When it comes to securing funding, understanding the funding terminology investors use is key to building strong relationships and making good business decisions for your startup. Whether you’re gearing up for your first investment round or simply want to get to grips with the financial side of your business, knowing the right terms can prevent misunderstandings and ensure nothing important gets swept under the rug.
If you’ve ever heard an investor mention “drag-along rights” or “exit strategy” and wondered what they meant, don’t worry! We’re here to break down some of the key funding terminology that will help you navigate these conversations with ease. So, grab a cuppa, and let’s dive in!
1. Exit Strategy
An exit strategy is a founder’s game plan for providing themselves and their investors with a return on their investment in the form of cash in exchange for shares. This could involve selling the company outright, merging with another firm, or going public through an Initial Public Offering (IPO). Investors like to see a clear exit strategy because it shows them how they’ll eventually make money and get a return on their investment. If you’re talking to investors, make sure you’ve thought about your long-term plans, even if exiting feels a long way off right now.
2. IPO (Initial Public Offering)
An IPO (Initial Public Offering) is when a private company goes public by offering shares for sale to the public on a registered stock exchange. It’s one of the most high-profile ways for investors to exit a business and can be a sign that your startup has truly ‘made it’. However, it’s not the only exit strategy and it’s certainly not suitable for every business. Going public requires a lot of preparation, including meeting strict regulatory requirements and being ready to have your company’s performance scrutinised by the public and shareholders alike.
3. Cap Table (Capitalisation Table)
A cap table is essentially a spreadsheet that outlines the ownership stakes in your company. It includes details of who owns what percentage of the business, including founders, employees with stock options, and investors. Keeping your cap table tidy is critical, especially as your business grows and takes on more funding rounds. A messy cap table can make it harder to bring on new investors or manage your equity distribution fairly, so make sure you don’t let it get out of hand.
4. Preferential Rights
Investors often seek preferential rights, which give them certain privileges over other shareholders. These could include getting their money back first in the event of a sale, having a say in important company decisions, or even influencing future rounds of investment. As a founder, it’s important to understand the implications of granting preferential rights, as it could affect your control over the company or limit your flexibility in future decisions. Also, as most investors don’t like feeling someone has got a better deal than them, it’s worth making sure you treat all investors equally (by avoiding preferential rights) in the early days of your startup.
5. Preferred Stock
Preferred stock is a type of equity that gives shareholders certain advantages over “ordinary investors” who hold common stock (the type of shares that founders and employees typically own). Preferred shareholders usually receive dividends first, and in the event of a sale or liquidation, they get their money back before “ordinary” shareholders. While it might sound tempting to offer preferred stock to investors, remember that the more rights you give away, the less control you may have in the long run. Aim to treat everyone equally for as long as you can!
6. Vesting
Vesting is the process by which a founder or employee earns their shares in the company over time, rather than receiving them all upfront. For example, if you have a vesting schedule over four years, you’ll earn a portion of your shares each year. Vesting is designed to encourage founders and employees to stick around and contribute to the company’s success. It also prevents someone from walking away with a huge chunk of equity if they leave early on.
7. Founders Agreement
A founders agreement is a crucial document that outlines the roles, responsibilities, and ownership stakes of each founder. It can also cover important issues like how decisions are made, what happens if a founder leaves, and what the company’s mission is. Having a solid founders agreement in place helps avoid messy disputes down the line and ensures everyone is on the same page from the start. Think of it as a pre-nup for your business!
8. Exit Multiple
An exit multiple is a calculation used to determine how much money investors can expect to make when they exit the business. It’s usually expressed as a multiple of the company’s revenue or profits at the time of exit. For example, if a company is sold for five times its annual revenue, the exit multiple is 5x. Investors use this number to gauge the potential return on their investment, so having an idea of what kind of multiple your business could achieve will certainly grab their attention. Remember though, this is a “ready reckoner”, it’s not reality. You will need to grow your business in order to achieve any hope of an exit multiple down the line!
9. Tag-Along Rights
Tag-along rights protect minority shareholders by giving them the right to “tag along” if majority shareholders sell their stake in the company. Essentially, it allows smaller shareholders to sell their shares on the same terms as the majority, ensuring they don’t get left out of a lucrative deal. If you’re a founder or minority shareholder, tag-along rights can give you peace of mind, knowing you’ll have the opportunity to cash out alongside the bigger players.
10. Drag-Along Rights
On the flip side, drag-along rights allow majority shareholders to force minority shareholders to sell their shares if a sale of the company is on the table. While it might sound a bit heavy-handed, drag-along rights are often used to ensure that a sale can go through smoothly, without being blocked by a small group of shareholders. It’s important to understand how these rights could affect you, particularly if you hold a minority stake in your company.
Why Understanding Funding terminology Matters
Mastering these terms will give you a strong foundation for navigating the often complex world of startup funding. Whether you’re negotiating with potential investors or simply getting your house in order with your co-founders, understanding these concepts will help you avoid surprises and ensure nothing gets swept under the carpet.
As you grow your business, these terms will become increasingly important, so it’s worth investing time to familiarise yourself with them now. And remember, investors don’t expect you to know everything, but speaking their language will show that you’ve done your homework and are ready to engage on their level.
Ready to take the next step in your funding journey? Sign up for our Funding Strategy Workshop to gain further insights into what it takes to raise funding, and to make sure you’re equipped with all the knowledge and tools you need to succeed!
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