10 Terms You Must Know Before Raising Startup Capital

12/1/2014 10 Terms You Must Know Before Raising Startup Capital

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10 Terms You Must KnowBefore Raising Startup Capital

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There are a lot of ways to get tripped up while

building a company. Failing to understand financial

jargon shouldnt be one of them.

Its not that investors and venture capitalists are evil

or anything. Its just that their interests dont

perfectly align with those of entrepreneurs. You

want to build a company, keep control and earn a fair

share of any windfall. Investors want to profit from

your company as much as possible, minimize their

financial risk and, often, gain the operating control

needed to do so. Balancing these interests is a

delicate process that requires a clear-eyed

understanding of the terms involved during negotiations.

So in the tsunami of legalese that entrepreneurs face during fundraising

discussions, FORBES has uncovered 10 terms that we think are essential to

understand. A familiarity with the phrases below will help you avoid needlessly

giving up equity, control and profits in the event of a successful exit. This post

is no replacement for a lawyer, but it will help you, hopefully, call BS on less-

than-forthcoming investors. (For a quick summary of the terms, check out the

full list here (http://www.forbes.com/pictures/elld45eefhf/pre-

money-vs-post-money-valuation/).)

Pre-money vs. Post-money Valuation

Lets start very simply: valuation is the monetary value of your company.

Internally, company shareholders often agree on a formula to determine

valuation in the event of a partners death or exit. When looking for venture or

angel financing, your valuation is, frankly, whatever you can convince

investors to agree on.

J.J. Colao (http://www.forbes.com/sites/jjcolao/) Contributor

All of the blood, sweat and tears of startups.

Opinions expressed by Forbes Contributors are their own.

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The difference between pre-money valuation and post-money valuation is also

very simple. Pre-money refers to your companys value before receiving

funding. Lets say a venture firm agrees to a pre-money valuation of $10

million for your company. If they decide to invest $5 million, that makes your

companys post-money valuation $15 million.

Post-money valuation = pre-money valuation +

new funding

These terms are important because they determine

the equity stake youll give up during the funding

round. In the above example, the investors $5

million stake means hes left with 33% ownership of

the company ($5 million/$15 million).

Lets consider a counterexample. Say the company

was valued at $10 million post-money instead,

implying a $5 million pre-money valuation. This

means that the investors $5 million counts as half

the companys valuation. He comes away with 50%

of the company in this scenario, rather than 33%. Given the difference in

equity, you can see how important it is clarify between pre and post-money

valuations when discussing investment terms.

Convertible Debt (Convertible Notes)

When a company is young, quantifying its valuation is often an arbitrary,

pointless exercise. There may not even be a product in hand, let alone revenue.

But companies at this stage may still need to raise money, and if investors

decide on a pre-money valuation of say, $100,000, another $100,000

suddenly buys control.

Convertible debt (also called convertible notes) is a financing vehicle that

allows startups to raise money while delaying valuation discussions until the

company is more mature. Though technically debt (see this post on

convertible equity (http://www.forbes.com/sites/jjcolao/2012/08/31/adeo-

ressi-introduces-convertible-equity-convertible-debt-without-debt/) for a

further explanation) convertible notes are meant to convert to equity at a later

date, usually a round of funding. (Often notes convert to equity during a Series

A round of funding.)

Investors who agree to use convertible notes generally receive warrants or a

discount as a reward for putting their money in at the earliest, riskiest stages of

the business. In short, this means that their cash converts to equity at a more

favorable ratio than investors who come in at the valuation round. I wont go

into detail on warrants and discounts here, but Fred Wilson, a venture

capitalist at Union Square Ventures, provides a nice explanation of these

terms on his blog (http://www.avc.com/a_vc/2011/07/financing-options-

convertible-debt.html).

Capped Notes vs. Uncapped Notes

As discussed above, convertible notes delay placing a valuation on a company

until a later funding round. But investors often still want a say in the future

valuation of the company so their stake doesnt get

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diluted down the line. 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.

So if a company raises $500,000 in convertible

notes at a $5 million cap, those investors will own at

least 10% of the company after the Series A round

($500,000/$5M).

An uncapped round means that the investors get no

guarantee of how much equity their convertible debt

investments will purchase, making these kinds of

investments most favorable for the entrepreneur. Lets consider a company

that raises $500,000 in an uncapped round. If they end up making so much

progress that they convince Series A investors to agree to a $10 million, this

means that their convertible note investors are left with just 5% of the

company, half of what they would get if they capped the round at $5

million. (For the sake of simplicity, were ignoring discounts and warrants

here.)

Again, you can see how important these distinctions are in terms of retaining

ownership of your company.

Follow me @JJColao (http://twitter.com/jjcolao) and on Facebook

(http://www.facebook.com/JJ.Colao). Also try me at Haymaker.

