In India’s rapidly growing startup ecosystem, venture and capital (VC) is one of the most important sources of funding for entrepreneurs. For both startup owners and potential investors, it’s essential to understand the fundamental terms that are often used in venture capital transactions. In this first blog of our three-part series, we’ll break down some of the most important VC terms that every Indian investor and startup owner should know.
1. Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is an important measure investor use to determine the profitability of an investment in the future. Essentially, it is the discount rate that will equate the net present value (NPV) of an investment's cash flows to zero. For venture and capital, a higher IRR typically translates to the potential for greater returns.
For Indian startup founders who are looking for VC funding, knowing IRR is essential. Investors prefer a high IRR because it indicates that their investment has the potential to increase at a fast rate. Startups with a high IRR are preferred because they offer a greater return on investment over a shorter duration.
2. Payback Period
Payback Period is the length of time before an investor regains his/her initial investment in the cash flows of the startup. This phrase is important both for entrepreneurs and investors India because it serves to indicate the risk for the investor in the investment. A short payback period will mean that the startup will soon start earning a profit, limiting the risk of the investor.
For Indian businesspersons, it is essential to understand the payback period because it enables you to plan your business strategies so that your cash inflows are adequate to repay the investor's capital within a reasonable period.
3. Equity Stake
Equity stake is the proportion of ownership that an investor has in a company after investing in it. When a venture capitalist invests in a startup, they typically trade money for equity in the company. This ownership gives them a portion of the profits and a voice in business decisions.
Indian startup founders must take into account very seriously how much equity they will provide for the investment. While providing too much equity can water down ownership of your business, giving too little might mean not securing enough investment.
4. Valuation
Valuation is how to value a startup company to invest in. It is a key consideration for entrepreneurs as well as investors because it will determine how much equity to issue for a certain level of financing. In India, startups tend to be valued based on forecast revenue, potential of the market, and founding team expertise.
For investors India, valuation is the most important factor in determining if a startup's potential merits the risk. For founders, it's important to understand the correct valuation to prevent undervaluing or overvaluing the business.
5. Convertible Notes
Convertible notes are debt instruments with short tenure applied during early-stage financing, which get converted into equity at a future point of time, usually at a later stage funding round. They are highly sought after within the Indian startup ecosystem, given that they are easy to arrange and do not involve an up-front valuation.
For founders of startups, convertible notes are a great means to raise capital immediately without having to negotiate an early-stage valuation. For investors, they offer the chance to convert debt into equity once the company has become more established.
6. Exit Strategy
An Exit Strategy describes how an investor will ultimately sell their stake in a company and harvest their return on investment. This may occur through several means including an Initial Public Offering (IPO), merger, acquisition, or secondary sale of shares.
Indian entrepreneurs must also have an exit strategy in mind, as it assists investors in understanding how they will eventually get a return. For investors India, a defined exit strategy means there is a specific way to realize their investment.
7. Due Diligence
Due diligence is the process of researching and analysing a startup's business model, financials, and overall viability prior to investment. For Indian investors, doing proper due diligence is important in order to make low-risk investments.
Startups must be ready to provide their business plans, financial reports, and other necessary documents to substantiate their authenticity and viability.
Conclusion
These are some of the basic terms of venture and capital that must be known by every Indian investor and startup owner. The terms covered here — IRR, Payback Period, Equity Stake, Valuation, Convertible Notes, Exit Strategy, and Due Diligence — are the building blocks of making wise investment choices and raising investors. In the second blog of this series, we will delve into more crucial terms like Term Sheets, Burn Rate, and Vesting Schedules to continue building your knowledge base in venture capitalism.
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