Venture Capital Terminology

Round

Refers to an investment round. In it, several venture capital investors gather – sometimes only one investor – for the purpose of financing a startup. It is named as such because startups typically raise investments in successive rounds until they reach profitability. Rounds are usually divided into early rounds called Pre-Seed and Seed, which are rounds specialized in by individual investors, incubators, and accelerators, followed by later rounds that investors commonly label with letters A, B, C, etc.

Rounds are categorized by whether they are equity deals where the investor purchases new shares issued by the company, called a Priced Round, or convertible debt rounds where the purchase is deferred to an agreed-upon time, called Convertible Notes or often abbreviated by investors as Notes.

Convertible Notes

It is a document signed by the startup with the investor, summarized by the investor financing the company with a specific amount in the form of debt, with the investor having the right to convert this debt into equity shares upon the fulfillment of certain conditions agreed upon between the two parties. Among the most famous models of this type of financing are SAFE, developed by the accelerator Y-Combinator, and KISS, developed by the accelerator 500 Startups.

Lead Investor

He is the investor who leads the investment round. He typically leads the negotiations and commits to financing the largest portion of the funding amount, and is usually a venture capitalist with strong financial standing and good experience in structuring venture investments, having previously executed several deals. His tasks include conducting negotiations, setting the valuation and the rights that investors in the round will receive, in addition to performing due diligence and arranging the entry of other investors.

Sometimes, the lead investor may obtain rights different from other investors in the round, such as obtaining a seat on the board of directors or requiring their approval before the company makes a specific decision, or other rights.

It may sometimes happen that two investors lead the round, especially when the investment amount is large, but the majority is that only one investor leads the round.

Institutional Investor

This refers to the institutional investor, as opposed to the individual or angel investor. Institutional investors may be venture capital funds, investment arms of large corporations, institutions and family offices, or investors in venture funds. The term refers to an investor with strong financial standing and extensive experience in the investment field. In later rounds, startups often seek to attract institutional investors and avoid individuals, due to the company's need for different expertise and skills in rapid growth stages, which may not be available from an individual investor.

Down Round

This is a round whose valuation is lower than the valuation of the previous round. For example, a company raised an investment of 2 million at a valuation of 10 million (i.e., the company's value became 12 million), then after a year raised 1 million at a valuation of 8 million (i.e., the value became 9 million), so this round is called a Down Round.

Venture capitalists view this type of round as a negative signal for the company's future because the company's inability to increase the valuation is often a result of decreased or stagnant growth at best. Investors protect themselves against such rounds by including provisions in partnership agreements that mitigate the impact of these rounds on their shares, represented by a clause called Anti-Dilution.

Venture Capital Fund

It is an investment fund specialized in venture investments, specifically in investing in technology startups. These funds are usually invested in by institutional investors, corporations, pension funds, and other large investment institutions. Sometimes, these funds accept investments from high-net-worth individuals. Each fund has an independent management team whose task is to search for, evaluate, and invest in opportunities, called the Fund Manager.

Due Diligence

It is due diligence. In it, the investor scrutinizes the legal and financial status of the company by reviewing important documents and studying financial aspects. The investor usually visits the company and speaks with senior employees. Due diligence comes in two types:

The first type: Financial/Commercial Due Diligence

In this, the investor delves into the financial aspects of the company. They attempt to assess the sustainability and quality of revenue, whether there are risks from its concentration on a specific group of customers, and also study unit economics. In this process, the investor may resort to talking to the company's customers and asking about their satisfaction with the service or product provided.

The second type: Legal Due Diligence

In this, the investor hires a specialized lawyer to review the company's contracts, whether internal, such as the partnership agreement, founding agreement, and employment contracts for senior management, or contracts with external parties, such as contracts with suppliers, customers, lease agreements, and others. The purpose of this review is to identify any risks arising from these contracts.

Usually, the investor conducts commercial and financial due diligence before legal due diligence. As for the invested companies, they prepare themselves for this process by gathering all documents in one place called the Data Room.

