Being an entrepreneur involves wearing many hats. In addition to thinking about product and design, you must also be able to speak the language of investors.
Below are some important terms every entrepreneur should know before undertaking his or her first investment round.
A pre-money valuation is the value of a company prior to an investment round, while a post-money valuation is its value after the investment round. Pre- and post-money valuations are used to determine the percentage of holdings an investor will receive in the company once he or she invests.
Convertible Loan Agreement (CLA)
A convertible loan allows an investor, instead of investing cash for shares in a company, to extend to the company a loan that will carry interest. This loan can either be converted into shares in the company (usually during the next investment round), or repaid by cash, at a specified later date. Unfortunately, the choice between the two options, rests with the investor.
Simple Agreement for Future Equity (SAFE)
Created by one of the world’s largest VCs (Y Combinator), a SAFE is a standard form agreement that allows an investor to invest cash in a company that will automatically convert into shares upon the consummation of a future financing round. A SAFE is not a debt instrument, and is meant to be a more efficient and cost-effective alternative to a convertible loan because it defers the major terms of the investment to a future financing round. Although meant to be a standard form agreement, in recent years, numerous types of SAFEs have emerged, each with specific provisions that prefer either the investor or the company (as applicable).
Reverse Vesting/Vesting Schedule
Reverse vesting refers to when a founder receives his or her shares of the company up front, subject to the company’s right to repurchase the shares for a small amount of money in the event the founder stops being involved in the company. The percentage of the founder’s shares the company can repurchase decreases periodically over time (the vesting schedule). Reverse vesting is common to early-stage startups and helps investors ensure the founder has an incentive to continue working toward growing the company.
A cap table breaks down the ownership of a company and lists each investor, the number of shares he or she owns, the type of shares (ordinary or preferred), and the percentage of the company owned. The cap table differentiates between an “outstanding basis” (the current actual holders of shares) and a “fully diluted basis” (which specifies the holdings in the company shares assuming conversion of all options, SAFEs, CLAs, warrants, etc.).
A term sheet, sometimes called a “letter of intent,” is an agreement between a company and an investor outlining the key terms of a deal. The terms are usually non-binding, as they are subject to a final/definitive agreement, though some terms, such as the exclusivity period and the confidentiality clause, may be binding.
Preferred shares provide investors a greater claim to the company than those who hold ordinary shares. Preferred shareholders also possess greater rights and privileges. For example, in exit events, preferred shareholders are sometimes paid before ordinary shareholders and have special veto rights to preserve their rights in the company.