The following are some of the commonly used terms in the world of venture capital and their meanings:
Perhaps the most commonly used cliché ever when it comes to acquiring funding for a venture, it is still the most sensible. Picture yourself in an elevator with a potential investor. If you can explain your business concept to the potential investor before the investor gets to their floor, and capture their interest, you have succeeded. Although this scenario probably never occurred in real life (alright may be once), it is still an excellent idea to imagine yourself in the scenario.
Nearly every venture capital firm requires a business plan. A business plan starts with an executive summary, which gives a brief synopsis of the business concept and history, industry, market, competition, management, marketing plan, as well as the financial projections. The rest of the plan explains the contents in the executive summary in much more detail. The executive summary is the key to getting an investor’s attention.
Aside from business plans, venture capital firms require the management team to present a slide presentation in which they show their business concept and summary financial projections. Unlike business plans, which are usually mailed or e-mailed, slide presentations have Question and Answer sessions in which potential investors will prod the management team with questions and ascertain whether the business is of interest to them.
Venture capitalists or any analytical investors for that matter carry out due diligence before investing in a business. In due diligence, analysts conduct in depth research, analysis, and forecasts of a business concept and revenues in order to determine the viability and value of a business.
Return on Investment (ROI), Internal Rate of Return (IRR), Hurdle Rate, Net Present Value (NPV):
In conceptual terms, ROI and IRR is where the Cash Flows from a venture break even with the original cost of investment after factoring in the Opportunity Cost of Investment or “interest” that the investor could have gotten from another investment of similar risk.
Formulaically, ROI and IRR are the rates of return “r” at which the NPV equals zero according to the basic valuation formula:
NPV= Cash Flows/ (1+r)^t minus Capital Investment, where t=time
The Hurdle Rate is the minimum ROI or IRR a venture capitalist or another investor will accept; otherwise they will refuse to fund a venture.
Although valuation gets more complex than this in reality, the essence of valuation follows these basic principles.
Investors and venture capitalists will often talk about multiples when discussing a prospective venture. Although valuation and complex analysis will take place prior to the funding of a venture, multiples are a language everyone speaks and are used as a way to gut check forecasts and valuations of financial projections. For instance the most commonly used multiple is usually the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiple, which is [Enterprise Value / EBITDA]. Companies in certain industries will usually have EBITDA multiples within a certain range and venture capitalists can use these to assess whether to invest in a certain venture.
Seed Stage is usually the earliest stage of the company. In the seed stage a business is forming a management team, developing prototypes of products or beta testing them in the case of services. Seed stage financing is typically provided by angel investors or friends and family.
Early Stage (Series A&B):
After the seed stage comes the early stage of a company. In the early stages of a company, a prototype or concept has been tested and proven and a management team has been formed. However, financing will still be needed for the next stage in order to start production and get the business to a self sustaining level where retained earnings can fund future projects. Series A refers to the first investment of institutional capital in a company.
Later Stage (Series C, D, etc…):
At this stage, a company is self sustaining but needs more financing to expand more rapidly in order to increase production or expand to new markets. At this stage companies have shown that their products or services have traction in the market and that they require financing to “run” with their concept.
This is the financing stage right before the IPO. In this stage the company is in very good shape and is looking for financing before investors cash out during the IPO. The risks involved become less risky as the stages progress and mezzanine financing is much less riskier than seed stage, early stage, and later stage financing.
Initial Public Offering (IPO):
An IPO is the first offering of a company’s shares to the public. It is used by pre-IPO stage investors to cash in on their investment as well as raising money for the company.
Upside is the increase in the value of an investment. It may be realized upon a harvest or exit.
Venture Capitalists harvest their investments by cashing out during an Initial Public Offering (IPO) or realizing returns on some of their equity investment through a partial or complete sale of the company to an acquirer. An exit is a complete harvest of an investment. Sometimes venture capitalists exit through a stock repurchase by the company in which the remaining equity holders buy the stock of the owners cashing out.
Private Equity is ownership in companies that are not publicly traded on an exchange. Since private equity is not traded at volumes anywhere near volumes of publicly held companies, it is highly illiquid and requires a higher rate of return. However, the upside of private equity is that it does not need to follow Securities and Exchange Commission (SEC) regulations at the level publicly held companies do, thereby reducing compliance costs. Venture Capital is a type of Private Equity and Private Equity is a type of Equity.
Institutional Investors are investors represented by groups tasked to invest and manage funds on the investors’ behalf. The include pension funds, investment funds, and mutual funds looking to earn a rate of return on their funds which would otherwise lay idle. Many venture capital firms receive investment from institutional investors since venture capitalists are constantly looking for growth opportunities and investment ideas.
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