Data Room

A secure place where important files that investors want to review for due diligence are placed. The reason for the name is that companies used to place these files in a physical room and then allow investors to enter and study the files without taking them or copying them. Currently, most of these rooms are virtual rooms, meaning the company uploads files to file-sharing sites like Dropbox or Google Docs and then gives investors permissions to access these files. However, some companies still use traditional methods and place files in a physical rather than virtual room.

Quality of Revenue

Venture capitalists are highly interested in sales and pay great attention to them, as they are the major element in measuring the company's success in convincing customers of its products or services, in addition to the fact that startup valuations are often based on sales, not profitability, as in traditional companies. Therefore, they study the quality of sales and whether they are sustainable. The most important thing an investor looks at is the composition of these sales and how they came about. For example, if we have two companies, each achieving sales of 1 million, but the first company obtained these sales from only 3 customers, while the other company sold to 20 customers, the quality of sales in the second company is better than the first due to the concentration of the first company's sales on only three customers, which raises the risk level of losing them and consequently a sharp decline in sales.

Investors also look at the likelihood of recurring sales. One-time sales are of lower quality than monthly recurring sales, due to the ease of estimating and forecasting sales and then building financial projections for them.

Strategic Investor – Financial Investor

A strategic investor is one who invests in a company with a similar or complementary activity to their current activity. For example, a perfume and cosmetics sales company investing in a perfume sales website (similar activity), or a car maintenance company investing in a spare parts sales website (complementary activity).

Usually, the objectives of a strategic investor are not primarily financial. They may wish to enter into activities complementary to their current activity, but through the gateway of investing in startups that preceded them in this field. Also, among the reasons may be acquiring technologies that the strategic investor lacks and that are costly to develop, or the goal may be to acquire a customer segment owned by the company they wish to invest in.

A financial investor is an investor whose sole goal from investing is to obtain financial returns. Financial investors often do not target specific sectors, but invest in all sectors where they find suitable opportunities. A venture capitalist – generally – is considered a financial investor, not a strategic one.

Value Proposition

This term refers to determining the value provided by the company to its customers. In other words, what are the reasons that will drive the customer to purchase the good or service. The reasons may be speed of service delivery, cost reduction, or making a task more efficient in terms of resource utilization. For example, the value provided by Uber is the speed of getting a taxi and its lower cost compared to traditional taxis.

Cash-in / Cash-out

When a venture capitalist invests an amount in a startup, this amount is usually to finance the company's future operations. Therefore, the amount goes to the company's accounts, not to the owners' or founders' accounts. Hence the term Cash-in, which literally means injecting investments into the company. Legally, the company in this case issues new shares for the new investor, and these shares are called Primary Shares. The vast majority of venture capital deals in early stages are Cash-in deals. .

Sometimes, especially in later stages, an investor may purchase shares from existing shareholders. This process is called Cash-out, which literally means buying shares from shareholders wishing to exit their investments in the startup. In this case, the company does not issue new shares for the venture capitalist and does not receive the money, but shares are transferred from an old shareholder, and these shares are called Secondary Shares.

Usually, venture capitalists do not prefer to conduct Cash-out deals, especially in the early stages of the company. This is because the founder's or current shareholder's desire to sell their shares is not considered a good signal, as the seller usually knows the company better than anyone else, so there is a possibility that the reason for the sale is something related to the company's performance. Therefore, the venture capitalist is keen to know the real reason behind the exit.

Liquidity Event

The term Liquidity here does not mean the literal meaning of liquidation or settlement, but rather refers to exit. The phrase refers to exiting through the company's initial public offering (IPO) on the stock market, or being bought by another company, or the investor exiting by selling their stake to another investor. All of these are called a Liquidity Event. In other words, the company continues its operations even after the exit process occurs.

This term often has legal implications built upon it. For example, when convertible debt deals are made, the debts are converted into shares in the event of an exit opportunity, so that the debt holders are included in the shareholder list and thus obtain an ownership stake.

