Whether we greet each other with words such as Hujambo, Bonjour, Hola, or Hello – speaking in the language of our birth comes naturally. The sounds are familiar. Through the dynamic context of families, villages, tribes, communities, cities, and countries; over time, these sounds have miraculously evolved as words. With mindfulness and persistence, the coordination of our tongue, mouth, and lips is intentionally mastered so that clarity of expression is validated. As a result, the art of communication beautifully emerges where understanding is affirmed, actions determined, and the community is enriched for living that is harmonious and vibrant. It should therefore be of no surprise to you that the language pertaining to funding your startup has been developed specifically for the founding entrepreneur.
While speaking the language of your birth feels as natural as breathing, speaking a new language can be quite exhausting and daunting. Learning new words, gaining clarity on their meaning, then retaining their meaning within the context of the associated entrepreneurial ecosystem is often challenging and intimidating. Yet while challenging, the depth of understanding and the capacity for funding your startup makes becoming proficient in this language of raising money for your venture worthy of your time and investment.
It is for this reason that for this week’s Part I, we review the basic terms and definitions that are conventionally used in the language of raising capital for startup ventures. This language of the entrepreneurial ecosystem is so very sacred to many investors that they will only consider funding your startup if and only if they believe that through the mastery of these conversational funding terms, you have validated that you respect this discipline of entrepreneurship in a manner that is credible, transparent, reliable, and worthy of their investment.
In accordance with the context herein, we motivate the founder’s mastery of the definitions of this new language, by reviewing the basic terms of The Language of Raising Money for Your Startup. In the following paragraphs, we present Part I of the terms used in the language of raising money for your startup:
Equity is the word used to refer to the concept of company ownership. Specifically, the percentage of the company that a founder or an investor owns. For the startup founder, ownership in the startup is the ultimate reward for taking the high risk of starting and growing a startup into a sustainable company. As a founder, you are certainly aware that most startups generate hardly enough cash flow streams during their early stage to pay their founder(s). Consequently, it is natural that founder(s) compensations will come in the form of equity ownership with the expectation of a potentially valuable venture in the future. Naturally, the more equity each founder owns, the larger is the exit compensation. Another factor that adversely affects founder(s) compensations in a startup occurs when the startup needs to raise money from angels/venture capitalists in exchange for equity ownership in the company. As angels/venture capitalists acquire equity in a startup, founder(s) give up a portion of their equity ownership to these new investors. This process results in founders’ equity dilution in the form of a tradeoff for securing much needed funding to grow the startup into profitability. Although the founder(s) equity ownership may be diluted at each funding round, it is expected that the startup overall valuation will continue to increase over time, and ultimately provide the founder(s) lucrative dividends at the investors’ exit in the future.
2. Capitalization Table
These words are often abbreviated as Cap Table and are used to refer to the spreadsheet that contains the identity of the people and the amount of equity that they have in your company. Therefore, for best practice, the founder should maintain a Cap Table as the startup grows through the funding rounds. This Cap Table becomes the founder’s guiding reference in answering at a minimum a few critical questions such as:
- What is the valuation of my startup at each funding round?
- What is the equity split/ownership for each founder?
- How much money has been invested over time during the startup’s history?
Furthermore, an ideal Cap Table should provide to the founder(s) tracking statistics on at least the following items:
- The impact of convertible debt investment and warrants on the startup;
- The share prices and valuation of the startup;
- The exit strategy structure with regards to the percentage of the company each stakeholder will be entitled to in the event the founder(s) liquidate the startup.
- The equity and stock options issued as compensation to critical service providers including marketing and law agencies or independent software developers.
3. Convertible Debt
Also referred to as Convertible Note, it is defined as a debt commitment to the lending angels/venture capitalists. Here the lenders’ expectation is that as the owner of the startup, you are fully aware that the loan made to your startup is in fact a debt that will convert into equity at some pre-determined future date. It is furthermore understood that this money is to be fully repaid at a mutually agreed upon future date with an extra reward to the investors for taking on higher risk that is usually inherent in an early-stage startup venture. It is also important to know that when the founder issues convertible debt, the underlying assumption is that the founder will be raising additional money rounds in the future from even more angels or venture capitalists.
Liquidation is the word which is used to describe the exit option for the startup’s angels or venture capitalists. This term refers to the expectation of the investors to receive in the form of cash or sometimes stock, a full return of their money, ideally with additional revenue gains realized through the growth and scalable success of your startup.
Valuation is the word used to describe how much your startup is actually worth. Often you will hear angels or venture capitalists use the word valuation within the context of pre-money, valuation, and post-money valuation stages. It is essential that you understand the fact that pre-money valuation refers to the value of the startup before the receipt of investors’ money, whereas post-money valuation refers to the value of your startup after the receipt of investors’ money.
