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There are a lot of ways to get side tracked and confused while building a company. WoolcocknDunns will help in learning that failing to understand financial jargon shouldn’t be one of them.
Investors and venture capitalists can be very intimidating, but it doesn’t have to be. It’s just that their interests don’t perfectly align with those of entrepreneurs. Do 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.
In the tsunami of legalese that entrepreneurs face during fundraising discussions, FORBES has uncovered 10 terms that we think are essential to understand. Having a solid 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, see-through on less-than-forthcoming investors.
Pre-money vs. Post-money Valuation
Let’s 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 partner’s death or exit. When looking for venture or angel financing, your valuation is, frankly, whatever you can convince investors to agree on.
The difference between pre-money valuation and post-money valuation is also very simple. Pre-money refers to your company’s value before receiving funding. Let’s 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 company’s post-money valuation $15 million.
Post-money valuation = pre-money valuation + new funding
These terms are important because they determine the equity stake you’ll give up during the funding round. In the above example, the investor’s $5 million stake means he’s left with 33% ownership of the company ($5 million/$15 million).
Let’s 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 investor’s $5 million counts as half the company’s 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 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 won’t 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.
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 doesn’t get 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. Let’s 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, we’re ignoring discounts and warrants here.)
Again, you can see how important these distinctions are in terms of retaining ownership of your company.