Are you a startup founder venturing into fundraising? Understanding the essential terms in the world of startup financing is crucial. This comprehensive fundraising glossary will equip you with the knowledge you need to navigate funding rounds successfully.
Introduction
Every field of study has its basic vocabulary of words and phrases that come up over and over again. This vocabulary is so fundamental that it is used to explain other concepts that are more advanced. Well, fundraising is no different. This article is intended to serve as a primer of sorts. It includes a description of ten basic terms that must be understood by any startup pursuing fundraising. As a bonus, it also includes some extra terms beyond the basic ten and a list of fundraising slang and acronyms.
Equity
Equity is simply ownership in your company. It is expressed as a percentage whereby the equity amounts of all investors and shareholders add to 100%. For example, if I say that I have 5% equity in your company it means I’ve got 5% ownership. See below a complementary term called “fully diluted”.
Capitalization Table
More casually referred to as the “cap table”. It is a ledger that keeps track of the various equity holders in your company and their relative equity stakes (ownership percentages). This includes investors, advisors and company employees alike – assuming all have some form of equity.
Authorized and Issued Shares
When US companies incorporate, they file for a certain number of shares to be created (authorized). Often, only a subset of those shares are actually issued onto the cap table at the start. This leaves unissued shares that can be issued onto the cap table later without much additional legal work.
Because of the extra flexibility this offers, a lot of US startups incorporate with 10 million authorized shares, but they initially only issue 8 million of those shares onto the cap table, leaving 2 million still available for easy future use.
Fully-Diluted Equity
Most cap tables include shares that have been issued, but not yet granted to any particular individual. The best example is the stock option pool. Over time, shares in the stock option pool will be granted to employees and advisors. Calculating someone’s equity on a fully-diluted basis means dividing their quantity of shares by all shares on the cap table, even those in the stock option pool that are still available to grant to individuals.
The other common way to calculate someone’s equity is on an “issued and outstanding” basis. This method only takes into consideration shares actually held by a person or entity. Because of this, someone’s equity calculated on a fully-diluted basis is usually less than their equity calculated on an issued and outstanding basis. Below is an example to illustrate.
- Your share ownership: 1 million shares
- Total issued shares: 10 million
- Option pool shares available for grant: 2 million
- Your issued and outstanding equity: 12.5% (1M divided by 8M)
- Your fully-diluted equity: 10.0% (1M divided by 10M)
Dilution
Dilution is the result of an activity that causes a shareholder’s equity to be reduced (diluted). Since equity is calculated by dividing a shareholder’s quantity of shares by the total shares issued, the most common cause of dilution is issuing additional shares onto the cap table. Why might this happen? Here are a few examples:
- Raising money via an equity round of funding. New shares are created and “sold” to the investors.
- Issuing previously unissued shares into the company to make room for a co-founder or to create a stock option pool
In all cases, the total number of issued shares increases. That, in turn, causes each of the previous shareholders’ equity positions to be reduced (diluted).
Side note: Dilution is natural and is often evidence of a growing and successful company. For example, two co-founders might each have 50% equity in the early days when the company is only valued at $2M. Later, after the creation of a stock option pool and a couple of funding rounds they are diluted to 20% equity but the company is valued at $30M. Eventually, they are acquired for $200M when they each have 10% equity. Their starting position on paper was $1M each (50% of $2M) and they each ended up earning $20M in the acquisition (10% of $200M). As long as the amount of dilution is more than offset by an increase in valuation, the math works just fine.
Classes of Stock
These are typically two broad classes of stock (shares) created over time. Before taking on external funding, most startups only have what are referred to as “common” stock. But later when professional investors put money into the company, they want special rights for protection and control. These extra preferential rights define a new class of shares referred to as “preferred” stock.
In this way, a “class” of stock denotes a group of shareholders with the same rights. Sometimes this results in multiple sub-classes of shares being created to further differentiate the rights of a larger class. For example, a company might have Series Seed Preferred, Series A-1 Preferred, and Series A-2 Preferred classes of stock, each with a different set of rights, even if only slightly different.
