Fundraising Fund-amentals: Key Terms Every Founder Should Know

This article will break down the key terms and concepts that every entrepreneur should know in order to effectively communicate with investors, and make informed decisions.

For founders venturing into the startup world, getting familiar with the key terms and concepts in startup funding is like learning a new language before moving to a foreign country.

If you’re in a foreign country, you'd want to know at least the basics of the language, right? Maybe how to greet people, ask for directions, or order food. It's similar when you're stepping into the startup fundraising ecosystem. The "language" in this case consists of terms like 'equity” 'valuation” 'seed funding” 'venture capital” and so on.

Knowing these terms is essential for initiating conversations with investors and understanding the landscape you're stepping into.

This article highlights key terms that help you articulate your needs and goals, whether you're seeking an initial investment to kickstart your venture or aiming to accelerate growth through Series A, B, or C funding rounds.

Here’s a quick rundown of some fundamental terms you should be familiar with:

Equity

Ownership interest in a company, represented by shares of stock. This is what investors receive in exchange for their investment and determines their share of profits and control in the company.

Equity Percentage = (Number of Shares Owned / Total Shares Issued) * 100

Sweat Equity

The non-monetary investment that owners or employees contribute to a startup.

Sweat Equity Value = (Hourly Rate * Hours Worked) / Total Shares

Valuation

Valuation is the process of determining a company's current worth. It affects the percentage of equity investors receive and is crucial for negotiating funding deals. There are two types: Pre-money valuation (value before new investment) and Post-money valuation (value after new investment).

Valuation Cap

A Valuation Cap is commonly used in convertible notes or SAFEs (Simple Agreements for Future Equity). It sets a maximum limit on the company’s Valuation at the time of conversion into equity, benefiting early investors.

Runway

The amount of time a startup can operate before it runs out of money.

Runway = Cash balance / Burn rate (monthly expenses)

Burn Rate

The rate at which a company spends its cash reserves. There are 2 types of Burn rates: Gross burn (total monthly expenses) and net burn (monthly expenses minus revenue).

Burn Rate = Total Monthly Operating Expenses - Monthly Revenue

Cap Table (Capitalization Table)

Cap Table is a spreadsheet that shows the ownership stakes, equity dilution, and value of equity in a company. It helps manage equity distribution and is crucial for understanding ownership structure.

A typical table includes Founders' shares, investors' shares, option pools, and convertible securities.

Ownership Percentage = (Number of Shares Owned by Shareholder / Total Shares Issued) * 100

Option Pool

A portion of a company's shares reserved for future issuance to employees, advisors, or board members.

Convertible Note

A form of short-term debt that converts into equity, typically in conjunction with a future financing round.

SAFE (Simple Agreement for Future Equity)

An agreement between an investor and a company to provide future equity without setting a valuation at the time of the initial investment. They simplify early-stage investments and align investor and founder interests.

Dilution

The reduction in existing shareholders' ownership percentage due to the issuance of new shares.

Dilution = New shares issued / Total shares outstanding after issuance

Term Sheet

Term Sheet is a non-binding agreement that outlines the terms and conditions of an investment. A term sheet sets the groundwork for the final investment agreement and helps align expectations.

It outlines essential components like Valuation, investment amount, equity stake, liquidation preference, and board composition.

Vesting Schedule

Vesting Schedule is a timeline over which employees or founders earn their equity shares. Instead of receiving all the equity upfront, it is distributed over a set period, ensuring continued contribution to the company.

For example, a common vesting schedule might be over four years, with a one-year cliff (no equity is earned during the first year, but after the first year, 25% is vested).

ROI (Return on Investment)

ROI measures the gain or loss generated on an investment relative to the amount of money invested.

ROI = (Net Profit / Initial Investment) * 100

Pro Rata Rights

Pro Rata Rights are the rights of existing investors to participate in future funding rounds to maintain their ownership percentage.

Contribution Margin (CM)

Contribution margin represents the portion of sales revenue that exceeds total variable costs. It is an important metric that helps businesses understand the profitability of individual products and services.

A high contribution margin could mean you’re not investing enough in growth, while a low one could mean you’re burning too much cash.

CM1 = Revenue - Direct expenses ( Business expenses like labour costs, product development costs)

CM2 = CM1 - Indirect expenses (Expenses like shipping, logistics, or warehouse)

EBITDA

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial metric used to assess a company's operating performance.

EBITDA = Net income + Taxes + Interest expenses + Depreciation + Amortization

It shows a company’s profitability before accounting for costs like interest, taxes, and non-cash items such as depreciation and amortization.

These are just some of the key terms you must know if you're trying to prepare yourself for a funding round. We're going to explain all these terms in a way that's easy to get, starting with our next few blog posts.

And if you’re too excited to wait, check out our all-inclusive program- Pitch Perfect!

It’s designed to help you learn the best way to tell your story, build a winning deck, and refine it so that you can keep the investors hooked right from the first slide.

Stay tuned! In our upcoming articles, we’ll cover everything you need to know about fundraising and introduce you to even more key terms along the way!

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