed’ for rates and figures in lieu of historical data used in the creation of Pro Forma financial sheets to drive projections of future revenue, expenses, and net income or loss. When seeking investment, Assumptions should be backed with an operation plan that specifies how a business plans to achieve these numbers.
Balance Sheet: financial statement detailing the assets, liabilities, and shareholders’ equity held by a company at a specific point in time. Balance Sheets create a snapshot of the company’s financial health. Balance Sheets are typically produced quarterly or annually, along with Income Statement and Statement of Cash Flows.
Board Control: ability of an investor or founder to appoint the majority of seats on the Board of Directors for a company and elect other board members. Board Control varies by company and is laid out in the Term Sheet. This is extremely important as a company’s board possesses voting rights allowing the board to overpower any decision made by a founder, C-level employee, or majority stock holder.
Note that Board Control typically goes to the majority shareholder, therefore much like a member of a Presidential Cabinet chosen by the President, the board’s values and decisions will likely align with the majority shareholder. Similarly, C-level employees can be hired and fired by the board, so their values will likely follow those of board members.
Burn Rate: amount of money currently required to fund a company’s operations in a given period (typically a month), less recurring revenue used to offset expenses. Alternatively the speed at which a company is burning through its cash resources. Burn Rate is a measure of how long a company can stay afloat without further investment. Burn Rate will normally fluctuate month-over-month and therefore should be viewed as an average.The formula used to calculate burn rate is as follows:
Capitalization Table (Cap Table): the matrix showing the shares held, equity held, and estimated value of equity for each shareholder in a company.
Common Stock: shares owned in a company without any special rights or liquidation priority given. Normally held by vested employees and founders.
Convertible Debt Note (Convertible Note): a debt instrument that allows investors to loan money to the company with the intent to convert their investment from debt to equity at a given triggering event. The most common are (1) a valuation set in future equity financing (2) a maturity date.
Convertible Notes allow early stage investors to finance early stage companies quickly and with a minimum of (costly) legal due diligence. Some Convertible Notes will not include a valuation, but have a Valuation Cap, which can function as a valuation for the time being.
Dilution: refers to reduction in percentage of equity held by stockholders as additional rounds of funding are taken on.
Discount: term that can be provided to investors in Convertible Notes to reward the investor for their earlier and therefore riskier investment. A discount is represented as a percentage and is discounted off the price-per-share of the valuation of the next round. This allows Convertible Note investors to effectively pay less per share than later investors and purchase more shares for less capital.
Dividends: a fixed percentage yield on an investment that is owed after a given amount of time (usually a year). As startups are normally low on expendable capital, this is normally given as an option to convert into additional stock in an eventual liquidation event. Investors can negotiate the amount of Dividends they will receive on an investment subject to numerous terms.
Cumulative Dividend: does not require the Board of Directors to declare the Dividend. Investor will receive the Dividend automatically.
Non-cumulative Dividend: requires the Board of Directors to declare a Dividend. If no Dividend is declared, the right of an investor to attain one does not exist for that year.
Because Dividends work to increase the amount of shares held by an investor or increase the capital return, they can be used by investors to aid in Anti-Dilution or to ensure a minimum return on their investment.
Dividends differ by negotiations laid out in the Term Sheet. They can be specified to be paid out as only Common Stock, or only as capital in the event of a Liquidation.
Down Round: a round of funding in which the company has a lower Pre-Money Valuation than the previous round’s Post-Money valuation, resulting in a lower price-per-share. While down rounds are not uncommon and are recoverable, they are largely considered to be a negative signal to the market.
Drag-Along Rights: Provisions that enable a majority shareholder to force any minority shareholders to sell their shares for the same price and agreement as they have agreed to. A drag-along clause is used when sale of 100% of a company is proposed; exercising drag-along rights allows the acquiring company or investor to purchase the entire company. This is a standard term and required for companies to go public.
ESOP—Employee Stock Option Plans and Pools: shares set aside present and future for employees. Shares are usually added in Pre-Money.
ESOPs exist to encourage talented potential employees to join a company without a direct pay increase. These are popular as they provide employees an incentive to personally care about the longevity and success of a company, and allow companies with limited capital available to compete for talent against larger companies that are able to offer larger salaries.
ESOPs work slightly differently in startups than publicly traded companies. However, startups generally do institute a vesting period, or a period that an employee must wait before gaining access to the shares. Vesting periods incentivize employees to stay with a company by preventing them from accessing the full value of their employment until they have completed a certain amount of time with the company.
The ESOP may entitle the employee to outright ownership of the shares or allow them to purchase shares below market price, therefore profiting from the difference of market and strike price. (Strike price being the named price-per-share at which the allotted amount of shares will be available to the employee).
It is important that employees are made aware of the preferences available to investors, so they may better understand potential payout in the event of a Liquidation resulting from an acquisition or bankruptcy.
It is important for investors to understand the ESOP a startup utilizes, as they are incentivized to lay one out in the terms of their investment to ensure the company is able to attain talented employees. Furthermore, the manner in which they are utilized by the company and how many stocks are available will affect investors’ Dilution.
Fully Diluted: number of shares outstanding if all options and Convertible Debt Notes are exercised.
Income Statement (AKA Profit and Loss Statement): shows the financial activity of a company over a period of time, typically monthly, quarterly, or annually. Breaks down revenue and expenses and provides net income or loss for the period.
Initial Public Offering (IPO): exit event in which a company registers with the SEC in order to sell stock to the general public.
