The startup entrepreneur is always juggling 20 balls at once. For this reason, it is often hard to not let mistakes slip through. Every additional ball provides an additional area to trip you up. However, failing to understand financial jargon is one thing you shouldn’t rush past, it could be your downfall.
There is a misconception that Venture Capitalists and Angels are evil, this is not true. However, the only thing they want more than to see you succeed is getting a return on their investment. If they can negotiate terms that protect their investment, then why wouldn’t they. In short, an investor’s interests don’t completely align with those of an entrepreneur. An entrepreneur wants to build an empire, keep control and earn a good pay-out at the end. Investors want to profit from your company as much as possible and minimize their financial risk. They will often like to have the right to take operating control if they need to do so. Therefore, although both parties want the companies to succeed, balancing these interests is a delicate process and one that requires a good understanding of the terms involved in discussions.
Below we provide some key terms you need to understand.
Your company’s valuation is the monetary value of your company. Listed companies or well established private companies often have formulas to translate earnings into a credible valuation. When you are looking for venture or angel financing, your valuation is generally whatever you can convince investors to agree on.
The difference between pre-money valuation and post-money valuation is very simple but often misunderstood by first-time entrepreneurs. If you get this wrong in your meetings, the VC will start to question if you know what you are doing. Pre-money is your company’s value before you receive any funding. Let’s use an example. Let’s say your investors agree to a pre-money valuation of $10m. If they decide to invest $5m, that makes your company’s post-money valuation $15m.
Post-money valuation = pre-money valuation + new funding
Why is this important? Largely because these terms define the equity stake you’ll give up to your investor in this round. Let’s use the example above. The investor’s $5m stake gives them 33% ownership of the company ($5m/$15m). If however, the investors meant the company was worth $10 million post-money, this implies they have given the company a $5m pre-money valuation, and they want a 50% stake in your company. Although it is unlikely, we hope, a final deal would be signed with the entrepreneur not understanding this, it may save time when you are trying to seek out interested VCs.
When a company is young, determining its valuation is often a “finger in the air” exercise. In fact, it is often a pointless exercise that sees investors and founders arguing over the unknown. In Silicon Valley, it is common for companies to raise capital before there is even a product in hand, let alone revenue. Convertible debt (also called convertible notes) is a financial instrument that allows startups to raise capital whilst at the same time delaying these tedious valuation discussions. Although you shouldn’t forget that these instruments are technically debt, convertible notes are meant to convert to equity at a later date, usually during a round of funding.
Why do investors do this? Investors who offer an entrepreneur convertible notes generally receive warrants or a discount as a reward for putting their money in. This is only fair as they backed the company at the earliest, riskiest stage of its lifecycle. In short, this means that their initial investment converts to equity at a more favorable ratio than investors at a future round. We will not go into much detail on warrants and discounts here, they deserve a blog of their own, but just remember that convertible notes have both positives and negatives, they are not free money.
As discussed above, convertible notes postpone putting a valuation on a company until a later funding round. They are very common in startup land, but you should understand the risk and rewards. Obviously, the investor thinks he is getting the better deal..right? Investors often want to have a say in the future valuation of your company, and this is largely because they don’t want their stake to get diluted down the line. When a “capped” round is agreed upon by entrepreneurs and investors, this means that they place a ceiling on the valuation at which investors’ notes convert to equity.
Let’s use another example. Say your company raises $500,000 in convertible notes at a $5 million cap. That means those investors will own at least 10% of your company after your next round, normally called a series A round ($500,000/$5M).
With the example above, you can only assume that an uncapped round means that the investors get no such guarantee. This means they can not tell how much equity their convertible debt investments will purchase, and therefore these kinds of investments are favored by the entrepreneur. Let’s use the same example. The same company gets offered $500,000 in an uncapped round. If they end up making so much advancement with their business that they are able to persuade Series A investors to agree to a $10m valuation, their convertible note investors are left with just 5% of the company.
You can see there are two sides to the coin, despite the same initial valuation. It is easy to sign terms when you are desperate for cash, but they can be costly down the line.