Important startup terms to know (Part I)

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Aug 9, 2022
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This blog post explains certain terms and keywords that are commonly used to describe people, systems, processes, activities and operations in startups.

1. Angel Investor

Most times, angel investors are mistaken for business angels. Although there is a similarity between the two, a subtle difference exists between them. Angel investors are most times defined as wealthy private investors who finance startups in exchange for equity or convertible debt. Angel investors are most times also called seed investors or angel funders. Some angel investors provide funding to startups either through online crowdfunding startups offering loans that can be converted to equity (between 20-30%) when the business grows, allowing them to be on the board of the said business. Some others provide funding through a convertible stock payment option, deferring the dividend payment to a set date, building/joining a pool of other angel investor networks to pool capital together, or getting a direct equity stake in the company. 

For this category of investors, funding is carried out in two forms; one-off investments or ongoing capital injections to help a business get through a difficult time. Typically, angel investors are referred to as ‘risk takers’ as they invest in businesses that are at an early stage and hence, have no guarantees of becoming successful in the future. In addition to providing funding, some angel investors play active roles in the management of the business, ensuring that the founders and the business thrives. 

The most common sources of angel investment are crowdfunding, angel syndicates, and wealthy individuals. 

2. Business Angels

Same as an angel investor

3. B2B

B2B means Business to Business. This refers to business transactions or commerce that happens between two businesses; both traditional and online commerce and this transaction cuts across every industry as all companies require services provided by other companies. In business-to-business transactions, both businesses often have comparable negotiation power and sometimes may involve staff and legal counsel in the negotiation. However, in most B2B interactions, larger companies may have more commercial, resource, and information sway over smaller businesses. Online product and supply exchange websites facilitate B2B transactions by creating an avenue for businesses to search for products and services needed and initiate procurement through different e-channels created for this purpose. 

There are 2 standard b2b models; the horizontal and vertical models. The vertical b2b model involves the exchange of goods and services within a specific industry. For example, 2 startups in the fintech industry rely on each other's API. This is also common within the manufacturing industry where a company makes tires and sells them only to car manufacturers. For the horizontal model, different industries are served. This means company A provides services or sells goods that can be used by company B in fintech, Company C in Proptech, etc. As mentioned previously, platforms that provide an avenue for businesses to exchange goods and services can also be classified to be under the b2b horizontal model. 

4. Bootstrapped

At one point or the other, you must have heard founders say they are ‘bootstrapping their business. In simple terms, this means that they are financing their business with either personal funds or money gotten from initial sales, without inputs from traditional financing methods such as crowdfunding, loans, angel investments, etc. This form of financing allows a founder to retain more ownership over their business as opposed to giving equity in cases of receiving external funding. 

There are different stages of bootstrapping and including; the beginner, customer-funded, and credit stages. The beginner stage involves having a full or part-time job to help with business finances while building the business. It also involves using saved money or cash from yielded investments to finance the business. At the customer-funded stage, money gotten from services rendered or products sold to customers is used to sustain the business. During the credit stage, founders focus on funding specific activities such as hiring, upgrading equipment, or loans for expansion. 

5. Buyout

This term is also known as acquisition. It is the purchase of the controlling interest in a company either through a complete buyout or by acquiring 51% of voting shares. This can be done by a company’s management (buyout) and can be funded by high levels of debt (leveraged buyout). Most times, buyouts happen when a company is going private (that is when a company is moving from being public- having shareholders claim a part of the company’s assets and profits to being private- where shareholders are unable to sell shares in the open market). 

Buyouts occur when the buyer acquires 50% of the company, causing a change in control. In private equity, investors look for struggling or undervalued companies, buy them and make them private,  change them/ make them better and then go public. Most buyouts are facilitated by buyout firms that specialize in facilitating these deals alone or together with other buyout companies and are financed by high net worth individuals, loans or investors. 

Management buyouts provide an exit strategy for companies who wish to sell off units of their business that do not contribute to the core part of their business operations, and for private business owners who are retiring. The financing for this buyout is sourced from a combination of debt and equity gotten from the buyers and sometimes the seller. For leveraged buyouts, huge amounts of borrowed money are required. This is done with the assets of the company being bought and used as loan collateral and then the company performing the buyout by providing 10% of the needed capital. The rest of the company needed to complete the process is then sourced through debt financing. 

For further context on buyouts (specifically leveraged buyouts), read the Blackstone Group and Hilton hotels LBO story. 

6. Capital

Capital refers to the money or assets owned by a person or a group of people set aside for the sole purpose of starting or launching a new business. It can also be defined as anything that gives benefit and value to its owners, like in the case of a factory and its machinery. 

