Guide on understanding Terminology used by Investors during valuation stage for startups
Are you a startup founder and are confused about words and terms and terminology used by Investors or PE firms , in this article we try to explain the terms used the meaning , this will help startup companies in their valuation decisions and business valuation decision , this Guide on understanding Terminology used by Investors during valuation stage for startups will help them in making a informed decision
When a Startup entrepreneur is considering equity financing or getting their startup valuation, it’s important for him to be familiar with the terminology used in equity investments. There are many different types of shares that can be issued to investors.
This basic domain knowledge of these stock market terms is really important if you want to enter the stock market to succeed.
Common Types of Terminology used in Equity Investments
There are many different kinds of investment that are made by VC / PE Firms . This article will provide you with complete information to make the right decision.
Term Sheet
A term sheet is a document that outlines the terms of an agreement. It includes information such as the amount of money you will be paid, the length of time you will work, and how you will get paid.
SHA/SHA – Shareholders Agreement
You need to understand the Agreement for Share Subscription Agreements. In other words, it is a contract between two parties in which the terms are defined before the agreement.
This is known as the shareholders’ agreement (SHA). The other type of agreement that you might be familiar with is the sale of assets agreement (SSA).
An agent is a stock brokerage firm that does the buying/selling of shares on behalf of the investor in the stock market.
Cap Table
The cap table is an essential component of your company’s financial structure. Or Employee Stock Ownership Plan (ESOP).
Capitalization – This is what the market thinks a company’s value is.
Equity: This type of funding comes from outside investors who are willing to put money into the venture.
Debt: Debt financing involves borrowing money and using it to fund the project.
Cap table: A list of all the owners and their percentage ownership of a particular company.
Equity investment: An investor puts money into a new venture by buying stock shares in the company.
Pre-money Valuation:
Pre-Money valuation is a term used by investors to describe the value of a company before any money has been invested in it.
Post-money/pre-money Valuation Example
When you invest your money, you need to know how much your equity is worth. This can be difficult when you have a lot of debt. However, it’s important that you understand the difference between pre-money and post-money valuations.
Investment of Rs. 100 for 25% shareholding:
Post money Value = 100/25% = 400.
Pre-money = 400-100 = 300
Defensive Stock: A stock that provides constant dividends and stable earnings even in periods of economic downturn i.e. even in the extreme critical situations of the stock market.
If a stock is considered to be overvalued, the price of the stock is expected to drop down.
Delta: A delta relates to the ratio of change in the price of a derivative in response to the change in the price of the underlying asset. A higher delta suggests higher sensitivity to the price changes of the underlying asset.
Option Pool
Options are rights to buy stock in the future at a set price. They are awarded to people who have been highly successful in their professional or career pursuits.
The pool is the total number of shares of the stock that you have reserved for options outstanding and options to be granted in the future.
“Up Round”
In Up Round, the second round valuation is greater than the first round valuation.
Liquidation Preference
Liquidation preference is the term used to describe how much money a person wants to receive before he sells his shares in a company. In this, Investors must receive preferences over the other shareholders. This means that investors get paid before other shareholders in any liquidation.
Anti Dilution Protection:
Protects investors in a down round when more money is invested at a lower valuation.
Control – Board Seats:
Generally, preferred share holders will require one or more board seats to be filled at their company. Sometimes called a “board observer,” this position is an opportunity to sit in on a business meeting and take notes.
Veto rights
A comprehensive list of the different ways investors give their consent to the company’s decisions. Consent at both the Board and Stockholder levels is a must.
Tag Along Rights:
An ability to sell and negotiate effectively is important for any Investor/entrepreneur.
Drag along rights
A company can force all shareholders to go along with the sale of the company if it meets certain conditions.
Right of first refusal (ROFR)
It’s the ability to purchase the shares, sometimes from the other investor or sometimes for sale by the founder or management of the company.
Pre-emptive rights
It’s a right to participate in any future financing in normal proportion.
Pay-to-Play
The ability for investors to force each other to invest in the next round.
Information rights
It’s the right of shareholders to get the periodical information. Right to get periodic information.
Various Equity like Instruments:
● Convertible Notes
A convertible note is a debt instrument that can be converted into equity at the discretion of the holder.
● Convertible Debentures
A convertible debenture is a type of debt instrument that can be converted into equity.
● Convertible Preference Shares
Convertible preference shares are a type of equity instrument that can be converted into another kind of security, typically common shares
● Optionally Convertible Debentures/preference shares
Optionally convertible debentures (OCDs) are a type of debt instrument that gives the holder the option to convert the debenture into equity shares of the issuing company at some point in the future.
Usual Model of Convertible Note / Preference Share:
The CN/ Preference share shall be converted into equity shares based on the formula below:
Where,
Discount Price = Price per Security issued)*Discount Rate
“Discount Rate” = (100 – X)%.
X = [!]% up to 12 month before closing date
X = [!]% increased by [!]% for every completed month from the
Closing Date OR X = [!]% where Qualified
The financing Round is between 13 – 18 months of Convertible Note
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