#29 - VC Terms Startups and Emerging Fund Managers Need To Know - Part 3 of 3
The Agile Growth Entrepreneur Newsletter
A company's pre-money valuation is the amount at which it was valued before receiving its most recent investment. The term "pre-money valuation" describes a company's value before any outside funding has been added.
After the most recent investment round, we add that sum to calculate a company's worth. The term "post-money valuation" describes a company's value following an investment.
When investors have pro-rata rights, sometimes called participation rights, they are guaranteed the opportunity to participate in succeeding investment rounds without diluting their current stake in the firm. By default, Y Combinator's pro rata agreement form only covers the following round.
Suppose an investor chooses to exercise pro-rata rights. In that case, they will normally invest at the same valuation as all other investors in the same round.
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To maintain their status, current investors must participate in subsequent funding rounds on a pro-rata basis under the pay-to-play rule. Non-participating investors' preferred shares may be converted to common stock.
Pay-to-play is rarely used.
As the name implies, drag-along rights allow the majority shareholder(s) to force the minority shareholder(s) to participate in an acquisition when a company receives an appealing offer. Early-stage companies often have a majority ownership stake held by the company's founders.
Tag-along rights allow minority startup owners to participate in a sale if the company receives a favorable acquisition offer. In other words, they are welcome to "tag along" with the transaction. Some people use the term "co-sale rights" to refer to this.
Board of Directors
A company's most important decisions are made by its Board of Directors, an elected body of prominent shareholders. Fiduciary obligations require board members to take steps to ensure the firm is being managed in the best interest of all stakeholders.
Compared to Series A firms, those at the seed stage are much less likely to have a formal board.
The phrase "pari passu" implies "on an equal footing." Ordinary shares are typically pari passu, meaning that all shareholders have an equal chance at receiving dividends and other benefits.
Preferred stockholders have certain advantages over common stockholders. For example, preferred stockholders get paid before common stockholders in the case of a solvency event with a value lower than the company's valuation (such as bankruptcy or a merger or acquisition).
Preferred stock is owned by investors, whereas ordinary stock is owned by the company's founders and early workers.
Common stock is more widely held by the company's founders and early workers than preferred stock is. Typically, workers are allowed to buy common stock through stock options.
The runway is the projected period a company may keep operating without seeking external financing.
The typical runway for a seed-stage startup is 18 to 24 months of funding. However, we advise entrepreneurs to shoot for a runway of 24 months or more, especially in uncertain market situations.
The phrase "burn rate" refers to the monthly pace at which a company is depleting its cash reserves. Every month, it is determined by subtracting the original cash balance from the current cash balance.
Total Value to Paid-In Capital (TVPI)
The overall value of the fund's assets, including realized and unrealized, expressed as a percentage of the total amount of capital invested in the fund, is known as the TVPI. Total value = dividends + net asset value / paid-in capital. When the TVPI is greater than 1.00x, the value of an investment has increased, and when it is less than 1.00x, the value has decreased.
If a fund's TVPI is 1.5, then for every $1 invested, the fund has returned 50 cents. This is the standard method of evaluating a fund's efficiency.
According to Pitchbook, the median TVPI for top decile VCs worldwide in the 2010-2020 vintage years was 3.84x. However, this number fluctuates greatly from 1.96x to 5.87x, depending on the vintage year.
Multiple on Invested Capital (MOIC)
The Return on Invested Capital (MOIC) is determined by dividing the portfolio's (total value) by the number of stocks (initial investment). The numerator is where you'll find the key difference from TVPI. Instead of the amount of money contributed to the fund being used as the denominator, the entire amount of capital invested by the fund is used here. Management fees are considered part of the "paid-in" capital.
Distributions to Paid-In Capital (DPI)
The distribution payout ratio (DPI) is the amount of money returned to limited partners (LPs) relative to the amount initially deposited. While TVPI might serve as a useful precursor to actual performance, DPI ultimately matters.
To get the realized, or cash-on-cash, return on investment, one must divide the payouts by the initial investment.
According to Pitchbook, the median DPI for the top decile of VCs worldwide was 1.67x for vintages 2010-2020, albeit this number ranges greatly from vintage to vintage (from 0.10x to 3.17x).
Liquidity events, such as an IPO or a sale of the firm, trigger distributions. GPs can initiate a distribution by selling their stake to new investors during a future investment round.
Cash-on-cash multiple and realization multiple are other names for DPI.
Internal Rate of Return (IRR)
The internal rate of return, often known as IRR, is the rate of return that causes the net present value of a portfolio to become zero. It is a projection of your portfolio's yearly growth rate.
Although it is more difficult to define than the performance, as mentioned earlier, indicators, IRR, may be thought of as the predicted yearly rate of growth generated by an investment over a certain period. Therefore, considering the value of time while making investments, IRR is a helpful tool.
Pitchbook reports that the median internal rate of return (IRR) for the top decile of global VCs from 2010-2020 ranges from 43.97% to 96.23%.
In the initial few years of a fund's existence, IRRs are notoriously unpredictable and may not indicate performance.
When an investment is worth more now than it was originally valued and/or purchased, it is known as a markup.
It is common for early-stage investors to see their portfolio firms raise additional cash on a SAFE or note with a bigger cap than their first investment. A true markup is determined by pricing rounds, with the new price per share used in the calculation. In your correspondence, you may mention these SAFE or notice rounds to LPs, but you may not falsely label them as markups.
A cash-on-cash return, or money-on-money return, is calculated by dividing an investment's yearly net cash flow by the cost of the investment (initial investment). This statistic is similar to ROI in that it evaluates the amount of money made from an investment about the amount put in.
A K-1 is a tax form provided to investors in venture capital funds to aid them in determining their annual tax liability. Each year, LPs and GPs get K-1s from the VC fund (usually their legal counsel or back office) to determine their tax obligations.
The Internal Revenue Service (IRS) requires businesses to file Form 1065 (or "partnership tax return") each year to provide information about their financial situation from the beginning of the tax year to the conclusion. The partnership's total net income and other pertinent financial information must be reported in Form 1065.
Limited Partnership Agreement (LPA)
A Limited Partnership Agreement (LPA) is a contract between limited partners (LPs) and general partners (GPs) that establishes the terms and conditions of the fund. The size of the fund, the management fees, the distribution of profits, and the fund's duration are only some details that may be found in a limited partnership agreement (LPA). The fund's fundamental governing document is the LPA.