Capital can be sourced from family or friends, investors, bond issues, or through equity or debt financing.  It is often referred to as ‘the lifeline of a business’ because of its critical role in the survival and growth of any organization. There are 4 types of capital businesses focus on and they are;

- Debt capital involves borrowing money through private or government sources to establish a business.

- Equity capital involves obtaining money from either family/friends or investors in exchange for shares or stocks in a company.

- Working capital is a company’s liquid assets available for meeting the daily obligations of the business

- Trading capital; is the amount of money allocated to a business to buy and sell various assets. It is simply, the amount of money a business has to make trades.

7. Convertible debt/ note

For startups that are not ready for valuation, a convertible note is the best way for seed investors to invest in the business. Convertible debt is a short-term debt that converts into equity, where an investor gets equity in a startup as opposed to getting a return in the form of principal and interest on the money given. 

Let’s examine an example to explain better; Investor A gives debt funding to startup A. Instead of getting the money invested with interest, he then gets equity (based on the terms of the note) when startup A gets series A funding. This example shows funding that initially starts as a loan with an option of converting the debt/ loan given into equity under certain conditions called ‘conversion privileges’ as written in the deal’s term sheet. Oftentimes, conversion terms contain the timeframe, the price per share, and the interest rate that will be paid until conversion or maturity. Under this agreement, valuation is not placed on the startup- the current and future value of the business is not taken into account when the loan is given. However, most investors are likely to ask to add a valuation cap on a convertible note to give them more certainty on the ultimate investment in the business. This places a limit on the value at which the debt can be converted. 

Convertible debt is mostly used by startups raising pre-seed or seed funding.  For seed funding, debt automatically converts to shares of preferred stock when a series A funding round is closed.  Convertible debt is most times provided by venture capital firms, angel investors, and debt lenders. 

Conversion debts are occasionally mistaken for SAFE (simple agreement for future equity) notes because of the similarity between the two. Although both are used by early-stage companies and have similarities yet, clear differences exist between the two. SAFEs are not debt obligations and no interest obligation exists in SAFE notes. Additionally, SAFE notes do not have a fixed duration and stay in effect until conversion. 

8. Debt Financing

In clear terms, debt financing is a funding process where a startup raises money to finance working capital by selling debt instruments to investors. In return, the investors receive principal and interest on the debt given at an agreed time. It entails selling bonds, bills, or notes to get the capital needed to finance the business. To calculate debt finance, this formula is used - KD= Interest Expense x (1- tax rate). KD is the cost of debt. Debt financing usually requires the borrower to follow some rules on financial performance.  There are three forms of debt financing and they are

- Instalment loans; In this case, debt is repaid with regularly scheduled payments or instalments. Here the borrower repays a part of the principal borrowed in addition to interest and some other fees like late repayment fees, loan origination fees, etc. Some of the factors that determine the amount of each scheduled payment are loan amount, interest rate, and loan repayment time frame. 

- Revolving loans; are typically issued by financial institutions where the borrower is given access to draw down, withdraw, repay and then withdraw again. This means that the borrower can repay and then borrow again. Revolving loans allow businesses to borrow needed for their working capital needs such as maintaining payroll, meeting operating expenses, etc. 

- Cash Flow loans; Cash Flow loan is used for working capital financing and is repaid from the incoming cash flow of the business. This loan is most times used to finance the daily operations of a firm. Cash flow loans are unconventional and used by small businesses that do not possess long credit history or notable assets to back the loan. Because of these factors, the lender usually collects high-interest rates to indemnify its great repayment risks although personal guarantees by the loan signers will be needed as a requirement for the debt agreement. 

9. Due Diligence

This is a process taken by potential lenders/ investors to examine, audit, check or review a business ahead of investment or funding. It involves the examination of financial records, a background check of the founder(s), revenue streams, the team, the product, and market, etc. It provides a standardized way for venture capitalists to analyze and vet startups for the sake of risk mitigation before investment. Due diligence generally occurs when the term sheet is signed between a business and an investor. Due diligence is performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies considering an acquisition.

10. Equity Financing

This is a startup funding process that involves the selling of a company’s shares or other near equity instruments such as preferred stock, and convertible preferred stock or warrants in exchange for finance/ funds needed to either launch or scale operations. Equity financing can come from family and friends, investors, or through an initial public offering and applies to both private and public companies. There are two forms of equity financing- private placement of stock with investors and public stock offerings.  Startups typically have several rounds of equity financing as they grow and use different equity instruments for this purpose. Some common sources for equity financing are investors, crowdfunding platforms, venture capital firms, individual and corporate investors, etc. 