Term Sheet
A term sheet outlines the key and material terms of your funding activity. For a seed round of funding that uses a convertible security as the investment document, the company often creates this high-level summary of their proposed terms via a term sheet. It is shared with interested investors first before later sending the full legal document for execution.
For an equity round of funding, the term sheet is instead produced by interested lead investors and used to communicate their proposed offer. It usually fits on 3-5 pages and is the key instrument during the negotiation phase of the funding round. Once the terms are agreed and the term sheet is executed, it serves as guidance for the attorneys as they produce the full set of legal execution documents to close the round of funding.
Valuation
Your valuation is simply the implied value of your company. And since the value of your company is only what someone else is willing to agree it’s worth, the valuation is most easily determined during fundraising events, an acquisition, or an IPO. During these activities, you and the investing parties must agree how much equity they will get for their investment. Each time, you are effectively setting the value (valuation) of your company.
Related to fundraising, since the injection of new capital into the company immediately increases the value of the company, you will hear the terms “pre-money valuation” and “post-money valuation”. The main difference is the post-money valuation includes the cash that was, or will be, invested into the company.
At the time the term sheet is written, it’s usually not certain how much of the authorized funding amount the company will actually raise. Because of this, the pre-money valuation is often negotiated first. Investors often just say “pre” or “post” to designate which version of valuation they are referring to.
When trying to figure out how much equity an investor will get, remember to divide by the post-money valuation. In other words, if your negotiated pre-money valuation is $8M and an investor is investing $2M, they will end up with 20% equity. That’s because the post-money valuation = $10M and $2M divided by $10M = 20%.
If enough time goes by after the last fundraising event, the board of directors or the company accountant might suggest the company have a professional valuation done. In the US, it is called a 409A. It allows for adjusting your stock option exercise price.
Side note: You might hear someone say they’re “doing a priced round”. A priced round is one in which company equity is sold to the investors. In order to calculate the amount of equity the investors will get, the company must first be “priced” (valued). We also refer to such rounds as an “equity round” to denote that equity is being sold.
Liquidation Preference
A liquidation preference is a right that is often given to preferred shareholders. It protects them in the event the company is sold at a distressed value. The investors want to make sure they at least get their money back before non-investing equity holders get any money. If fact, these preferred shareholders with a liquidation preference get to choose between whatever is better – taking their liquidation preference or taking their relative equity % of the total acquisition price. Not a bad deal, but that’s what they get for investing capital into your company.
The liquidation preference is expressed as a multiple of invested capital. So, a preferred class of shareholders with a 2X liquidation preference stands to get double their investment back before other equity holders get any acquisition proceeds. In this way, the multiple is very important for company founders and executives to understand and negotiate. 1X is most typical.
Side note: Be on the lookout for something called a “participation feature” or “participating preferred” class of stock, which means the investor doesn’t have to choose one option or the other, but rather gets both. They get their preference multiple and then also get their pro rata share of whatever proceeds are left over. It’s often referred to as the “double-dip” provision and is considered an aggressive right.
Accredited Investor
At the time of this writing, for most investments into private companies the US securities laws stress the importance of only selling equity to investors that are “accredited”. There are various financial tests to determine investor qualification. The spirit of the laws are to protect those that don’t have enough money to be investing in the riskiest asset classes like startup venture investing.
Search the SEC website for the current qualification criteria. Also, consult with your attorney to make sure you don’t accidentally jeopardize your company’s future by taking investment from the wrong investors or using the wrong process.
Want some more? Below are few extra fundraising-related terms that might be helpful to understand.
Angel Investor
Angel investors (often called simply “angels”) are high-net-worth individuals that allocate a portion of their personal net worth to investments in early-stage company ventures, such as startups. Many angels earn the moniker by also serving as an advisor to the startups they invest in.
Equity Round (of funding)
An equity round is one in which an ownership interest (equity) in your company is sold to the investors. In order to calculate the amount of equity the investors will get, the company must first be valued (assigned a price tag). For this reason, we also refer to such rounds as a “priced round”.
