As a matter of fact, the overall topic of the venture capital industry is not complicated: Start-ups having ideas and specific capital requirements (but currently lacking money) look for investors. Investors can provide capital (and possibly know-how) and receive shares of the company in return or a share of corporate success.
Nevertheless, it is often hard for founders, investors, and journalists to read up on the topic. After all, technical vocabulary and specific terms are to be found in every other sentence and even definitions and dictionaries contain further scientific terminology and specific terms.
To achieve this aim in the best possible way, we decided to organize this extract from our dictionary thematically and not alphabetically (the upcoming venture capital dictionary is an ongoing project).
This is why you will not find a complete dictionary here containing all words, phrases and technical terms which are present in legal provisions and complex securities legislation. However, we hope this resource will somewhat clarify the subject matter for founders, prospective investors, and interested parties.
Venture capital basics
Private equity (PEs) – “private” off-market capital
Private equity in the narrower sense basically means shares of a company which are not traded on a public market (i.e. on a stock exchange). In a broader sense, private equity refers to the entire industry engaged in the purchase and/or sale of non-exchange traded shares. Typically, private equity investors are regarded as capital providers for companies in later stages when the companies have already exceeded a significant turnover and profit threshold.
Venture capital or risk capital is a subset of private equity. Start-ups or companies in the founding phase can also sell corporate shares, of course. The difference in the notion of venture capital is not sharply delimited, but specifically means the share in private equity consisting of early-stage companies not yet generating revenues or profits or companies which produce positive figures for the first time but are still in the midst of their growth phase.
Venture capital companies (VC companies, “VCs”)
Venture capital companies (obviously also private equity companies) are companies founded for managing one or several risk capital funds.
Venture capital funds (VC funds)
Venture capital funds (in principle, the description also applies to private equity funds again) are pools of capital set up by venture capital companies (see the last point). Subsequently, investors can acquire shares in that fund. Usually, these funds have the legal form of a limited partnership in which investors then acquire shares. Ultimately, it is precisely this limited liability company (i.e. the venture capital fund) that buys the shares in a start-up, provided a deal takes place.
This is why it is important to distinguish between a venture capital fund and a venture capital company. The company controls the fund and invests in start-ups on behalf of the fund. By contrast, the fund actually invests in start-ups. The investors who acquired shares to the fund can be institutional investors, family offices or HNWIs (high net-worth individuals).
Venture capital investors for start-ups
Accredited investors are individuals or institutions meeting certain requirements according to national investments laws, e.g. based on net assets or revenues. The rules for defining an “accredited investor” differ from country to country. In Germany, similar investors are referred to as semi-professional or professional investors, for example.
FFF (“Friends, Family and Fools”)
Not every investor must be accredited, because this requirement is basically only important when acquiring fund shares. A start-up may also receive capital from so-called non-professional investors. The famous FFF – i.e. Friends, Family & Fools – providing capital for a start-up company belong to the category of non-professional investors. With a hint of irony, this designation describes the sources of capital: Friends and family because of a close connection to the start-up founder through private, family and friendly relationships but also through professional relationships. The term “fools” refers to the higher than average risk of an early-stage investment in a start-up.
Angel investors or business angel investors (“BAs”)
Angel investors are mostly independent wealthy individuals investing their personal money in start-ups. The term business angels is often used synonymously, but denotes in addition to the previous definition private individuals who have also gained and provide exceptional insights, experience, and connections which can be relevant for the success of the start-up. Typical investment sums of angel investors usually range from five-figure amounts to 500,000 Euros – of course, exceptions always prove the rule.
An accelerator is a program aiming to accelerate the growth of start-up companies by mentoring, procuring connections and providing services and infrastructure (e.g. cost-free provision of office space for a certain limited period) in exchange for a small number of shares in the participating start-up.
Seed investors invest capital in a very early stage of a start-up company and are thus a subset of venture capitalists. In principle, there is no general rule that angel investors exclusively invest in seed rounds and venture capital funds only place the subsequent so-called series A rounds. However, capital requirement is typically lower in an early stage of a start-up, which is why more angel investors are to be found during this period. Venture capital companies, on the contrary, have certain obligations towards their investors so that they often may only join after a certain minimum investment sum has been reached.
Venture capital investors
Venture capital investors are institutional investors who invest in young companies through their fund. In general, they are also the group of investors who invest capital after a seed round (i.e. subsequently to a seed investor). As described above, venture capital investors are a subset of private equity investors, but in American parlance, a distinction is made between a venture capitalist and private equity.