Liquidation: occurs when a company cannot repay debts and obligations, becomes insolvent, and must sell assets to repay investors.
Liquidation Preference: a benefit commonly allotted to Preferred Stock allowing the possessor to reclaim some multiple of their investment in the event of a Liquidation. Investors typically require a liquidation preference of a minimum of 1x, or the return of capital invested.
Pay-to-Play: investment term that mandates that investors continue to invest in the company in future funding rounds to their full Pro-Rata Rights or else forfeit protective provisions outlined in the original funding round such as Anti-Dilution.
Post-Money Valuation: the implied worth of a company following a round of funding based on shares outstanding at the current price-per-share. Also equal to a company’s Pre-Money Valuation plus the amount raised in the current round of fundraising.
Preferred Stock: stock in a company usually reserved for investors (founders and employees normally hold Common Stock) that allows the holder exclusive privileges, such as Liquidation Preferences and Pro-Rata Rights. The exact rights differ significantly depending on the terms of the investment. It is not uncommon for voting rights to be different, or non-existent, for preferred shareholders.Pre-Money Valuation: the agreed upon valuation of a company when seeking funding.
If you are seeking $1M for 25% equity, the pre-money valuation is $3M. (($1M/.25)-$1M).
The Pre-Money price can be used to find the amount of equity a company must offer for a given funding raise.
It doesn’t matter if Pre- or Post- Money figures are used in finding the price-per-share as long as there is consistency. If Pre-Money valuation is used for “valuation”, the number of shares outstanding before new shares to be issued are added should be used in the equation.
Pro Forma: financial sheets that provide projected numbers for future accounting periods based on Assumptions and foreseeable changes. Typically, an Income Statement, Balance Sheet, and Statement of Cash Flows are predicted 3-5 years into the future. Used for planning, fundraising, and analysis.
Investors typically need to see Pro Forma statements to ensure that founders have a good understanding of their company and operations. These sheets can also be used to understand the effect potential changes will have on the future of a company, and analyze which changes will provide the best outcome.
Pro-Rata Rights: gives investors the right, but not the obligation, to participate in future rounds of funding so that they are able to maintain their ownership percentage. Can be included in straight equity, Convertible Notes, or SAFEs.
Investor purchases the equity percent they purchased with their original investment of the new raise. For example, if the company is raising 10M and the investor previously held 1% of the company, they will invest an additional $100K to maintain 1% equity in the company.
Redemption Rights: right of an investor to make a company buy back their shares. This is normally never exercised; if a company is doing poorly enough for an investor to want out, there is typically no capital available for a buy back. However, it helps if a company earns enough revenue to remain afloat with no sign of an acquisition or IPO.
Runway: amount of time a company would survive without any additional investment at the current level of operating expenses and recurring revenue – in short, the number of months the company would survive at the current Burn Rate.
Simple Agreement for Future Equity (SAFE): created by Y Combinator as an alternative to Convertible Notes. Enables founders to receive funding without valuation, instead deferring conversion to equity for future valuation. Unlike Convertible Notes, SAFEs are not a debt instrument, therefore there is no risk of repayment in the case of failure before conversion. Additionally, as there are fewer terms on a SAFE, this type of agreement saves time and money on negotiation and attorney fees.
Statement of Cash Flows (SCF): financial statement depicting the changes in the Income Statement and Balance Sheet have on cash and cash equivalents. Broken down into operating, investing, and financing activities.
Term Sheet: legal document laying out the terms negotiated by founder and investor before funding is provided. Seen in Notes, Safes, and equity deals. Exact terms vary by company, round, and investor. Generally they are set in place to protect an investor or founder and ensure they will receive a minimum return on their investment/work regardless of outcome. Terms are typically known to be more in favor of the investor, who has significantly more experience and much needed capital. Common Stock holders rarely receive any preferential terms or provisions to their stock.
Holders of preferred stock are more likely to receive protective provisions:
|Anti-dilution||Liquidation preferences and participation|
|Board control/voting rights||Pay-to-play|
|Drag Along Rights||Redemption rights|
While holders of convertible notes are not limited to the below terms, they are more likely to receive a bonus for investing in a young company:
|Maturity date||Interest rate|
Total Addressable Market (total available market): generally refers to the size of market addressable by a company or product. In other words how many people would be potential users or buyers of your company or product?
Total addressable market is most commonly referred to as a factor in a company’s revenue potential, which is one of the first questions an investor will have. Market size has an enormous impact on growth assumptions and pricing strategy.
In-depth research on a startup’s addressable market will also help you enter the market by focusing on your beachhead consumers until the product is finely tuned to address the greater market’s needs. Doing so will help you iterate on the product and receive market validation before firming up a differentiation strategy to reach a total serviceable market.
Valuation Cap: the maximum valuation at which a Convertible Debt Note will convert to equity. Ensures a minimum number of shares for an investor and allows founder to raise funds without committing to valuation before the company is ready.
Warrant Coverage: gives an investor in Convertible Debt the right, but not the obligation, to purchase additional stock in the coming round of equity.
Given as a percentage of original investment. Converts at new Pre-Money price-per-share.
For example, if the note is 100k with a 20% warrant, and the following round is $1M pre-money for a $1-per-share price. The holder would be able to exercise the warrant and invest an additional $20K (100k*20%) for 20k shares.
Disclosure: always be sure to consult your attorney with any investment decisions, this series is for educational purposes only.