We all know that investing in startups is not easy. It is not because of the lack of funds but because of the jargon that is present at each step. A common investor is afraid because they do not understand the meaning of the most commonly used terms. Here are some of the most commonly discussed terms that we believe everyone should know of:
- Accounting Rate of Return: Accounting Rate of Return or ARR is the formula that calculates what percentage of return is expected from a project or an asset compared with the initial investment. It simply divides the profit derived from a particular asset or project and the initial outlay. It does not take the time at which the profits are flowing in. It is used to calculate a potential project’s profitability as takes into account all the possible expenses such as depreciation. It is useful in making decisions concerning investments and acquisitions.
- Internal Rate of Return: Internal Rate of Return or IRR is one of the most commonly used metrics to estimate the financial viability of a project. It is the minimum rate of return that every investor desires. It equates all the cash inflows with the cash outflows after taking into the consideration time value ofmoney. Time Value of Money is the value of a certain amount for a certain time. It is based on the
assumption that money loses value with time. Though Many businesses use IRR many times, in startup culture, investors use it to calculate whether they should invest their funds in a particular startup or not, or if an investor has multiple options, in
which startup should they invest. An ideal rate of IRR can be anything depending upon the cost involved and the industrial nature.
However, one rule always remains the same i.e., the higher the IRR, the better it is! - Net Present Value: With IRR, another term comes into the picture i.e. Net Present Value or NPV. It is the difference between the present value of cash inflows and the present value of cash outflows over some time. It is widely used in capital budgeting and taking investment-based decisions. It is based on the time value of money as the future cash flows are converted to present cash flows using discounting. The rate at which discounting is derived from the cost of capital or a minimum rate of return which a
company generally desires on its project. Investors invest in a project if its NPV is positive. It depicts that the project is profitable and generates significant returns. The only limitation is that it relies on a lot of assumptions and estimations, which generates room for
errors. To avoid this, businesses or investors have to exercise due diligence. - Pre-Money and Post-Money Valuation: These terms are handily used in the startup culture. Pre- Money Valuation is the value of the startup before funding in any round. It is the value of a startup before any investment. It gives an idea to the investor about the worth of the startup. On the other hand, post-money valuation is the value of the startup after the investment or latest capital injection in any startup. It is important to know which of them is being referred to when someone talks about valuation as both are important.
- Burn Rate: As the name depicts, it is the rate at which a new venture or a startup is burning or losing money. The money is used to finance overhead expenditure when the venture is not earning anything. It is generally quoted in terms of cash spent per month or per week. It can be also used as an ultimatum like till what time the company will run off of its funds. If the firm’s burn rate exceeds the revenue forecasts and the company will run of the funds, then a startup must cut its cost and rethink the financial viability of the business.
- CCPS: Compulsorily Converted Preference Shares or CCPS are the instruments that compulsorily convert into the equity shares of the issuing at some pre-determined conditions. It is an anti-dilution or a hybrid instrument as the holders are benefitted by maintaining the equity stake whenever the company issues new equity shares to any investor or during any specific events. Events can be the next round of funding, mergers, and acquisitions, or IPO. These are the most preferred instruments for Private equity firms, which link the conversion of CCPS to the performance of the company. If the company does not perform well, they reserve the right to increase their stake in the startup.
- Discount Rate: When CCPS are converted, they are not converted on their face value. Since investors take risks in backing the startup early, a discounted price is given to them. The discounted price reduces the value of the share for them so that they get additional shares when the instruments are converted. The general discount rate is between 15 to 30 percent.
- Valuation Cap: Many investors are not happy with the idea of a discount when the startup does exceedingly well because they will be off with the fixed discount rate and are not going to get any benefit from the high valuation. To cover this drawback of Discount Rate, Valuation Cap plays a major role. It entitles the investors to equity priced at a lower valuation cap or the pre-money valuation (the one with the discount rate). So, if the company reaches a decided valuation after investment, CCPS is converted on even cheaper prices as if the current valuation is the original one.
- Cap Table: It is a record that depicts the capitalization of a startup or any other company. It is an inclusive breakdown of the shareholders’ funds of a particular startup. It shows which investor owns what kind of equity (Common equity, preferred equity, share warrants, convertible equity).
- Carried Interest: It is a percentage share of profit that the investors have made from their investments in startups. Generally, it is money that venture capitalists or private equity funds make for their investors, when they exit or the startup goes for an IPO. However, it is only paid when the valuation reaches a certain threshold as decided by the concerned parties.
In case you have any other queries, feel free to reach out to us at [email protected]. We all will be happy to help you out in every possible manner.
