Fundraising Jargon 09: Vesting

Although this term does not directly relate to raising capital, it is an important financial term to consider nonetheless, and the investors will expect to know vesting schedules of the employees. A vesting schedule is imposed on employees who receive equity and determines when they can access that equity.  This is useful because it means that if you give 5% of your company to a partner, that partner cannot just quit a couple of months down the line and keep the equity.

A typical vesting schedule takes four years and involves a one-year cliff. The “cliff” means that none of the employee’s shares vest for at least one year. After that year, typically 25% of the employee’s equity is released, and the rest vests on a monthly or quarterly basis. “Vesting” in simple terms means ownership. and are an incentive program for employees that gives them benefits when they have contractually fulfilled a specified term of employment. Each employee will vest, or own, a certain percentage of their account in the plan each year. An employee who is 100% vested in his or her account balance owns 100% of it and the employer cannot forfeit, or take it back, for any reason.

Fundraising Jargon 08: Option Pool

Option pool is a term used to refer to a chunk of equity reserved for the future team expansion. Although it sounds quite simple, straightforward, and harmless, the size of the option pool, as determined during a round of funding, has a direct impact on the valuation of the company valuation and hence, the ownership of the entrepreneur in their business.

The option pool is often included in the pre-money valuation of a company. Let us understand this concept through an example. Say investors agree to invest INR 2Cr at an INR 10Cr pre-money valuation, implying an INR 12Cr post-money valuation. Option pools are expressed as a percentage of post-money valuation, so if the deal includes a 20% option pool, which means the pool is worth INR 2.4Cr. The INR 10Cr pre-money valuation is now effectively an INR 7.6Cr pre-money valuation. The investor will not be taking a larger percentage as a result — they will still own 16.7% (INR 2Cr/INR 12Cr) of the company in this case — but the stake of the entrepreneur will be substantially diluted because the option pool will come directly from management's stake. So, if the entrepreneur owned 100% and they are under the impression that they will now own 83.3% (100% original equity - 16.67% investor equity post-investment), the entrepreneur is mistaken. The option pool, reserved for future employees, is 20% and is contributed from the entrepreneur's end, which means the entrepreneur now owns only 63.3% of the company.

We see yet again how pertinent, and paramount, the understanding of these distinctions is in terms of retaining ownership of your company.

Fundraising Jargon 07: Pro-Rata Rights

The term pro-rata gets thrown around a lot during financing discussions, often in different contexts. Pro-rata is Latin for “in proportion." Replacing the Latin with its English equivalent is helpful in deciphering its meaning in legal documents.

Pro-rata rights refer to the right of investors to participate in later funding rounds so they can maintain the amount of equity they own in a company. Let’s say that a company raises an INR 5Cr Series A round from an investor at an INR 20Cr post-money valuation, leaving that investor with 25% of the company. In a later round, the company raises INR 10Cr at an INR 100Cr valuation. To maintain a 25% stake, the investor needs to throw in at least 25% of the new funding, or INR 2.5Cr, otherwise their stake in the company will be reduced proportionately. Pro-rata rights obligate the company to leave space in subsequent funding rounds so investors can avoid such dilution.

Subsequently, we also have "super pro rata rights” which allow investors to increase their equity stake in subsequent funding rounds. Super pro rata rights are a right of first offer to purchase up to 50% of the total amount of the next round raised. 

Super pro rata rights pose a few unique advantages and disadvantages to founders and investors alike. They effectively prevent other investors from participating in later rounds. Having more investors in a company prevents a greater number of investors from supporting competitors, gives the entrepreneur more networks and more expertise to lean on, and prevents any one investor from having too much control in a company. Super pro rata rights pose an advantage to entrepreneurs in that they effectively guarantee a significant portion of the next financing round being raised. This lessens the often-vast amount of time entrepreneurs spend fundraising, giving founders more time to focus on building the company.

Fundraising Jargon 06: Participating & Non-participating Preferred Stock

There are several types of preferred stocks, each giving its holder different rights, and this is where things start to get a little complicated. For our purposes of immediate understanding, the rights of participating and non-participating stockholders are most relevant.

As we know, preferred stock owners often get a 1X liquidation preference, meaning that in the event of a sale or bankruptcy, they get their money back at the 1X value before common stockholders get a chance to recoup anything.

Let us consider that a company realizes a successful exit, and common stockholders are left with equity worth 4x what preferred stock owners paid per share at the time of their investment. In this case, preferred stock owners can still exercise their liquidation preference to get their money back, but if everyone else is making four times that money, it makes more sense to convert those preferred shares into common stock to enjoy the 4x gains. During successful outcomes, preferred stock owners are essentially forced to convert to common stock. Participating preferred shareholders are also entitled to additional dividends and the predetermined dividend rate. This means they receive a share of any additional dividends paid to common shareholders. For non-participating stockholders, this is where it ends. They convert their shares to common stock and enjoy the same 4x returns as everyone else. Simple enough.