The strategic orientation of a fund may vary considerably. Some VC investors provide capital already in early stages and accordingly place somewhat smaller amounts from 500,000 Euros up to several million Euros. Other VC investors want to see a fully validated business model and in later stages only invest in start-ups which already achieve significant sales and profits. In the latter case, even tens of millions are not an unusual investment sum.
Private equity investors
Private equity investors are institutional investors who compared to BV investors invest large sums of capital in companies in very late stages, for example, to drive expansion plans, to finance M&A activities, to perform a management buyout or a so-called leverage buyout or to make the company fit for going public. With private equity investors, the options are widely varied and depend to a large extent on the strategic orientation of the private equity company.
Corporate Venture Capital (CVC)
More and more frequently, established companies provide capital as well. In most cases, their strategic calculation is different from angel or venture capital investors.
Investments are often made either in young enterprises outside the company or in business concepts which have their origin in the company and are to be promoted in a dynamic way within the framework of a proprietary shareholder structure and with their own team. Another reason for corporate venture capital activities might be that the established company presumes certain market trends it does not want to miss but (preliminarily) wants to keep the product development separate from its own communication and brand. As a rule, corporate VCs have large capital stock and invest through their affiliates, i.e. mostly not through limited partnerships.
Investors investing in investors
Limited Partner (LP)
As mentioned above, a venture capital company does not invest in a start-up itself. The VC company invests on behalf of the venture capital fund, which is usually a limited liability company. Where does the money in the fund come from? This is the job of the venture capital company which does not invest its own capital but the capital of its investors. These investors acquire a share of the fund, i.e. of the limited partnership and are therefore called limited partners (LPs) with respect to their limited liability. These investors can, therefore, monitor the progress of the partnership without taking part in the day-to-day management if they want to keep their limited liability.
Please note: There are many kinds of investors who can become a limited partner in an investment vehicle. In general, they are all considered accredited, i.e. semi-professional or professional investors. The following are some examples of investor types who often invest in venture capital funds.
A family office is a private consulting firm which typically manages the wealth, tax and estate planning of high net-worth individuals and families. Often the capital has accumulated due to successful family-run businesses. For that very reason family offices are keen to invest – but not necessarily – in start-ups coinciding with the industry sector of the family business.
A pension fund is a pooled investment fund run by an intermediary on behalf of a government, a corporation or a company to pay out pensions to the employees later on. Typically pension funds use a portion of their assets as part of their risk capital investment strategy.
The long-term pool of financial assets held by many universities, hospitals, foundations and other non-profit bodies is called endowment fund.
Fund of funds (FOF)
Obviously, funds can invest capital not just in start-ups but also in other funds. An investment vehicle which on behalf of its investors distributes its assets over a series of other funds – and not directly to private companies for example – is referred to as fund of funds in this context.
The venture capital characters
Most junior employees in a venture capital company, most recent graduates, are analysts. The main task of analysts is to create networks in the industry and collect information at inaugural meetings and to analyze and answer capital requests from founders. Often analysts also support the business model analysis, market research, and possibly due diligence immediately prior to an investment.
Associates are mostly on the next higher hierarchical level. These positions are usually “partner careers” and open to university graduates or analysts having worked for the venture capital company for some years already. The employees are usually entrusted with due diligence processes, obtaining progress reports from portfolio companies (i.e. companies held by the venture capital fund) and procuring investment opportunities to the partners taking the ultimate investment decisions.
Principal, Vice President (VP)
A principal is a member of the company management, usually holds some managerial positions in portfolio companies of the fund and provides strategic support or explores opportunities to sell the start-ups. A principal or vice president usually obtains the partner status on the next hierarchical level.
A venture partner is a person who gets a VC company on board to help with investments and their management, but who is not a full and integral member of the partnership. As opposed to entrepreneurs in residence, venture partners generally conclude several transactions for the company during their term.
Basically, partners have a similar function to principals or vice presidents. They sit on the boards of portfolio companies just as often and spend a large portion of their time networking investors, start-ups and potential buyers. However, the partners are also assigned higher level tasks such as identifying emerging technology sectors for the company to invest in, identifying and developing relationships with key players in these sectors, evaluating and communicating the fund performance to limited partners and procuring a further fund every five to seven years.
Venture capital economics and key figures
Term of the fund
Most venture capital funds collect a certain limited amount of money and are established for a specified period of time. Usually, these are closed-end funds, i.e. the limited partners (the fund investors) may not withdraw their capital prematurely. As soon as the target fund size is reached, this capital is managed by the fund mostly over a period of seven to ten years. Fund managers generally have the option to gradually extend the term of the fund by up to two years annually at their own discretion to ensure certain flexibility.
The period of time during which the fund utilizes most of its capital in its portfolio companies – usually five years on average plus an extension option of up to two years.
