Investment terminology that every entrepreneur should know
Bloggers Name Carl Jones
One of the most common things we hear from new entrepreneurs, especially those without a business background, is that they need to take some time to understand the terminology involved in both commercialisation and investment. We have made this easier for you by providing explanations of some frequently used terminology.
An angel investor is typically a wealthy individual who has successfully built a company of their own and who is seeking to give back to the community by guiding, advising, mentoring and investing into start-ups and their Founders. They may also be executives, or professionals e.g. accountants and lawyers, with both the funds to invest as well as business nous. Angel investors may belong to a wider Angel group who can pool their resources, in terms of money and experience, to help companies grow successfully.
Venture Capital (VC) is the term used to describe an investor who operates a pool of funds raised from a variety of investors. They operate on a structured basis and need to provide returns to their investors to enable them to raise another fund.
They typically have a focus on a certain area of expertise, which is more defined offshore than it is in New Zealand. New Zealand VCs tend to be more generalist in nature. VCs typically invest larger amounts than Angel Investors and often at a later stage in the company’s development.
Board of Directors
A group of individuals who are elected by the shareholders to govern the company and make decisions in the best interests of the company. The Board of Directors are different to a Scientific Advisory Board, who are set up to advise on the technical side of the business.
The ownership of a company – typically in the form of shares.
Funds invested into a company. This can be in a variety of forms including equity funding, where money will be raised from investors, who will then be entitled to shares in the business. Debt funding, where money will be borrowed, or other sources such as a hybrid of debt and equity, called Convertible Notes.
Convertible Notes are a form of capital that provides debt funding, which may convert to equity under certain conditions, or alternatively, and less common, it gets repaid by the company at a later date.
Convertible Notes are generally put in place in early investment rounds to avoid having to value the company, often pushing out a difficult decision to a later date. Many investors won’t invest into an unpriced (unvalued) Convertible Note and may choose to convert into equity at a discounted price to the next round of investment that the company raises instead.
Why is this attractive to an investor? Because if a company doesn’t go well and has to be shutdown, any money left over is paid out in a certain sequence. Firstly, the IRD gets paid, then employees, then secured creditors (e.g. secured loans), then unsecured creditors and then equity. A Convertible Note is usually a secured creditor, so the note holder has a better chance of receiving their money than anyone else. Once the note is converted into equity they are ranked last, so are at a higher risk as a result.
This a term to describe the value of the company before receiving funds into the current investment round. This is typically the number that everyone bandies about as the value of the company.
Once you receive investment you then get to the Post-Money Valuation. This is the number that can be used to work out the percentage ownership of the company acquired through the investment.
For example, if an investor invested $100,000 on a Pre-Money valuation of $900,000, the Post-Money valuation then be $1,000,000, resulting in the investor having purchased 10% of the company ($100,000/$1,000,000).
Ordinary Shares are the standard ownership structure and typically give the holders the right to vote at company meetings and receive a share of the profit, if any. These are the type of shares that are generally issued to Founders.
Preference Shares rank ahead of Ordinary Shares when it comes to the profits or dividends that are paid, however, this is dependent on the preference that is given to these shares. There are different types of preference, which can be related to how profits are distributed, voting rights and various other rights, which you need to be aware of.
Brad Feld and Jason Mendleson have written a book called Venture Deals: Be Smarter than your Lawyer and Ventures Capitalist, which gives an excellent run down of all the types of funding structures and things to look at for.
The process of reviewing a company before committing investment funds. This typically covers areas such as technical, commercial, legal, people and financial. This is where the hard questions are asked, and a good due diligence process should be able to add value to the company.
Liquidity Event or Exit
The process by which shareholders receive returns from their investment of either time or money. Often called an Exit, when a shareholder sells their stake in the company and receives a return hopefully of more than what they put in.
The term Liquidity Event is broader than an Exit as it includes selling the company’s shares or assets as well as other forms of returns, such as a payment of a dividend (being a payment to shareholders of a company through a distribution of the profits).
The Investor, or investor group, who is leading the negotiations and investment structure on behalf of a variety of investors. If there is only one investor, they will take the lead, or it could be several groups, with one group leading it on behalf of all.
A pivot is a change to either the product, strategy or business model of a company. The Lean Startup, by Eric Ries, outlines the pivot in great detail. This book is a must read for anyone looking to start a new business.
The first time a company has received investment funding outside of the three FFF’s (Friends, Family and Fools).
The terms provided under which an investor will invest their money. A Term Sheet is typically prepared to outline the major terms of an investment and will facilitate the negotiations with a company as to its structure and operation after receiving the investment.
The areas covered off in a term sheet include – Governance, Investment and liquidation i.e. valuation, milestone/tranches, investor protections, Directors appointment rights, how funds are to be spent, other areas of control for investors, what happens when a company is sold or has a liquidity event.
Milestones and tranches
Often investors will set milestones that a company will need to achieve in order to get the next part of their investment (tranche). The milestones are agreed with the Founders and while not being so simple they are pointless, they also shouldn’t be so difficult that they are impossible to achieve.
They also dictate the direction of the company, so it is important, and often difficult, to get them right, otherwise there is the risk that Founders will spend time developing the company in one direction to get the next tranche of funding, rather than the direction the company should be going.
A constitution sets out the rights, powers and duties of your company, Board, each director and each shareholder. If no Constitution is put in place the company will be governed by the Companies Act 1993.
This document sets out how the company operates in terms of its management and the relationship between its shareholders e.g. how funds are to be invested into the company, the rights of the shareholders and what the company should be doing with any profits or returns, director appointment rights etc.
The New Zealand governments agency responsible for administering New Zealand’s business registers. A new company registers itself on the Companies Office and reports changes to Directorships or shareholdings, as well as various other information requirements. Companies are also required to maintain a separate shareholding register.
Please let us know, via firstname.lastname@example.org, if there are any other terms you think should be on our list.