Those who haven’t been involved in the investment sector for a long time may be lost in the common terminology and acronyms. So, we have made a list of words and phrases that every good startup founder and emerging fund manager should know.
With any luck, you can use this as a resource and spare yourself any embarrassment when pitching investors or LPs (Limited Partners).
General Partner (GP)
General Partners (GP) handle venture capital funds. As a result, they have the last say on where the LPs’ money is invested.
Limited Partner (LP)
A limited partner (LP) is a backer of a venture capital fund. In exchange for a return on their money, fund managers invest the money they get from limited partners (LPs), who usually don’t have to do much else. A fund can have more than 99 limited partners (LPs), but often they cap it at 99.
Fund managers will issue a capital call (also known as a “drawdown”) to their limited partners (LPs) when it is time for those LPs to make contributions to the fund. The GP usually has a predetermined timetable for this.
Capital calls are usually set up every six to twelve months, the same amount of time the fund takes to deploy its money. While GPs have the right to demand the full amount of cash up front, doing so may reduce the fund’s internal rate of return (IRR) if the money sits in a bank account.
When deciding whether or not to participate in a particular fund, limited partners (LPs) are often required to meet a minimum subscription before being considered for membership.
According to SEC rules, only “accredited investors” can put money into unpublicized businesses and funds. To be an accredited investor, a person needs to have at least one of the following:
- Someone with a personal or combined net worth of above $1M (not including the value of their primary residence)
- A two-year average of personal earnings over $200,000 or a joint annual average of $300,000, with the hope that this level of success would be maintained this year OR
- Any of the Series 7, 62, or 65 licenses
Accredited investors are often the only ones accepted by funds.
Rule 506(c) says that funds can talk openly about their fundraising efforts and let the public know about the fund.
While this can simplify the fundraising process, the LPs who contribute after the announcement need proof of their credentials. However, 506(b) funds, which can only ask a few people to invest, don’t need their investors to show proof of accreditation. Instead, they can accept a verbal acknowledgment.
Qualified Client (QC)
To be considered a QC, an individual or organization must satisfy all of the following requirements:
- After the fund investment, the adviser manages $1.1 million or more in assets.
- A minimum of $2.2M in liquid assets (not including primary dwelling value) to invest in the fund.
- Is a “qualified purchaser” (QP)
- Is an officer or director of the fund manager or works for the investment adviser and has done so for at least 12 months
Accredited investors must have a higher net worth than qualified clients; hence eligible clients must also be accredited investors.
The point at which sufficient funds have been collected for the GP to begin making investments. It is highly suggested that you celebrate reaching this important milestone.
The common practice for conventional funds is to raise all of their capital in one fell swoop, called the “First Close,” and immediately put that money to use. When a fund is closed, it no longer accepts new limited partners (LPs).
Still, it is common for fund managers to keep their funds “open” for a while while they use the money they already have and look for new investors.
Launched by AngelList in 2020, rolling funds are quarterly funds. The limited partners (LPs) in such a fund subscribe by agreeing to invest $X every quarter (often with a minimum of 4–8 quarters). This gives fund managers more freedom to change the size of their funds and to raise and spend money from current and potential limited partners (LPs) on a regular basis.
Limited Partner Advisory Committee (LPAC)
The GPs will pick a group of LP representatives called the LP Advisory Committee (LPAC) to advise them on possible conflicts of interest and major changes to the fund. In many ways, LPACs serve the same purpose as a corporation’s board of directors.
How each fund’s portfolio grows depends on things like the size of the fund, how the management fee is set up, the size of each check, how long it takes to use the money, and so on. Fund managers often utilize this structure, and LPs frequently request it to understand the investment’s intended purpose.
Reserves are money VC firms hold aside to make additional investments in portfolio companies.
The use of reserves as a strategy is a hotly contested topic in venture capital. Reserves are kept by only some funds, and some funds save up to half of their money for sequels.