11. Exit strategy

According to investopedia, an exit strategy refers to a plan carried out by investors, venture capitalists, or business owners to convert a position into a financial asset or dispose of physical and monetary business assets once agreed criteria for either have been met or exceeded. It is a plan to sell ownership in a company to other investors or investment firms or withdraw from an investment. Exit plans are used by founders to sell the company they founded with plans dependent on the role the founder wants in the future of the business. 

An exit strategy may be used to withdraw from a bad investment or close an unprofitable business to limit losses. It can also be applied in cases where the profit aim/ objective has been achieved or with changes in market conditions. Exit strategies include acquisitions, buy-outs, IPOs, management buyouts, family succession, liquidation, or bankruptcy (in cases of failed companies). Normally, most investors insist that a thoroughly planned exit strategy be added to a business plan before funding. An important part of every exit strategy is business valuation, mostly handled by specialists who examine the financials of the business to estimate the fair value of the business. 

12. Fund of Funds

A fund of Funds also referred to as multi-manager investment is a collective investment fund that invests in other funds. It is an investment medium where a fund invests in a portfolio made up of shares of other funds instead of directly investing in stocks, bonds, or other securities. The purpose of investing in a fund of funds is to achieve broad diversification and asset allocation where investors have bigger exposure with mitigated risks compared to direct investments in securities and individual funds. Fund of funds helps small investors shield their investments from losses caused by factors such as inflation. It also gives investors wealth management services and expertise and gives room for investors with lean capital to tap into a diversified portfolio with prime assets. 

In most cases, portfolio managers employ their expertise and experience to spot the best funds to invest in based on past trajectory and profitability. 

13. Incubator

A startup incubator is a program designed to help startups launch and succeed by helping them solve some of the problems associated with building a business, providing them with workspaces, funding, legal and accounting services, mentorship, and training at a discounted or free rate until they have enough resources to function independently. 

There are virtual incubators that focus on providing the above-listed services, virtually. This type is suitable for startups who need the advisory services given by incubators but want to maintain their own physical space, etc. Public incubators focus on providing social entrepreneurs with the tools needed to grow their businesses. Seed incubators are mostly focused on early-stage startups and are often in cohorts, are fixed-term, and often end with demo or pitch days. Seed accelerators can be privately or publicly funded and applications are most times, more competitive compared to other incubators. There are also corporate incubators usually established by bigger corporations, e.g. banks, as part of corporate social responsibility or for profit. Although different criteria exist for different incubators, the most common admission criteria is a feasible business idea and plan. More so, time spent at incubators is differ for various businesses and the founder’s level of expertise although most businesses spend 33 months on average, in a program. 

It is worth noting that incubators differ from accelerators although both are similar. Whilst incubators focus on businesses that are at the ideation stage, accelerators focus on startups with an existing model to help them grow and accelerate.

14. IPO

An Initial Public Offering is defined as a process of offering the shares of a private company to the public in a new stock allocation for the first time. Here, company shares are sold to both institutional and individual investors. To hold an IPO, companies are required to fulfil the requirements of the Security and Exchange Commission (SEC). IPOs allow companies to get capital by offering shares to the primary market. It is also an exit strategy for the founders and initial investors to get the full profit from their private investment. IPOs usually happen when a company gets to a stage in its growth process where it is mature enough to go through the rigours of SEC regulations and has hit unicorn status ($1 billion). In some cases, companies at various valuations with solid profitability margins can also qualify for IPO depending on the market and ability to fulfil requirements. 

The IPO process goes through two phases; the pre-marketing phase and the initial public offering itself. During the pre-marketing phase, companies interested in an IPO will advertise to underwriters or by making a public announcement to generate interest. Underwriters are usually involved in document preparation, filing, marketing, and issuance. 

15. Lead Investor

A lead investor is an investor who serves as a connection between a company looking to raise funds and other investors. A lead investor is usually the biggest investor and the first to fund a round. It can be an individual or a corporate investor depending on the series the company is focused on. Lead investors often negotiate terms, advise the startup, take a board seat, manage other investors, structure current and future rounds, review term sheets, respond to investor queries, participate in follow-up rounds and also bring in other investors. Ideally, your lead investor should have engaged with your business for some time to understand it better and see ways to better support the founders and business. 

A lead investor plays an active role in these two phases- The fundraising and post-fundraise stage. During the fundraising phase, this investor is tasked with validating the plan of the business, settling the valuation and terms of investment for that round, and is committed to being accessible and available to handle questions and queries from other investors. Post-fundraise, this investor is concerned with representing the syndicate by taking up a board position in the company, being actively involved in the governance of the company, and giving support to the founders for future financing rounds. 

16. Liquidation

Liquidation refers to the process of shutting down a business and distributing its assets to shareholders. This occurs when a company is unable to pay its obligations as when due when profit generation is low, or when a business is unable to meet competition. It can also be used in scenarios where a business sells off low-performing goods at a price lower than its cost to the business. Liquidation can also refer to the process of withdrawing from a securities position. In this, the position is exchanged for cash. 

