Starting your own business venture or diving into the world of startup investments can be thrilling, but equally stressful. Especially, if you’re unaware of the basic terminologies used in startup parlance, things could get difficult.
Navigating the A to Z of angel investing requires more than just knowledge—it demands a deep understanding of key terms, including cap tables, term sheets, valuations, follow-on theory, exits, and taxes. Each word has its own relevance and importance. As an angel investor, you should know these terms and understand their key concepts.
For your help, we’ll briefly take a look at these terms and their significance in the startup ecosystem.
Termsheets: Unraveling the Language of Investment
A term sheet is an agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. It lays the groundwork for an exhilarating partnership between a startup founder and an angel investor.
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Once the parties involved reach a consensus on the details laid out in the term sheet, a binding agreement or contract will follow.
Key concepts related to Termsheets
- Investment amount: Like a conductor setting the tempo for a symphony, the term sheet specifies the precise amount the investor will pour into the startup, setting the stage for growth and development.
- Valuation: It refers to the pre-determined money valuation of the startup, delicately balancing the investor’s financial commitment with the ownership stake they will ultimately hold.
- Liquidation preference: This provision gracefully strategizes the order in which investors and founders receive their well-deserved proceeds, protecting their interests even in the face of an exit or liquidation.
- Anti-dilution protection: It safeguards investors from the threat of dilution should the startup raise additional funding at a lower valuation in the future.
- Voting rights: It empowers investors with the opportunity to weigh in on critical matters, such as the composition of the board and other pivotal decisions that steer the course of the startup’s destiny.
Cap Tables: Unveiling the Tapestry of Ownership
Cap tables reveal the true essence of ownership and equity distribution. It is demonstrated in the form of a spreadsheet or table that shows the equity capitalization of a company.
A capitalization table is most commonly utilized for startups and early-stage businesses but all types of companies may use it as well.
- Shareholders: Cap tables methodically shows all the stakeholders on a spreadsheet. It includes details of founders, employees, and shareholders who all share similar visions for the startup’s success.
- Equity Breakdown: Besides shareholders, the cap table also clearly mentions the number and types of shares (general shares and preferred shares) held by each shareholder and their holding in the company. Overall, it presents a quick snapshot of their contributions and influence on the company.
- Dilution: When the startup expands, the cap table will show details of additional funds raised, new shares issued, and changes in ownership patterns. Thus, the cap table is an important document that shows the delicate balance between a startup’s growth and dilution.
Valuations: Meaning and Explanation
A startup valuation is one of the most challenging tasks. Only qualified and experienced financial analysts should do it. There are various methods of startup valuation. We’ll briefly discuss these methods in the subsequent paragraphs.
Some of the most popular methods used for valuing a startup are: discounted cash flows, market multiple approaches, cost-to-duplicate method, and venture capital approach.
- Discounted Cash Flows: The discounted cash flow (DCF) looks at the startup’s future cash flow. Based on the analysis, the discount rate or ROI is then determined. Investing in startups always includes a high degree of risk. That’s why investors usually assume the future cash flows of the startup and then apply a discount rate. In a nutshell, the higher the discount rate, the greater the risk of the investment.
- Market Multiple Approach: In short, the market’s multiple methods aim at identifying the startup’s value based on comparing the target startup’s financial metrics to those of similar startups. Under this technique, a financial analyst assumes a particular ratio and uses the same for various companies operating within the same line of business. So, when firms are comparable, the multiple approaches capture many of a firm’s operating and financial characteristics in a single number and which can be later multiplied by a specific financial metric like EBIDTA to yield an equity value.
- Cost-to-Duplicate Approach: It includes all costs and expenses relating to the startup and the development of its products, besides other fixed costs such as the purchase of the physical assets. All such expenses are taken into account while determining the startup’s fair market value. However, this method has some inherent drawbacks, including not considering future potential and doesn’t consider intangible assets such as brand value, goodwill, and patent rights.