One way for the founder(s) to think about their startup valuation over time can be summarized along the following basic understanding:
- At the beginning, your early-stage startup has very little valuation, if any at all.
- At the early-stage of the startup, there is no reliable algorithm for deriving the valuations. This period is usually the pre-money valuation stage. However, as the startup achieves notable milestones of product delivery and customers’ acquisition, the startup’s valuation increases correspondingly.
- Angels and venture capitalists want low valuation before they inject their money in your startup, whereas founder(s) want a higher valuation of their startup.
- The valuation of your startup is mutually determined through an agreement between you and the angels or venture capitalists.
- When founder(s) raise equity funding from angels or venture capitalists, they must know that they will be giving up a percentage of their company’s ownership in exchange for funding.
6. Founder Dilution
These words refer to the fact that the founder’s pre-investment ownership is decreased once an investment from angels or venture capitalists has been secured. For example, prior to securing angels or venture capitalists, as the founder of your startup, you may have 100% ownership of the company. However, after receiving money from the investors whose terms require 20% equity ownership of your company, your founder ownership becomes diluted from 100% to 80%.
7. Term Sheet
Term sheet refers to the glossary of words that angels and venture capitalists have determined as essential for the founder to understand and agree to in exchange for the money to be received from the investors. In a nutshell, the term sheet delineates four key clauses of the proposed investment agreement as follows: 1) Investment Prerequisites: this clause of the term sheet summarizes the conditions that the founder must meet in order to secure the funds from the angels/venture capitalists; 2) Investment Control and Protections: this clause of the term sheet defines the angels’ or venture capitalists’ voting rights as well as their rights to limit the founder’s ability to raising additional money from other investors, including even selling the founder’s own company; 3) Preferred Share Rights: this clause of the term sheet defines the rights pertinent to the shares of stock the angels or venture capitalists will get in exchange for their investment; and 4) Financial Deal Points: this clause of the term sheet defines among other things, the financial terms of the investment agreement including the pre-money valuation of the founder’s startup and the stock price valuation.
In light of these constraints imposed on the founder, it is therefore absolutely essential that as the founder, you make the time to carefully review and understand the language stipulated in the term sheet such that the foundation for a mutually beneficial and sustainable partnership is established.
- Create flashcards to facilitate your learning of the key conversational entrepreneurship words and meaning fundamentals to the language for raising money for your startup. Designate 5 minutes each day to reflect, understand, and master this language so that when the opportunity presents itself for you to make your pitch to investors, it will be deemed worthy of approval.
- Create your startup’s capitalization table. Review and ensure its accuracy so that its credibility will be clearly evident to future angels or venture capitalists.
- Write a paragraph that uses your newly acquired money funding language to describe your company’s pre-money, current valuation, and post-money valuation. Read this paragraph daily so that as the founder, you gain the confidence necessary to convince angels or venture capitalists of your funding worthiness.
- Determine what percent of ownership you want to retain as founder. This clarity will provide the context for any future conversations with angels or venture capitalists that will inform the concerned parties on the founder(s) dilution.
- Request from a potential angel or venture capitalist a sample of the term sheet used for their convertible debt. Then carefully review and obtain mastery of the understanding and use of these terms.
- Start a journal for reflection where you document weekly entries using the words that describe and analyze your cash flow and funding needs. In this reflection, include action-items that you will carry into the following week, month, quarter and year to maximize cash flow, minimize expenses, and increase funding for scalability.
- Each day, practice speaking the language of raising money for your startup. For such practice, choose a “money term for the day”, then use this funding term in your meetings or business transactions. For example, if the chosen term is “valuation”, then your plausible use of the term in a sentence could be: “On August 25, 2020, the valuation of our startup is assessed at 1 million dollars”.
NOTE: As a reminder, SIMBA Global Startups offers mentoring assistance for the design and implementation of the above Call-To-Action formulation to qualified entrepreneurs. We invite you to review our qualification criteria at our website: https://simbaglobalstartups.com/entrepreneurs/
Mentoring Moment: York Zucchi, Swiss born global entrepreneur
When it comes to securing money to fund your startup, the distinguished entrepreneur York Zucchi gives the following advice: “there’s no doubt that one day you’ll need funding, but try and push that day down the line as far as possible and focus on making money. As your portfolio of clients grows so will your business model’s maturity as well as making your ability to raise funding (or even better, financing) easier”.
Please join us next week for Part 2 of “The Language of Raising Money for Your Startup.”
Until then – Just IMAGINE!