In the initial blog of our venture and capital series, we had looked at terms such as IRR, Payback Period, and Valuation. Here, in this second part, we shall take a look at some other very important terms that are crucial for both Indian startup founders and investors to know. These terms have the potential to greatly influence how investments are negotiated, structured, and finally, how startups grow.
1. Term Sheet
A Term Sheet is an informal, non-binding contract that defines the terms and conditions of an investment transaction between an investor and a startup. Although it is not legally binding, it is used as a basis for preparing the final investment agreement. It generally provides information on valuation, amount of investment, nature of equity, investor rights, and special terms.
For Indian startup entrepreneurs, the term sheet is a very important document to negotiate terms of investment. It assists in setting expectations of the investment structure. As an entrepreneur, understanding the intricacies of a term sheet can avert future issues with investors.
For investors, the term sheet is a means of ensuring their interests are safeguarded. Reading the fine print in such documents allows investors to gauge the risks and returns on their possible investments.
2. Burn Rate
The Burn Rate is the pace at which a startup is consuming its available funds prior to the point at which it begins generating a positive cash flow. Essentially, it is how fast a startup is "burning" through its capital. It is an important measurement, particularly for early-stage startups, as it provides a reflection of how long the startup can sustain itself prior to requiring additional capital.
Indian startup founders need to be in tune with their burn rate. A high burn rate may result in a liquidity crunch if the startup cannot raise additional funds or generate revenues. Investors India usually analyse burn rates in order to determine the financial health and viability of a startup.
3. Vesting Schedules
A Vesting Schedule describes the period during which a startup founder or employee vests in their equity in the business. This usually pertains to stock options or equity issued to critical staff. Vesting is employed to encourage long-term service and performance.
In India, where startups are typically started by a small group of people, vesting schedules are essential to ensure a motivated and committed team. They also avoid co-founders or early employees from quitting the company too early after being granted equity. A typical vesting schedule is four years with a one-year cliff, i.e., no equity vests in the first year, but after that, equity vests over the next three years.
For investors India, a properly set vesting schedule ensures that core team members remain with the company and are motivated to contribute to its success.
4. Cap Table (Capitalization Table)
A Cap Table is an elaborate document that reflects the ownership of a company, such as the equity stocks held by founders, investors, and employees. It's a vital instrument for startup owners and investors to know the ownership breakdown.
To founders of Indian startups, the cap table is a useful instrument in learning how the ownership gets diluted at every funding round. It makes it easier to keep the structure of the ownership in harmony with the strategic ambitions of the business. For the investors, the cap table brings clarity about their holding and how it can potentially change with more rounds of funding for the business.
5. Pre-Money and Post-Money Valuation
Pre-Money Valuation is the valuation of a startup prior to receiving investment from outside parties, whereas Post-Money Valuation is the company's valuation after the investment has been received. The only distinction between these valuations is the level of investment received by the startup.
It is important for both Indian startup founders and investors to understand the difference between pre-money and post-money valuation. For founders, having knowledge of pre-money valuation allows them not to give away too much equity in return for too small an amount of money. For investors, the post-money valuation is helpful in determining how large their equity stake in the company will be.
6. SAFE (Simple Agreement for Future Equity)
A SAFE is an investment contract that allows an investor to convert their investment into equity in a future round of funding, without valuing the company at the time of investment. SAFEs are a popular instrument in early-stage financing because they simplify the process and avoid the need for an on-the-spot valuation.
Indian startups typically utilize SAFEs with a view to raising capital from seed investors or angel investors. For the investor, SAFEs are attractive inasmuch as they offer the prospect of being convertible into equity under favourable conditions in a follow-up round.
7. Lead Investor
A Lead Investor is an investor who initiates and leads a round of funding. The lead investor tends to negotiate the terms and conditions of investment and assist in establishing the valuation of the company. Lead investors generally have a considerable influence on the company's strategy.
For Indian startups, having a lead investor provides credibility and encourages other investors to join the funding round. For investors, being a lead investor provides them with greater control over the deal and ensures that their investment is accompanied by terms agreed for other investors.
It is very important for both Indian startup founders who want to raise funds as well as the investors who are interested in investing and making prudent decisions. More advanced topics including Convertible Equity, Seed Round, Series A/B/C Financing, etc., will be written about in our next blog on key terms in venture and capital.
Stay tuned!
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