Participating preferred stock works differently and allows venture investors to essentially double dip in the company's gains. Participating stockholders get to exercise both their liquidation preference and enjoy a pro-rata share of common stock gains simultaneously. So, if a participating stockholder owns 25% of the company at the time of a liquidation event, they get their money back plus 25% of the remaining proceeds.

Let us better understand the differences through an example - 

Assume, company sells for = INR 10Cr

Original Investment = INR 2.5Cr @ post-money valuation = INR 5Cr 

Hence, share ownership of investors = 50%

In case of non-participating preferred shares - obligation of converting those shares to common stock

Earnings of Investors = 50% x INR 10Cr = INR 5Cr

Now let us say these investors instead own participating preferred stock. The outcome changes significantly:

Exercising 1X liquidation preference = 1 x 2.5Cr (original investment) = INR 2.5Cr

Also entitled to 50% share of the remaining INR 7.5Cr = 50% x INR 7.5Cr = INR 3.75Cr

Total Earnings = INR 2.5 Cr + INR 3.75Cr = INR 6.25Cr

In this case, they capture most of the exit’s value even while owning just half of the company.

Fundraising Jargon 05: Liquidation Preferences

The primary objective of any VC or other investor is to make money out of their investment. Their investments are no good unless they eventually realize a payday. In venture parlance, these paydays are referred to as “liquidity events,” the moments when everyone with an equity stake gets a chance to cash out. These events come in the form of acquisitions or an IPO.

Liquidation preferences determine who gets paid what and when during these events. If the company goes bankrupt (may come up as a liquidation event for less successful companies), for instance, there are often not enough assets left to pay every creditor and shareholder the money due to them. In such a case, liquidation preferences determine the order in which everybody gets paid. In general, creditors get paid first, then preferred stockholders, then, if there is anything left, common stockholders.

Liquidation preferences are also relevant during more successful outcomes though. The standard and most beneficial liquidation preference from an entrepreneur's perspective is 1X, meaning that preferred stock owners must get their money back (1 x their money) before common stockholders get anything.

Fundraising Jargon 04: Capped Notes vs. Uncapped Notes

As discussed before, 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 that their stake does not 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 INR 1Cr in convertible notes at an INR 10Cr cap, those investors will own at least 10% of the company after the Series A round (INR 1Cr/INR 10Cr).

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. As taken as an example previously, let us consider now that a company raises INR 1Cr in an uncapped round. If the entrepreneur ends up convincing the investors at round Series A to agree to an INR 20Cr investment, it will mean that the convertible note investors are left with just 5% of the company, half of what they would get if they capped the round at INR 10Cr.

Fundraising Jargon 03: Preferred Stocks

Venture capital firms are issued preferred stock, rather than common stock in a company. In startup investing, investors typically negotiate for preferred shares, while founders and employees usually receive common shares. Preferred stock confer certain rights and advantages to investors that help them mitigate their risk, such as protective provisions and liquidation preferences. 

Preference shares, more commonly referred to as preferred stock, are shares of a company's stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders. 

While we learn about preferred stocks, we would also come across related terms like common stocks. Similar to every other type of share, common stocks are securities that reflect the ownership of investors in the company. This means that the investors become part-owners of the company in proportion to the shares held. The primary motive behind buying common stocks is to have the voting power they give to the investors. 

The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock does. The preferred shareholders have priority over a company's income, meaning they are paid dividends before common shareholders. Common stockholders are last in line when it comes to company assets, which means they will be paid out after creditors, bondholders, and preferred shareholders.

Not all preferred shares are created equal. Different preferred share classes may have different rights, which to limit the scope of this discussion will not be explained here and will be understood in detail later. The different classes of preferred stocks are - Cumulative Preferred Stock, Non-Cumulative Preferred Stock, Convertible Preferred Stock, Participating Preferred Stock, Callable Preferred Stock, and Adjustable-rate Preferred Stock (ARPS).

Fundraising Jargon 02: Convertible Debt

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.

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. Technically debt convertible notes are meant to convert to equity at a later date, usually at a future round of funding. (Often notes convert to equity during a Series A round of funding.

Investors who agree to use convertible notes receive warrants or a discount as a reward for putting their money in at the earliest, and the 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.

Your First Unicorn

Employment sounds so 20th century. The youth of the day want to dip their feet into entrepreneurship and be their own masters. This has been evident from the fact that India has the third largest startup ecosystem in the world and with almost 90,000 startups (of which 115 are unicorns), has become a powerhouse for startups in the last decade. Every year, investors spread across the globe come across scores of business plans from eager entrepreneurs who seek funding for their emerging enterprises. For those high achievers who have thoughtfully prepared outstanding plans, with reliable assumptions, they often receive the funding they need for company growth.

