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This guide provides startup founders with essential domain knowledge regarding equity investment terminology to assist in valuation and financing decisions. It explains key concepts including Term Sheets, Cap Tables, Pre-money and Post-money valuations, Liquidation Preferences, and various equity instruments, ensuring entrepreneurs can make informed decisions when negotiating with investors and firms.
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.
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.
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.
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.
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.
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.
In Up Round, the second round valuation is greater than the first round valuation.
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.
Protects investors in a down round when more money is invested at a lower valuation.
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.
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.
An ability to sell and negotiate effectively is important for any Investor/entrepreneur.
A company can force all shareholders to go along with the sale of the company if it meets certain conditions.
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.
It’s a right to participate in any future financing in normal proportion.
The ability for investors to force each other to invest in the next round.
It’s the right of shareholders to get the periodical information. Right to get periodic information.
● 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.
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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Pre-money valuation represents the value of a company before any investment occurs. Post-money valuation is determined by the total value after investment. For example, with a 100 investment for 25% equity, the post-money value is 400, while the pre-money value is 300.
A cap table, or capitalization table, is an essential component of a company's financial structure. It provides a comprehensive list of all company owners and their specific percentage of ownership in a particular company, helping stakeholders understand the equity distribution within the venture.
Liquidation preference defines how much money an investor receives before selling their shares. It ensures that investors receive preference over other shareholders, meaning they are paid before other stakeholders in the event of a liquidation of the company assets or business.
Drag along rights are provisions that allow a company to force all shareholders to participate in the sale of the business. If specific conditions are met, the company can require shareholders to go along with the sale process, ensuring consistency during exit negotiations.
A convertible note is a debt instrument that provides the holder the discretion to convert the debt into equity at a later time. It typically uses a formula involving a discount rate based on the time elapsed until the qualified financing round occurs.