Raising money for your startup can be a challenging experience for any entrepreneur, but especially as a newbie. Not because pitching is difficult and not because VCs are hard to impress. The challenge lies in the nuances of hearing and understanding what a venture capitalist says. As is the case in every industry, there’s a certain level of jargon used in the venture capital world that can make you feel like you’re reliving the Tower of Babylon. Navigating the complicated world of money can be a mess of confusing terminology.
In a recent article, Forbes put together 10 terms you need to learn before raising venture capital. Read our abridged definitions for the terms below and study them well!
Put your money where your mouth is
- Pre-money vs. Post-money Valuation: Valuation is the monetary value of your company. Pre-money valuation refers to a company’s total value before new money is invested. Post-money valuation refers to a company’s total value after new money is invested. In other words: Post-money valuation = pre-money valuation + new funding.
- Convertible Debt: Convertible debt (also called convertible notes) is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. Convertible debt allows startups to raise money while delaying valuation until the company is more mature.
- Uncapped Notes vs. Capped Notes: These terms relate to convertible debt and valuations. When entrepreneurs and investors agree to a capped round, this means that they place a ceiling on the valuation at which investors’ notes convert to equity. An uncapped round means that the investors get no guarantee of how much equity their money purchases.
- Preferred Stock: Venture capital firms are issued preferred stock, rather than common stock in a company. Preferred stock comes with certain rights attached. The upside: generally has dividends payed out to its owners before common stock and has priority in a liquidation event. The downside: usually does not have voting rights.
- Liquidation Preferences: Liquidation happens when a business goes bankrupt. It’s assets are sold and the money is distributed to the credit holders and then to the shareholders. Liquidation preferences determine who gets paid what and when during these events.
- Participating Preferred Vs. Non-Participating Preferred: If a company realizes a successful exit, and common stock holders are left with equity worth 4x what preferred stock owners paid per share at the time of their investment, preferred stock owners can still exercise their liquidation preference to get their money back. But if everyone else is making four times that money, it makes more sense to convert those preferred shares into common stock to enjoy the 4x gains. For non-participating stockholders, this is where it ends. Participating preferred stock, however, allows venture investors to essentially double dip in the company’s gains. Participating stockholders get to exercise both their liquidation preference and enjoy a pro-rata share of common stock gains simultaneously.
- Pro-rata Rights: Pro-rata is Latin for “in proportion.” Pro-rata rights refer to the right of investors to participate in later funding rounds so they can maintain the amount of equity they own in a company. Pro-rata rights obligate the company to leave space in subsequent funding rounds so investors can avoid dilution.
- Option Pool: Option pool is a term for shares of stock reserved for employees. The size of the option pool, as determined during a round of funding, has a direct impact on the company’s valuation and ownership. This is because the option pool is often included in the pre-money valuation of a company. Employees who get into the startup early will usually receive a greater percentage of the option pool than future hires.
- Board Control: Companies are ultimately responsible to their shareholders and to their board. So even if you manage to maintain a controlling stake of the company after a financing round, if you suddenly take on three outside board members you have effectively lost control of the company. Slip up and your board can now fire you at will.
- Vesting: A vesting schedule is imposed on employees who receive equity, and determines when they can access that equity. A typical vesting schedule takes four years and involves a one year cliff. The cliff means that none of the employee’s shares vest for at least one year. After that year, typically a quarter of the employee’s equity is released, and the rest vests on a monthly or quarterly basis.
Still confused? We’re here to help
For more detailed information on the ins and outs of investing, check out some of our previous blog posts covering these issues:
If you have any great examples or stories for the terms above, please share them with us in the comments section below!