Q: I’ve been reading as much as I can about approaching investors for business funding. Even though I’m a capable manager and my business is profitable ahead of schedule, I’m afraid of seeming unknowledgeable in front of investors. What do investors expect entrepreneurs should know?
A: When entrepreneurs make accounting and financial community terminology mistakes during their presentations, I’ll take a few minutes at the end of a meeting to explain the fine points of accounting and finance in a friendly way so they won’t make the same mistakes at future presentations.
Most investors, however, are not as forgiving. They often consider terminology blunders as a warning sign that entrepreneurs are financially “unsophisticated” or don’t have the financial “bandwidth” to manage money wisely or report financial results in an accurate way.
Here are a few terms that are helpful to know.
Pre- and post-money valuations. At some point, entrepreneurs have to estimate the total value of their company before negotiating fundraising deal terms with potential investors. Of course, entrepreneurs seek high pre-money valuations, whereas investors prefer lower valuations to more adequately compensate them for investment risk. For fundraising purposes, the term “pre-money” valuation refers to the estimated value of a business before new funds are invested in the company. A “post-money” valuation refers to the final negotiated value of a company plus the amount of funds raised post deal closing.
Warrant. A warrant is a form of investment security which gives its owner the right to purchase a number of shares of common or preferred stock at a set price before the warrant’s expiration date. Ideally, warrant holders want the value of a company to grow, so they can buy shares at a below-market rate at some future date. Entrepreneurs should not be surprised when commercial lenders, consultants and investors ask companies for a “warrant kicker” to kick up or “sweeten” their potential compensation.
Preferred stock. Most savvy angel investors and certainly all VCs have a strong preference for receiving “preferred stock” rather than common stock as a condition for investment. Preferred stock transactions may include rights to earn dividends that can be paid in cash or additional shares of stock. The longer investors have to wait to “exit” or sell their stake in a company, the more dividends investors earn to boost their overall financial returns.
Preferred stock holders also negotiate “liquidation preference multiples” which give investors the right to receive one or more times their invested capital at the time of exit before common stockholders (usually company founders, employees and family members) receive a penny.
In simplified terms, if a $3 million investor receives a preference multiple of two times invested capital, then the investor would receive the first $6 million of funds received from a company sale. Riskier startups and troubled companies tend to face higher liquidation preference multiples than more established, profitable companies.
Milestone financing. As a sign of today’s more cautionary investment climate, investors are not always handing over their money to startup entrepreneurs in lump sums. Rather, entrepreneurs receive funding in “stages” or “traunches” as the company achieves specific business performance targets or “milestones.” If entrepreneurs meet their milestones in a timely way, then investors will release more funds to support continued company progress.
Letter of intent. A letter of intent or “LOI” is a non-binding document that outlines primary terms of a proposed investment in a company. Most LOIs that are presented by investors are subject to “due diligence” which is a comprehensive investigative process to confirm information about a company’s management, legal organization, customers, intellectual property, competition or market position. Any errors in document production or other “materially adverse” due diligence results may cause investors to withdraw their LOI.
Capitalization table. A capitalization or “cap” table is a summary of a company’s total number of authorized and outstanding common and preferred shares, stock options and warrants. Well-prepared business plans include a detailed cap table for easy reader reference.
Investment banker. Despite the name, investment bankers don’t typically invest money or lend money to entrepreneurs. Rather, they are professional match makers who help entrepreneurs solicit and negotiate deal terms with investors.
Investment bankers are also called “bankers,” “agents,” or “intermediaries.” Investment bankers can be paid a cash monthly retainer fee as well as a “success fee” that is based on the total amount of funds raised for a company. Entrepreneurs should carefully screen investment bankers’ qualifications because some agents are highly skilled while others don’t know how to target investors or really help entrepreneurs succeed. A co-founder of Yahoo famously referred to his company’s investment bankers as mere “potted plants!”
Investors don’t often give entrepreneurs a second chance to make a good first impression. If you aspire to build a prosperous business, aspire to learn the language of the financial community.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. Her work is dedicated to improving startup longevity in rural, urban and suburban America. She is the founder of www.takecommand.org, a community service organization that offers the largest centralized database of startup and small business funding sources in the U.S. Follow Susan on Twitter @TakeCommand.