- Venture Capital Approach: It involves a series of steps required to come close to the value of the startup. It involves the following steps: Determine the amount of investment required, forecast the startup’s key financial details, identify the time of exit, and finally, determine the valuation of the startup.
For example, “Tech Innovators” (a startup) has developed a groundbreaking software platform for managing remote teams. They are seeking funding from a venture capital firm to fuel their growth. The VC firm finds out that the global market for remote team management apps is estimated to be $1 billion and is growing at a steady rate of 10% annually.
Meanwhile, Tech Innovators has already generated $500,000 in annual revenue within its first year of operations. The venture capital firm projects that with the right resources and investment, the startup has the potential to achieve significant revenue growth, around $5 million in annual revenue within the next three years.
VC firms will now take a look at similar companies in the industry that have recently received funding or been acquired. They find that comparable companies with similar growth potential have been valued at a price-to-revenue multiple of 8x.
Based on these factors, the venture capital firm calculates the valuation of Tech Innovators using the venture capital method as follows:
Projected Annual Revenue in the third year: $5 million
Price-to-Revenue Multiple: 8x
Valuation = Projected Annual Revenue x Price-to-Revenue Multiple
Valuation = $5 million x 8
Valuation = $40 million
Therefore, based on the venture capital method, the venture capital firm values Tech Innovators at $40 million.
Follow-on Theory: What You Should Know
Follow-on investments serve as a crescendo—an opportunity to build upon the initial success and further nurture the seeds of growth. Here are some key principles of investment that come under it.
- Pro-rata rights: Investors often negotiate for pro-rata rights, entitling them to participate in future investment rounds. This right allows them to maintain their ownership percentage, ensuring their continued influence in the startup.
- Timing and scaling: Investors can’t ignore the timing and scaling factor of their follow-on investments. These decisions hinge on the startup’s progress, traction, and funding requirements, ensuring that the infusion of capital harmonizes seamlessly with the company’s trajectory.
- Investment syndicates: Co-investing with other angels or venture capital firms in follow-on rounds not only amplifies the financial resources available but also brings together diverse expertise, nurturing the startup’s potential and reducing individual risk.
Exits: Key concepts and principles
An exit strategy that crystallizes the efforts, risks, and rewards of the journey. It includes several angles and terms that all investors should be aware of. Here are some key concepts relating to exits in startups.
- Acquisition: Startups may eventually find themselves embraced by larger companies seeking to harness their innovation and vision. An acquisition serves as a radiant moment of liquidity, granting investors their long-awaited returns.
- IPO: An initial public offering marks the culmination of years of hard work, as the startup enters the public realm, offering investors an exit opportunity by allowing them to sell their shares on the stock market.
- Secondary market: Investors can find solace in platforms that facilitate the sale of shares to other investors, providing an avenue to realize returns before the company goes public or gets acquired.
- Holding period: Investors must carefully consider their holding period, for longer-term investments may offer the potential for higher returns, while shorter-term investments can provide liquidity and the opportunity to explore new avenues.
Taxes: The Unmissable part of Any Business activity
Here are some key taxation concepts that investors and startups will have to pay:
- Capital gains tax: Profits derived from the sale of investments are often subject to this tax, a reminder of the financial obligations that accompany success. The tax rate may vary based on the holding period and the prevailing tax laws.
- Qualified Small Business Stock (QSBS): Under certain conditions, investments in qualified startups may be eligible for favorable tax treatment. This could potentially exclude a portion of the capital gains from taxation, allowing investors to savor a sweeter return.
In Conclusion
Angel investors should seek the counsel of tax professionals and financial experts before investing their hard-earned money in any startup. Besides, the valuation of a startup, it’s equally crucial to go through the due diligence process to make sure that the startup under consideration is sound and genuine. Starting from screening the startup to investing money in it and reaching its exit stage, an investor plays a key role in it.
So, Angel investing can be a rewarding journey, but it requires a solid understanding of term sheets, cap tables, valuations, follow-on theory, exits, and taxes. By grasping these fundamentals, you’ll be better equipped to navigate the world of startup investments and make informed decisions.