I spoke to a good friend of mine, to have his views on the key elements of a great business plan.  Over the years, he has seen numerous presentations from companies, and has seen a combination of terrific and terrible plans. In his view, some people get confused between a business plan and a marketing plan. A business plan is a genetic and molecular definition of the business. It crystallizes why one is there in business; it shouts what it does for the world, for consumers. It dissects the business DNA and how it is unique, and it clarifies why the customers should do business or consume the services and what is it about the product that will delight the customers.

So then, that brings us to the paramount question - what should be included in a well-conceived business plan?

1. What is the need that is being addressed?
2. Why and how is the company relevant to address this?
3. What is the overall state of the market and any important trends?
4. Why will customers buy the company's product or service?
5. Who the customers are?
6. Who are the current competitors and their advantages?
7. Which competitors will the company complement or supplement?
8. What are the product offerings?
9. How do these compete with other brands?
10. Why are competitive products or solutions needed?
11. What resources, including the people, will be needed and are at your disposal?
12. What are the corporate priorities and the processes to achieve them?
13. How do conservative financial plans shape up, with realistic and achievable sales revenues, margins, expenses, and profits on a monthly, quarterly, and annual basis?
14. How do moderate financial plans shape up, with realistic and achievable sales revenues, margins, expenses, and profits on a monthly, quarterly, and annual basis?
15. How do optimistic financial plans shape up, with realistic and achievable sales revenues, margins, expenses, and profits on a monthly, quarterly, and annual basis?

The purpose of the plan is to allow the entrepreneur, and everyone involved in the business to know the building blocks of the business and its purpose for existing. The value of the plan is to think, visualize and memorialize the business DNA so that successors can work consistently with the original vision, character, and purpose of the business through future generations.

Is Bootstrapping Worth It?

Nothing can make you feel anything even close to running a bootstrapped startup. Most have plans based on their extremely limited budget and choose to stay cash positive until they get stable customers. Here are Here are 12 pointers that can help an entrepreneur bootstrap a startup and provide structure to the process: 

1. Passion: Bootstrapping a startup does not start with great ideas but with a passion to make a mark and solve genuine business issues.
2. Research: Sometimes an idea should remain only an idea. This is the stage where a founder determines if his startup can grow to become a significant business.
3. Niche: Every idea must solve a problem in society or provide utility. It is only when the product or service is really needed that someone is willing to pay for it and the business is sustainable.
4. Market, Audience, and Users: Once the need is identified, it is important to define what constitutes the target audience.
5. Team: A founder cannot do a startup alone. Every entrepreneur needs a team to execute the idea and sometimes finding the right team is more important than a brilliant idea. A partner with complementary skills compared to you and who can handle a different part of your business can help you focus on your strengths more.
6. Mentor: Cultivating a network of mentors and advisors is one of the best things about running a startup. It is also prudent to reach out to other startups and talk to them in person. Most of them have the same worries and challenges, even if they are funded, and would love to share their story.
7. MVP (Minimum Viable Product): Creating the first prototype - Whatever may be the nature of the startup it is particularly important to get a working prototype of the key elements.
8. First Customers: Unpaid customers are needed primarily for two reasons. Once a definitive version of the product or service is ready, the real feedback and word-of-mouth advertisement comes from the customers.
9. Scale: In its infancy, things are easier to manage for a startup, but teething problems begin when a startup grows bigger and starts addressing the higher volume of clients or consumers, and hence fail to scale, due to lack of planning.
10. Strategy: Timing is the key when launching a product or service. From prototyping to marketing to servicing to hiring, all bases must be covered. 
11. Outsource: Outsourcing is a great option when there are limitations in terms of skill, money, and time. Outsourcing allows you to have skilled professionals solve any problem (as long as the right problem is attended to) for a nominal fee.
12. Branding: Just like how first impressions matter, so does the business’s branding. Trying to create a coherent picture of what the solution does for users is important for long-term success.

Staying consistent in efforts and working hard are inevitable for success, but it is more so for a budding startup. Bootstrapping has advantages and disadvantages, but the decision also takes into consideration the current economic situation and the need to fulfill the vision as quickly as possible. This is where bootstrapping becomes a boon for some and a risky option for others.

Fundraising Jargon 01: Valuation

In quite simple words, valuation is the monetary value of the company. More often than not, internally, all company shareholders agree on a formula or arrangement to determine valuation in the event of a partner’s demise or exit, which is also ideally documented and captured in all relevant agreements and communications within the firm, whether partnership, private limited, or public companies. When looking for venture or angel financing, the valuation is, honestly, whatever the entrepreneur can convince investors to agree on.