After an initial investment, the fund manager makes a second investment in the same company (a “follow-on”). Those investments may come directly from the fund or via a special-purpose vehicle.
Businesses frequently use a variety of subsequent approaches. Some players do their fair share in the majority of the following rounds. Others perform separate assessments after each one. Few people ever elaborate.
Funds charge shareholders an annual “management fees” fee to cover the fund’s costs. This is used more often to meet operational costs than to fund capital expenditures.
Management fees for venture capital funds are typically 2% per year of LP commitments. However, many people need to know that fees can be front-loaded to advance operational cash flows to the point where they are most needed in the fund cycle. This is especially helpful for smaller funds, where even 2% per year may not be enough to pay workers’ salaries.
Carry (or “carried interest”) refers to the portion of a fund’s profits that go to the general partner (GP) and any other members that contribute to the fund’s operation. Most funds charge a 20% carry, but others (generally larger, more reputable ones) ask for 25% or more.
As with any incentive, carry percentages might increase whenever certain performance thresholds are attained. Funds typically impose a load of 20% on the first 3x DPI and 25% on distributions above that.
General Partners are required to make a financial commitment, or “GP commits,” to a fund. This averages 1–2% over time. Therefore, it is essential for GPs to have some financial stake in the venture and for their motivations to align with those of their limited partners (LPs).
Nonetheless, many GPs find it difficult to donate even 1%. This is especially prevalent among new managers who need more capital to put $100,000 (or 1%) into a fund with a lower target return target, such as $10 million. Fortunately, we’ve seen LPs loosen these regulations, realizing that it’s not the absolute monetary amount Simple Agreement for Future Equity (SAFE)
Waterfall distributions refer to the sequence in which returns are paid out to different investors in a fund. It explains how earnings are distributed among the various categories of investors.
LPs often get an amount equal to or greater than their contributed money before GPs. As soon as the fund returns 1x DPI, the GPs are “in the carry” and begin receiving distributions according to the carrying structure they agreed upon.
The fund will invest its whole corpus over the deployment term. The average deployment period for conventional funds is 18–36 months.
Assets Under Management (AUM)
A venture capital company’s assets under management (AUM) are the whole sum of its financial resources. So instead of considering only the value of a single fund, it feels the value of all funds managed by the same fund manager.
Simple Agreement for Future Equity (SAFE)
To attract investors for a future equity round, a SAFE might guarantee them the right to buy a certain number of shares at a certain price or discount. At the time of the first investment, there is no set per-share price.
They are a quick and easy method to raise capital for a startup. Y Combinator first launched the SAFE in late 2013; since then, it has been the go-to method for funding startups.
Convertible notes are a form of short-term debt that can be exchanged for equity later. Depending on the note’s ceiling or discount, the debt may automatically convert into shares of preferred stock upon the closure of a later round of funding. Convertible notes, like SAFE agreements, simplify the negotiation of legal terms for seed funding.
Simple Agreement for Future Tokens (SAFT)
Financial institutions that foresee the widespread adoption of digital tokens may offer SAFTs to investors. It’s similar to a SAFE in streamlining the legal negotiating process.
A token warrant is a form of investment collateral that provides the buyer the right to buy a certain number of tokens at a specified price at some point in the future.
In the event of a liquidation, the amount that investors would get before any other shareholders will be determined by the Liquidation Preference (i.e., the company is acquired or IPO). So it’s a contract between a company and an investor.
It is often stated as several times the starting capital. For instance, if one shareholder has a liquidation preference of 2x, they will get a payment equal to twice the amount of their initial investment before any payments are made to shareholders lower on the preference stack. It is important to remember that creditors usually have higher priority than shareholders.
Liquidation preference structures are rarely requested by early-stage investors.
A ratchet prevents early investors’ stakes from being diluted during future fundraising rounds with reduced entry fees.
With “full ratchet” protection, if a later investor purchases shares in a firm at a lower price per share, the original investors’ purchase price will be adjusted to reflect the new lower price.
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.
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.