A liquidator is hired to handle the cessation of the business. The liquidator is appointed by shareholders or by creditors of a company through an application to the court. The liquidator is tasked with selling assets in the open market to generate funds to compensate investors and charge the company an agreed fee for services rendered. 

17. Pivot

Business pivot occurs when a startup changes its business model and strategy to accommodate changes in the industry, customer, and market preferences among other factors. Pivots happen when one feature of a product or service performs better than the others; a business can decide to pivot to focus on building a business around the feature that works best. Other times, pivots occur when a business is not financially rewarding, inability to get product-market fit, or in cases where a business is unable to meet competition. 

Pivoting does not always entail changing the entire business structure or model. Sometimes, it requires changing one aspect of the business or a revenue model or using a different technology to build a product. 

18. Portfolio company

A portfolio company is a public or private company that is a venture capital firm or holding company that has an equity stake. Common approaches involved in investing in a portfolio company include; leveraged buyout (using debt and little equity to finance the company’s buyout), venture (provision of capital to startup firms in exchange for equity), and growth capital (providing compatible to mature businesses to aid operations and expansion). 

19. Pro rata rights

This is right given to an investor that allows for the maintenance of their initial level of ownership percentage at later funding rounds. 

During new funding rounds, new shares are issued, diluting the equity stake of the current shareholders accompanied by the loss of voting power as board members as new shares will be given to new investors. To prevent this from happening, the initial investors can include a provision that allows them to keep the percentage of their equity stake unchanged while maintaining voting power even when new shares are issued. Pro rata rights are commonly seen in venture capital funding. 

20. Term sheet

A term sheet is a non-binding agreement between investors and founders that outlines the terms and conditions for investment. Valuation, investment amount, percentage stake, liquidation preference, etc are usually components of a term sheet. A term sheet is a prelude to a lengthier, more detailed legally binding document. It lays the foundation that ensures that both parties involved in the transaction agree on major aspects, preventing the chances of having huge disputes and disagreements. Every term sheet carries details of assets, initial purchase price, and plans for conditions that may affect pricing stated, pre-money valuation, voting rights, and a timeframe for a response. 

21. Valuation

Valuation is the process of determining the current or future worth of a company or asset. Valuations are based on the management of a business, its prospect of future earnings, and the market value of assets owned. 

There are 2 main categories of a valuation method- the absolute method which involves finding the value of an investment based on factors like dividend, cash flow, and growth rate. The relative model seeks to find the value of a company by comparing it to similar companies in the market. It calculates multiples and ratios and is easier to calculate compared to the absolute method. 

22. Vesting

Vesting means to give or earn a right to an existing or future asset, payment, or benefit. It’s commonly used to reference nonforfeitable employee rights over stock options provided or given by an employer as an employee retention incentive and can also include deferred compensation and retirement plans (e.g. pension).  Most startups grant common stock or employee stock options to workers. The company sets a vesting schedule that controls when the employee can have full ownership of the asset and once vested, the employee has total control over the amount in the account or asset. 

23. Milestone

Oxford English Dictionary defines a milestone as a significant stage or event in the development of something. It is a key event in a business that marks an important phase of progress. Milestones can also be viewed as markers within an established growth trajectory. 

For startups, milestones are more like growth timelines to tick off important business accomplishments. They are tracking metrics for both the business and investors because it shows how far a business has progressed in meeting its goals and proving competence to current and potential investors. An example of a milestone for a startup looking to get seed funding can look like this; releasing the prototype, creating an MVP, receiving feedback from customers on the released product, achieving market validation, getting more paid and repeat customers, etc. 

24. Ticket size

Ticket size is a business-performance metric used in calculating the average amount of sales per customer. It is calculated by adding total sales over some time and dividing it by the total number of customers. It is used in analyzing sales, profit margins and overall performance of the business. ‘Ticket’ here means sales made to a customer. It helps businesses to know the number of sales to be made either daily, weekly or monthly to meet a specific revenue target. In investment, ticket size means the amount of money in a single investment. 

25. Burn rate

Defines the rate at which a company is spending the funding received from investors to finance the business before it begins to generate its revenue from business operations. It is calculated in terms of money spent monthly. A burn rate is used as a metric to measure runway- the amount of time left before a startup runs out of cash. 

A startup’s gross burn rate is the total amount of operating cost incurred per month, providing insight as to the major cost drivers in a business regardless of revenue. The net burn rate is the total amount of money lost in operations per month. It is derived by subtracting operating expenses from revenue, showing the amount of cash needed to run a business for a specific period.