The Ultimate Guide to Venture Capital Terms
Ones I had a discussion with the founders of a startup. I asked them what their Run Rate was. The answer I received was epic: “Anton, absolutely, we’d be happy to tell you about our Run Rate, but do you mind telling us what the Run Rate means?”
The venture capital industry, like many others, has its own jargon. For a person not associated with this industry, there are a lot of difficulties with understanding of the terms. Therefore, in this article I want to provide definitions for some of the most important terms in the venture capital industry, which are often misunderstood or confused because the terms are similar or misused by the media.
Venture firm VS Venture fund
Venture fund is a sum of money investors (LPs) commit for investment in early-stage companies. Usually has limited size and limited life time. For example, $50M and 7–8 years.
Venture firm — a firm that manages venture capital funds. A venture capital firm may have several funds under its management. For example, Leta Capital has two funds under management.
Limited Partners VS General Partners
General Partners (GPs) are partners in a VC firm who are commonly managing a fund and are actively involved in the day-to-day operations of the business. They convince limited partners to add their money to the fund and then invest that money for them.
Limited Partners (LPs) are the investors who add their money to a VC fund and let General Partners invest that money for them.
Burn rate VS Run rate
The Run rate is the financial performance of a company, using current financial information as a predictor of future performance. In other words, it is an interpolation of current revenues for future periods. For example, your last month revenue is $1M, so your Run Rate for next 12 months is $12M.
The Burn rate is used by startups and investors to track the amount of monthly cash that a company spends before it starts generating its own income. A company’s burn rate is also used as a measuring stick for its runway, the amount of time the company has before it runs out of money.
If a tech startup spends $5,000 monthly on office space, $10,000 on monthly server costs and $15,000 on salaries and wages for its engineers, its gross burn rate would be $30,000. However, if the company was already producing revenue, its net burn would be different. Even if the company operates at a loss, with revenues of $20,000 a month and costs of goods sold (COGS) of $10,000, it would still work to reduce its overall burn.
In this scenario, the company’s net burn would be $20,000, derived as:
$20,000 — $10,000 — $30,000 = -$20,000
Valuation Cap VS Valuation
Often founders think that the Valuation Cap and Valuation are equal terms but it’s not true. Valuation Cap is usually used when an investor invests in early-stage companies via a convertible loan. However, the valuation is defined only in the equity round.
The Valuation Cap is a way to reward early stage investors for taking on additional risk. The valuation cap sets the maximum price that the loan will convert into equity. For instance, if the valuation cap is $10M and the new investor evaluates the company at $15M, the convertible loan of early-stage investors will be converted at a $10M valuation.
Valuation is the analytical process of determining the current (or projected) worth of an asset or a company. There are many techniques used for doing a valuation. An analyst placing a value on a company looks at the business’s management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets, among other metrics.
Post-money VS Pre-money valuation
Let’s imagine an investor approaches a founder with the following statement: “I am ready to invest $2M at a $8M valuation” — which equity share will the investor get for proposed $2M? It seems that the answer can be either 25% or 20%. Why?
Pre-money valuation refers to the value of a company not including external funding or the latest round of funding. Pre-money is best described as how much a startup might be worth before it begins to receive any investments into the company. This valuation doesn’t just give investors an idea of the current value of the business, but it also provides the value of each issued share.
In this case, if we consider proposed $8M as a pre-money valuation, then upon $2M investment, the investor will get 20% of target company shares.
Post-money refers to how much the company is worth after it receives the money and investments into it. Post-money valuation includes outside financing or the latest capital injection. It is important to know which is being referred to, as they are critical concepts in the valuation of any company.
Here the investor gets 25% for $2M, if $8M mentioned above is a post-money valuation.
Net Revenue VS Revenue
The problem is that some founders tell about their Gross Revenue not about Net revenue. But Net revenue is more interesting for investors rather than Gross.
Revenue/Gross revenue — all income from a sale is accounted for on the income statement. There is no consideration for any expenditures from any source.
Net revenue is the total amount of income you earn from business operations minus any adjustments, such as accounting for returns, refunds, and discounts.
Net Revenue Formula = Gross Revenue — Directly Related Selling Expenses.
ARR (annual recurring revenue) — an essential SaaS business metric that shows how much recurring revenue you can expect, based on yearly subscriptions.
Bootstrapping — starting a business with money and resources from the founders’ own pockets.
Capital Call — when a fund makes an investment and messages its LPs to put capital into the fund account to invest in the portfolio companies.
Cap Table — a table providing a shareholders structure, the history of changes and all parameters which can influence it in the future.
Convertible loan — a financial instrument typically used for investments in early-stage companies and startups.
Due diligence — an analysis an investor makes of all the facts and figures of a potential investment. Can include an investigation of financial records and a measure of potential ROI.
Exit — the sale or exchange of a company ownership for cash, debt, or equity.
Elevator pitch — A concise presentation given from an entrepreneur to a potential investor about an investment opportunity. The presentation should be concise enough to be shared during an elevator ride.
Fully Diluted — shares are the total common shares of a company counting not only shares that are currently issued or outstanding but also shares that could be claimed through the conversion of convertible preferred stock or through the exercise of outstanding options and warrants.
Fund of funds — these are larger institutional platforms that invest in many different funds. This allows institutional investors to get allocations in some funds that they perhaps otherwise wouldn’t be able to. This entity is often referred to as a Limited Partner to the venture capital funds.
Investment Syndicate — A group of investors that agree to participate in an investment round of funding for a company.
Liquidation — An event that could result in either investors or debt holders to receive cash from the company, either through acquisition or a sale of assets.
Management Fee — the fees that a fund will charge its limited partners each year. Venture capital fund management fees typically range from 1–3% annually (usually 2%) and are generally charged based on committed capital during the investment period, and then invested capital after the investment period has finished.
Non-disclosure agreement (NDA) — an agreement between two parties to protect sensitive or confidential information, such as trade secrets, from being shared with outside parties.
Term Sheet — a document that includes the basic terms of a company’s fundraising round (or any investment). Once signed, it indicates that the investor and the company intend to move forward to complete the transaction and stipulates the major economic or corporate governance terms related to the investment.
I hope now you have a better understanding of the terms of venture capitalists and will understand what an investor keeps in mind.
Do you run an innovative tech startup? We are investing in early-stage revenue-generating software startups across the world and would love to hear from you! You can reach us at leta.vc.