(http://www.haymaker.co/)

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(http://www.forbes.com/pictures/elld45eefhf/convertible-

debt/)

Pre-money vs. Post-money Valuation

So lets start very simply: valuation is the monetary

value of your company.The difference between pre-

money valuation and post-money valuation is also very

simple. Pre-money refers to your companys value

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All of the blood, sweat and tears of startups.

Opinions expressed by Forbes Contributors are their own.

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In the increasingly competitive world of venture capital, it pays to be helpful

literally. To get in on the best deals, VCs need to be seen as smart, insightful

and supportive. And since VCs are all about scale, what better way to do that

than a blog?

This is good news for entrepreneurs, because despite the bad rep that the

venture industry gets (these guys are technically in finance after all) VCs

occasionally know what theyre talking about. Whether youre looking

for recruiting strategies, pricing models, a glimpse into an industrys future or

tips for pitching, odds are that a VC has a post for it.

The picks here are based on a very unscientific methodmy own judgment of

bloggers frequency and content quality. (Posts that lack any evergreen value

whatsoever, like those celebrating the funding of a portfolio company, do not

count in either case.) For this reason I left off some more popular names, like

Dave McClure and David Hornik, in favor of lesser-known VCs who have

posted better content more regularly. The list here is weighted in favor of

smart analysis or directly applicable advice rather than anecdotes and

assertions.

For those of you who follow the space closely, many of the names in the full

list below (http://www.forbes.com/pictures/elld45mlkj/fred-

wilson-a-vc/) will likely be familiar. But here are a couple that might be new:

Tomasz Tunguz ex post facto (http://tomtunguz.com/)

Tunguz, a principal at Redpoint Ventures, relies on short, punchy posts to get

his point across. His penchant for expressing ideas in terms of frameworks

(see: The Three Phases of Startup Sales (http://tomtunguz.com/the-three-

phases-of-startup-sales) or The Five Characteristic of an Ideal SaaS

Company (http://tomtunguz.com/five-characteristics-of-an-ideal-saas-

company)) makes for effective, easily digestible pieces.

Standout Post: The Compounding Returns of Content Marketing

(http://tomtunguz.com/compounding-blogging)

David Skok For Entrepreneurs (http://www.forentrepreneurs.com/)

Matrix Partners David Skok only blogs a couple of times a year, but the

resources available in that small pool of posts make for a virtual textbook of

financial models and startup strategies. If you prefer Excel over anecdotes,

Skoks blog is a treasure trove of charts, graphs and equations. In terms of

directly applicable MBA-level insights, For Entrepreneurs

(http://www.forbes.com/entrepreneurs/) is unmatched.

Standout Post: SaaS Metrics 2.0 (http://www.forentrepreneurs.com/saas-

metrics-2/)

Chris Dixon Cdixon.org (http://cdixon.org/)

A New York entrepreneur and seed investor turned Silicon Valley VC, Dixon

likes to take the macro view. Many of his posts consider industry-wide trends,

then examine the consequences of those trends for entrepreneurs. Some

http://www.forbes.com/pictures/elld45mlkj/fred-wilson-a-vc/http://tomtunguz.com/http://tomtunguz.com/the-three-phases-of-startup-saleshttp://tomtunguz.com/five-characteristics-of-an-ideal-saas-companyhttp://tomtunguz.com/compounding-blogginghttp://www.forentrepreneurs.com/http://www.forbes.com/entrepreneurs/http://www.forentrepreneurs.com/saas-metrics-2/http://cdixon.org/



noteworthy insights: app stores have trained consumers to expect cheap

software, while startups going after popular incumbents (like Craigslist) are

better off focusing on niche products.

Standout Post: Some Thoughts on Mobile

(http://cdixon.org/2013/06/01/some-thoughts-on-mobile/)

First Round Capital The Review (http://firstround.com/article/the-

management-framework-that-propelled-LinkedIn-to-a-20-billion-company)

The Review is a bit of an outlier on this list. A compilation of startup-centric

content rather than the musings of an individual VC, the Review is First

Round Capitals attempt at creating a Harvard Business

(http://www.forbes.com/business/) Review for startups. (Its also the most

comprehensive attempt at content marketing in the industry.) The Reviews

preferred mode of instruction: case studies on the experiences of individual

entrepreneurs and companies.

Standout Post: The management framework that propelled LinkedIn to a $20

billion company (http://firstround.com/article/the-management-framework-

that-propelled-LinkedIn-to-a-20-billion-company)

Follow me @JJColao (http://twitter.com/jjcolao) and on Facebook

(http://www.facebook.com/JJ.Colao).

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10 Terms You Must Know Before Raising Startup Capital