The period of time during which the fund begins to achieve earnings from its investments through mergers and acquisitions, initial public offerings, technology licensing agreements and by other means.
Internal rate of return
In the context of private equity and venture capital, IRR is the annualized effective return that can be earned on the invested capital. The longer the money is tied up to an investment, the higher is the multiple of the original investment that has to be paid back to achieve a reasonable internal return. So the proceeds achieved are not the only thing that matters, but also how fast the revenues are generated. The success of a venture capital fund is evaluated according to the IRR.
The form of the internal yield curve over the course of the fund life cycle encompassing the investment period as well as the harvest period. The name of the curve derives from its similarity to the letter “J”.
Cash-on-cash return is a simplified return calculation method. It is determined by dividing the entire amount of money received from an investment (or the combination of returned funds and the current portfolio value) by the amount initially committed. A synonymous term is multiple on invested capital (MOIC).
Example: Suppose an investor invests 10 million Euros in a certain portfolio company. And to make things easier, let us also assume that no follow-up investments were made. The portfolio company is subsequently sold and the investor receives revenues of 50 million Euros from the sale. This means that the cash-on-cash return (or MOIC) of the investment amounts to 500%.
Assets under management (AuM)
The overall market value of the financial assets the venture capital fund currently manages on behalf of its limited partners.
The annual fee the venture capital fund charges for its administrative services, typically 2% of the managed assets. Deviations are not uncommon, however. The administrative fee is generally used to pay basic salaries, rents, legal and other service fees, marketing costs and other ancillary costs incurred by the fund in the course of its management activity.
Carried interest or “carry”
The carried interest or “carry” is the fee charged by the fund for profits realized on a certain investment. Usually, the value lies in the range of 20%. The carry serves to reconcile the interests of the limited partners and the personally liable partners managing the fund. There are some financial details to consider, for example when charging a carried interest, but they would go beyond the scope of this dictionary.
The financing round over time
Financing round; funding round
A financing round is a type of offer in which a company receives capital from investors in exchange for equity, as a loan or in another form of financing.
Startup financing is usually done in several rounds or phases. The standard naming scheme provides for each of these rounds to be sequentially identified by a letter from the alphabet, beginning with A. The name of the round is given by the name of the company. The increasing distribution of seed investors has led to a certain confusion about the naming. Some call early placed capital by seed investors “Series Seed”, while others, including the famous US Accelerator Y Combinator, call these rounds “Series AA”.
The principal investor in a particular financing round is referred to as the lead investor. He often accompanies the same company from financing round to financing round.
A syndicate is an association of investors who participate jointly in a particular round.
The valuation of a company before any additional investment in its current financing round.
The product of the price paid per unit in a financing round and the units outstanding after the financing round. The rule of thumb is the pre-money valuation plus the newly invested capital amount. However, this rule of thumb only applies if there are no shares returned or options in play.
Due Diligence (“due diligence”)
The process of closely examining a company before making a final investment, forming a business partnership or other long-term binding agreement. In the due diligence process, target company managers often need to disclose very detailed internal business information in order for an investor to make the most accurate assessment possible. Business information is therefore protected by non-disclosure agreements (NDAs).
Term Sheet; Memorandum of Understanding
A term sheet provides an overview of the structure of a company or share purchase agreement, typically negotiated and agreed before a more formal language is used. So a term sheet is like a letter of intent to take the final step. The share purchase is then formulated in a final binding contract.
Dilution refers to the reduction in the share of a company’s equity attributable to its founders and existing shareholders that is linked to a new round of financing. If a new investor acquires shares in the company, these shares must be released from the previous structure. Existing shareholders have a de facto lower stake in the company as a result of the dilution, but receive new financial resources in return.
Cap Table; Capitalization Table
The cap table is a list that lists all shareholders and investors in a company with their names, percentage shareholdings, share classes and, if applicable, the number of shares held.
Options represent the ability to purchase shares or shares issued directly by the Company at a specified price at a specified time in the future.
A convertible bond is a type of financial instrument that, under certain conditions specified in the investment contract, allows a loan to which the investor (= lender) is entitled to be converted into equity in the company.
Convertible bonds are a common solution to the challenge of valuing the underlying company in view of the high degree of uncertainty at very early stages. This valuation process is more often shifted to Series A investors. Once a valuation for the Company has been determined, the holder of the convertible bond is given the opportunity to convert the outstanding balance of the loan (i.e. the initial principal plus interest accrued during the holding period) into equity in the company in proportion to the valuation of the company. Further details on convertible bonds go beyond the scope of this overview article, but will also be discussed on capmatcher.com in the future.