Exit

The venture capitalist is keen to study exit possibilities carefully. The ultimate goal of every investor is to sell their stake after a certain number of years. Therefore, markets where exit is easy are considered favorable to venture capitalists. Exit avenues for the investor are multiple; it may be through selling only their stake to an external buyer, or selling the entire company to a strategic investor, or the company listing its shares on the stock market.

For professional investors, one of their tasks is to prepare the company for a successful exit. Among the exit strategies is for the investor to market the company after a period to other investors with whom they have close relationships, or to help the company grow and expand based on business models attractive to potential buyers.

Preferred Shares / Common Shares

Startups issue two types of shares: the first is Common Shares, and the second is Preferred Shares. Usually, at the beginning of the company's founding, it issues only common shares to the founders, and sometimes to individual investors who invested in the company's early stages. These shares have equal rights and are often simple and uncomplicated. However, when the company decides to bring in venture investments from venture capitalists, the investors request that the company issue Preferred Shares with rights different from those of common shares.

In each investment round, the company issues a new type of preferred shares. That is, the company issues preferred shares for investors in round A with specific rights, then issues preferred shares for round B with different rights. Generally, investors in the most recent round have shares with better rights than those from previous rounds. Common shares, on the other hand, are usually of only one type.

The importance of these types of shares also lies in the case of an investor wishing to purchase shares from existing shareholders (Cash-out or Secondary Shares). The investor will then evaluate the shares based on the rights these shares hold. Preferred shares are always more expensive than common shares, and preferred shares with stronger rights are more expensive than preferred shares with lesser rights.

Deal Structuring

This refers to deal structuring. Structuring begins with determining the type of deal: whether it is an equity deal or a convertible debt deal. Then, all details of the deal are agreed upon, including rights, valuation, and risk management. For example, deal structuring may involve purchasing a non-cash stake, such as a stake in exchange for providing specific services, like bringing in customers or achieving specific sales figures. Or it may involve reducing the valuation if the company fails to achieve certain targets. Overall, professional investors negotiate many detailed aspects to arrive at the best possible structure.

In contrast, some investors describe debt deals as Unstructured Deals, implying that they do not detail the precise specifics that equity deals provide, due to the lack of agreement on them from the outset.

Liquidation Preferences

This is one of the rights obtained by a venture capitalist as a result of their investment in the startup. This right is applied in the event of the company's sale or liquidation, where the investor has the choice between receiving their capital or participating in the resulting profits from the sale, if any, or both. Investors place this right as a means to reduce the risks arising from their investment in the startup and as an effective way to guarantee their capital in the worst-case scenario.

Vesting

This means granting founders or employees their shares gradually, often over 2 to 3 years depending on the company's stage. The reason is that the investor invested based on their assessment of the founders, so their departure is considered one of the biggest risks that no startup can bear. The investor requires the founders to pledge their shares to the company to ensure they do not leave during a specific period. If they leave the company for their own reasons, they receive a percentage of their shares proportional to their service period, while the rest returns to the company to dispose of.

Pre-money / Post-money Valuation

In startup valuation, there are two types of valuations. The first is the valuation of the company itself before investments enter it, called Pre-money. The second type is the valuation of the company after investments enter it, called Post-money valuation. In negotiations, the value of the company itself before investments enter is usually negotiated.

Cap Table

A table showing a list of everyone with an ownership or non-ownership relationship with the company. In this table, the names of founding shareholders and subsequent shareholders are recorded, in addition to the number of shares and ownership percentage for each. The table also contains a list of investors who financed the company through convertible debt and the value of each investment. Usually, the table shows the owners according to each round or share type. For example, owners of Series A shares are listed as Series A Investors, and the initial round as Seed Investors, and so on.

Investors wishing to invest in a startup pay close attention to this table, as it shows the list of their future partners and the company's financing history, including anyone with claims against the company – if any. It also shows the size of the founders' ownership and whether employees have any shares.