The difference between pre-money valuation and post-money valuation is also very simple. Pre-money refers to the company’s value before receiving funding. These terms are important because they determine the equity stake the entrepreneur will give up during the funding round.

Post-money valuation = pre-money valuation + new funding

Let us understand this with an example. Say a venture firm agrees to a pre-money valuation of $10 million for the company. If they decide to invest $5 million, that makes the company’s post-money valuation $15 million. Here, the investor’s $5 million stake means they are 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. The investor comes away with 50% of the company in this scenario, rather than 33%. Given the difference in equity, one can see how important it is to have a clarity on pre- and post-money valuations when discussing investment terms.

Know Before You Seek

While there are a lot of ways to wobble or worse, flounder while building up a company, failing to understand financial jargon should not be one of them.

You want to build a company, keep control, and earn a fair share of any windfall. Similarly, with their own vested interests in mind, investors and venture capitalists want to profit from the 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.

Amidst an abundance of technical jargon that entrepreneurs face during fundraising discussions, let us visit and learn about (each of these are covered in subsequent blogs) for understanding them better on our journey. Familiarity with the phrases below will help you avoid needlessly giving up equity, control, and profits in the event of a successful exit. While it is always advisable in my perspective to have an expert legal person to assist, knowing these will hopefully help any entrepreneur in talking sensibly and put forth a better impression on prospective investors.

1. Valuation: the monetary value of the company
2. Pre-Money Valuation: company’s value before receiving funding 
3. Post-Money Valuation: cost of company after investment
4. Burn Rate: how fast is the cash blown (or burned)
5. Convertible Notes: allows startups to raise money without valuation discussions
6. Capped Notes: ceiling on the valuation of notes converted to equity
7. Uncapped Notes: no guarantee of how much equity the debt will purchase
8. Preferred Stock: comes with certain rights attached
9. Participating Preferred Stock: get liquidation preference
10. Non-Participating Preferred Stock: convert shares to common stock
11. Liquidation Preferences: determine who gets paid what and when
12. Pro-rata Rights: right of investors to participate in later funding rounds
13. Option Pool: chunk of equity reserved for future hires
14. Board of Control: composition of the board post-funding
15. Vesting: an incentive program for investors and team

My Numbers in a Startup

Financial statements reveal the strategies and the tactics for designing the go-to-market strategy. While there are innumerable metrics and number crunched data for reference, a few of them which standout as the most essential while sifting through a startup’s operational model, whether for an investment or in an internal progress analysis board meeting --

a) Revenue: the growth in income indicates how quickly the company can grow if it moves at the same pace on the same path as today. The revenue growth projections indicate the potential of the business.

b) Net Income: the bottom line or burn rate is the revenue minus all the costs incurred. Net Income dictates the minimum amount a startup needs to raise to become profitable. By comparing Cash, Net Income and Revenue, one can estimate the financial profile at the time of the next funding round.

c) Gross margin: a measure of how expensive it is to make the product. It is calculated by taking the revenue and subtracting all the COGS (costs of goods sold). Gross margin is the glass ceiling of profitability because the net margin can never exceed the gross margin.

d) Sales Quotas: provide indications of how easily the product is sold and how well run the sales team is.  At the initial stages of a startup, more importance is of the value consistency: smaller deal sizes but more predictable deal velocity.

e) Sales efficiency: a gauge for how aggressive a company can be in marketing and selling its services. The longer the payback period, the greater the risk that a customer churns and the marketing expenses paid to acquire the customer are lost, and vice versa. A 12-month recovery window is typical.

f) Churn: a quantification of the revenue potential and lifetime value of each customer. The greater the churn, the more challenging revenue growth becomes over time. This often means a company will stimulate demand using paid acquisition, decreasing contribution margin, and impacting profitability.

g) Contribution margin: it measures profit per unit, without considering fixed costs. To calculate contribution, take the total revenue generated by selling one unit and subtract the variable costs to sell that unit. The greater the contribution margin, the more profitable the business is on a unit basis, and hence more sales and marketing expenses can be spent to acquire customers and fuel growth.

h) Marketing Spend (Non-personnel): is the most significant controllable expense in a business. It typically includes ad spending and event spending. This expense bucket can be turned on and off from month to month unlike salaries or rent. 

i) Fixed costs (HR): single biggest expense for most startups is salary. By looking at salaries across functional areas, one can get a sense for how a startup pays its employees relative to market rates. Low salaries could spell employee retention questions in the future. Excessive salaries reduce the company’s runway.

j) Revenue per employee: the beauty of any business lies in their leverage. Google’s market cap is 40% larger than Walmart but it has only 2% the size of Walmart’s employee count. Revenue per employee is a measure of how efficient a business is in using technology to bring their product to market. Some sectors and products intrinsically need more people to be sold.