Glossary of Startup Financing Terms

Equity Financing
Any financing where the investor is buying part of the company in return for the capital invested.  An equity investor has a claim to a percentage of all future profits of the company, and to a share of any future sale (or liquidation of the company). Unlike debt there is no operating repayment obligation. The percentage ownership share of an equity investor is always New Capital / (Pre-money Valuation + New Capital). So, for example, if we agree that Pre-money Valuation of the company is $2M, and the investor is putting in $1M, then the investor now owns 33.3% of the company (1/(2+1)). Simple math — the hard part with an early-stage company is agreeing on what the pre-money valuation should be.

Preferred Equity
In an equity financing is done (see above), the investor may get stock that has certain preferential rights. The typical example is venture capital financing where the investor receives Preferred Stock, while employees hold Common Stock, and the Preferred Stock is senior to Common Stock in the case of liquidation of the company (ie, the investors get their money first before any distribution to employees and other common stock holders).

Debt Financing
With a debt financing, the company has an obligation to re-pay the capital, principal plus interest, over some amount of time. The debt holder has no claim of equity ownership of the company and no claim to any future profits of the company (beyond repayment of principal plus interest). In the case of liquidation, debt is always senior to equity. 

Revenue Sharing Note
Structured as debt, with the repayment defined as a percentage of the company’s revenue instead of a fixed payment. So, for example, it might be a $100,000 loan, with the payment defined as 2% of the company’s monthly revenue, capped at 1.5x the loan amount. This can be especially well-suited to seasonal businesses, which generate more cash in some parts of the year than others.

Convertible Note
A very common investment structure for seed-stage financings, a convertible note starts as debt and then converts to equity upon some future trigger. A common scenario is a 24-month promissory note, with interest accruing but no payments required, with conversion to equity upon the company’s next equity financing. At that trigger the note then automatically converts to equity at face value plus all accrued interest, at the same valuation as the new equity investors have agreed to in the round. It is common for convertible notes to contain a “sweetner”, where the early investors get to convert their notes to equity at an X% discount from the new equity investors.

SAFE Financing
Developed by Y-combinator as an alternative to Convertible Notes, SAFE is an acronym for Simple Agreement for Future Equity. The principle difference from a convertible note is that a SAFE financing is not a loan, it is more like a warrant (gives the investor the rights to purchase shares in the future) but without pre-determined pricing on those shares. It is designed to be a lightweight instrument that can be issued without undue legal expenses and complications, while deferring the question of valuation. 

Valuation Cap
With Convertible Notes and SAFEs, the entrepreneur and investor are agreeing that the investment will convert to equity at an undetermined valuation in the future. In the case of a future crazy-high valuation, the investor may end up feeling this is unfair. Let’s say I put $1M into a very early stage company and then two years later a VC firm says they’ll do an equity round at $100M valuation. This means that my money will convert to 1% of the company and I’m going to scream bloody murder — I put a million dollars in when it was a high-risk, early-stage deal, I should be getting more than 1%!! Putting a Valuation Cap into the Convertible Note or SAFE solves this problem. If we agree on a Valuation Cap of $10M, then I know I’ll own at least 10% of the company, even if there is some crazy-high valuation at the time that my money converts to equity.

Warrants
Warrants are an instrument that gives the right (but not the obligation) to buy stock at a certain price within a certain time window. The price at which the stock can be bought is called the exercise price or strike price. 

EBITDA
An acronym for earnings before interest, taxes, depreciation, and amortization. It’s an artificial concept developed by investment bankers in the 1980’s when leveraged buyouts were all the rage. The only time you should think about EBITDA is if someone wants to buy your startup then EBITDA will make it look more profitable. Other than that, forget about it. As Warren Buffett says “References to EBITDA make us shudder. It is not a meaningful measure of performance”. 

Bootstrapping
Starting and growing a business using personal funds and revenue rather than external investment.

Angel InvestorA high-net-worth individual who provides capital to startups, typically in exchange for equity ownership, convertible debt, or SAFE’s.

Venture Capital (VC)
Investment funds formed to invest in early-stage, high-potential startups in exchange for equity (see the longer section in this book about how the venture capital business works). It is a high-risk, high-reward asset class. 

Series A, B, C, etc.
Stages of financing rounds as a startup grows. The name comes from the fact that lawyers once printed out a series of stock certificates for investors in each round of financing. Since lawyers have no imagination, they called the first series of stock certificates “Series A”, then “Series B”, etc. They are arbitrary names without any particular meaning except that the first equity financing is typically called a Series A (previous rounds are typically called “Seed, or Pre-Seed” and likely to be convertible notes or SAFE’s. 

Convertible Note
A type of debt that can be converted into equity at a future financing round, allowing early-stage startups to defer setting a valuation (an equity round of financing requires a valuation).

Valuation
The estimated worth of a startup, which is required in order to determine the percentage of ownership that equity investors receive for their investment.

Term Sheet
A non-binding document outlining the terms and conditions of an investment (or M&A transaction), serving as a basis for negotiation. See the next section, Anatomy of a Term Sheet. 

Pre-money Valuation
The valuation of a startup before a new round of investment. 

Post-money Valuation
The valuation of a startup after a new round of investment (Post-money valuation always equals Pre-money valuation plus the amount of new money). 

Runway
The amount of time a startup’s available capital will last based on its current burn rate (monthly expenses).

Exit
A liquidity event where investors can cash out their investment, typically through a merger, acquisition, or initial public offering (IPO).

IPO (Initial Public Offering)
The process of a private company selling stock to the public, by listing its shares on a stock exchange.

Due Diligence
The process of investors researching and analyzing a startup’s financial, legal, and operational aspects before finalizing an investment. 

Cap Table (Capitalization Table)
A list of all the equity holders in a company, and how much equity (shares of stock) they currently own. A Cap Table typically also shows how many shares are authorized but not yet issued, as well as outstanding stock instruments (stock options and warrants) that may be exersized in the future. 

Liquidity Event
An event where investors can convert their equity into cash, typically through an IPO or acquisition.

Burn Rate
The rate at which a company is using-up its current cash on hand. 

Venture Capital vs Private Equity
Technically, Venture Capital is a subset of Private equity. VC and PE are both types of funds created to buy stock in private companies and then sell that stock in the future, hopefully at a much higher price. Venture Capital (VC) focuses on buying equity in early stage companies and then waiting for a future liquidity event (M&A or IPO). Private Equity (PE) is more focused on “fixer-uppers” – buying an established company, spending a few years fixing it up, and then reselling it at a higher price.