Before you venture out to raise money for your small business, get hip to the lingo. Don’t wait until its too late to learn the difference between your Cap Table and your Capacity… between a Ratchet and a Warrant.
Whether you’re looking for a loan or angling for an angel, know the ropes. Nothing kills a money-buzz faster than finding out you just signed over your entire company to a fast-talking PEG.
- Archangel: a respected leader in the private investor community – often an ultra-high net worth individual who can influence other angel investors to make an investment. Maybe he has made other great angel investments… or maybe he’s just way rich to begin with. In any case, he’s a good guy to know!
- Capacity: ability to repay a loan. Capacity compares a company’s cash flow to the monthly minimum loan payment due. Before you’ll get a loan, the bank wants to know “what’s your capacity to repay it”. You better be able to show cash flowing in to cover regular monthly payments.
- Cap Table: Short for Capitalization Table. This is simply a spreadsheet in which you can list all of your investors, the amount they paid for stock, and the amount of stock they own. The cool thing is that a good cap table will calculate things like “Dilution” and “Valuation” (see definitions below). Don’t finish a round of investment without running a cap table. Get my best cap table spreadsheet here.
- Convertible Debt: a loan that can be converted to stock, either by election or automatically upon reaching certain business milestones. Be sure you know what will trigger the conversion … and who gets to decide. You could bargain for a loan, but end up with a partner. And if the loan is big enough, that partner may actually be your boss when he ends up owning more of your company than you do. I’ve seen it happen!
- Convertible Stock: stock that can be converted to debt, usually at the sole discretion of the investor. Since stockholders are last in line during a bankruptcy, the investor would only convert if he thought things were going south. On the other hand, you may want the right to convert stock to debt so you maintain ownership. That would be unusual, but you could try it.
- Dilution: the loss of ownership (as a percentage) which naturally results from selling stock to new investors. This is unavoidable. And its not a complicated calculation, but some people really get nervous about it. You need a good capitalization table to do the math. I’ve got one for you, of course! Click here to see my cap table.
- Down Round: an equity investment (stock purchase) at a price lower than previous investors paid. Down rounds can cause extreme dilution to prior shareholders. Stock prices can go up or down. When your’s goes down, and you sell stock, you could end up selling a big percentage of ownership in your company.
- Mezzanine Finance: Funding made of an unsecured loan combined with a grant of warrants. (from mezzanine – “middle” between debt and equity)
- Participating Preferred: a class of investor stock that, in case of any sale or liquidation, requires the company to pay back the initial investment before any other distributions, and also entitles the holder to participate in capital gains along with common shareholders. Sounds confusing, right? It can be. If you have an investor request Participating Preferred, call a lawyer.
- PEG: private equity group. Any organized fund or company that specializes in purchasing, and sometimes managing, private companies. Also called “buy out funds” or “holding companies” or, when you’re feeling snide, just “bankers”. These guys are great to have on your side, but they often look for radical cost savings — which means they might invest in you and then fire half the staff!
- Ratchet: an investor’s right to receive additional stock if the price of the stock declines. Ratchets allow investors to keep, or boost, their relative ownership of the company during a down round. See “Down Round” above. Before agreeing to a Ratchet clause, speak with an equities attorney, and understand the consequences.
- Term Sheet: a simple, plain-English memo which outlines the parameters of an investment or loan prior to the formal contract. When investors and business owners agree on the term sheet, it goes to legal counsel to draft the appropriate documents. Man does this make negotiating quick and easy. Don’t write a contract when a term sheet will do.
- Valuation: the dollar value of 100% of the company stock. If an investor buys 25% of the stock for $10,000, then the valuation of the business is $40,000. Can’t do the math in your head? Get a capitalization table.
- Warrants: the right to purchase stock in the future at a predetermined price (called the strike price). Similar to options, warrants are commonly used to reward early investors, consultants or lenders. The good news is that warrants generally do not have tax consequences (but don’t take my word for it) and they expire so that you won’t have them hanging out there forever.