Cash Fume Date
The date a startup projects running out of money. There are two typical methods of calculating the cash fume date. One assumes the company acquires no new customers in the future. The other method assumes the startup achieves its forecasted sales targets. Many companies calculate both, in order to understand the variance in remaining runway.
Family Office
A family office is a wealth management and investing function for ultra-high-net-worth individuals (think billionaires or close). They are managed by an investment professional, a staff of professionals, or an outsourced firm.
From the perspective of a startup, family offices operate similarly to a venture fund, but with the funding source being a high-net-worth individual rather than a collection of investors that are called limited partners (LPs).
Unit Economics
Unit economics is the science of breaking your business into individual units of measure related to the specific operational activities that ultimately lead to revenue. The activities and related metrics typically span the customer acquisition lifecycle, starting with awareness to consideration, and finally to a decision. Unique elements of unit economics are associated with each of the various possible startup business models.
An example could be a software startup that closely monitors their daily quantity of website visitors, the percentage that download a free trial, and the ultimate percentage that upgrade to a paid version of the software.
Change of Control
An activity that causes a change of company ownership is considered a change of control. An outright acquisition is the most familiar form. Other actions that significantly affect the balance of equity ownership can also be considered a change of control, depending on the definition included in the legal document.
How about some fundraising-related slang and acronyms? Below are some to digest.
409A
A professional valuation performed by a certified professional and compliant with the guidelines spelled out in Section 409A of the IRS code
ARR
Annual Recurring Revenue, calculated by multiplying the most recent month’s monthly recurring revenue (MRR) by 12 to derive a forward-looking annual equivalent
Burn
Shortened version of “cash burn rate”, which is the net cash that is being consumed each month
Cap (also Val Cap)
Shortened version of “valuation cap”, which is a key term in a convertible note
Commits
Short for “commitments” and related to investment commitments from investors. There are actually different levels of commitment, each with different words to describe. I’ve listed the most common variations below:
“Committed” can mean a few different things. Here are some variations:
- Fully Committed – The investor has no concerns or contingencies and is just going through the process of signing the docs or transferring their funds
- Verbally Committed – The investor is very interested and mostly committed to making an investment, but there is some inhibitor. Usually, they want the startup to get commitments from other investors first, so they don’t get stuck being the first and only investor. Another situation might be an investor that is just waiting for some cash to free up from some other transaction that is underway.
- Soft Circled – This category isn’t technically “committed” but rather very highly interested. They’ve given indications that they would like to invest but still want to do a little more due diligence. Investors don’t give very much credit for the total amount that is soft circled, but you might hear other founders use this phrase, usually because they don’t have any fully or verbally committed investments.
CVC
Abbreviation for “corporate venture capital”, which is the venture investing arm of a major corporation
F&F
Abbreviation for “friends & family” round of funding, which is common during the idea development phase of a startup
FMV
Abbreviation for “fair market value”, which is a value assigned to a class of stock (ie – Common or Preferred)
FOMO
Abbreviation for “fear of missing out” and relates to some investors that have this personality trait with respect to their investment interest
Lead
Slang for the lead investor for a round of funding, which is the investor that negotiates the terms and often invests the most money in the round
LP
Abbreviation for “limited partner”, which is an investor in a venture fund
MRR
Monthly Recurring Revenue, which is a key financial metric for subscription software companies
No Shop
Slang for a term that relates to the period of time in which a startup can’t solicit investment from other investors but rather must allow the lead investor get the deal done
Note
Short for “convertible note”
PE
Abbreviation for “private equity” and usually references a private equity firm/fund. For example, “They’re a PE on the west coast”.
Pool
Slang for the company’s stock option pool
Portco
Slang for “portfolio company”, usually meaning a company in a venture fund’s portfolio of investments
Pre / Post
Short for “pre-money valuation” and “post-money valuation”
Pref
Slang for “liquidation preference”, which is a key protective provision venture investors negotiate in an equity round of funding and helps ensure they get their money back first if the company exits in distress