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The Most Common VC Definitions Beginners Don’t Know

If you’re new to venture capital or venture capital SPVs then this article is for you.

In the fast-paced world of venture capital, it's easy to operate within an echo chamber where industry terminology feels like common knowledge. However, my recent interactions have provided a reality check: even highly accomplished professionals often encounter challenges with fundamental VC concepts.

A particularly enlightening moment occurred during a Deal Sheet call with a Wharton MBA candidate. Despite their very credible background, they were uncertain about their status as an accredited investor and the qualification process. This wasn't an isolated incident - similar conversations happen regularly.

Common questions frequently arise around terms that seasoned VC professionals use daily:

• "What qualifies someone as an accredited investor?"

• "Why did a founder choose a SAFE over a Convertible Note?”

• "How do pro-rata rights function in practice?"

These interactions highlighted a clear need for accessible educational resources. In response, we've developed a comprehensive guide covering 14 essential VC terms that new investors frequently encounter but might hesitate to ask about. This resource aims to bridge the knowledge gap for newcomers to the venture capital ecosystem.

If you want a more detailed education I refer you to Venture Deals - it’s one of the best starter books to quickly get educated on all things VC terminology. 

1. Accredited Investor

An accredited investor is an individual or entity that meets specific financial criteria set by securities regulators. Accredited investor status is important because it allows individuals to participate in certain private investment opportunities (like startup investing) that are not registered with financial authorities. In the United States, the Securities and Exchange Commission (SEC) defines an accredited investor as:

• An individual with an annual income exceeding $200,000 (or $300,000 combined with a spouse) for the last two years, with the expectation of the same or higher income in the current year.

• A person with a net worth exceeding $1 million, either individually or jointly with a spouse (excluding the value of their primary residence).

• An entity with total assets in excess of $5 million, not formed specifically to purchase the securities offered.

• Professional certification: Hold in good standing certain professional licenses like Series 7, Series 65, or Series 82. Yes, you do NOT need to meet income or worth thresholds if you hold one of these certifications. 

• Many more as displayed via the SEC website here

As you can see in 2024, there is no shortage of ways to become an accredited investor. If you’re of wealth ($1m+ net worth or annual income exceeds $200k for the last two years), then lucky you - you’re likely accredited. If you're not accredited based on income/wealth, just take either the Series 7, 65 or 82. You can pass the Series 65 or Series 82 with two weeks of intensive studying. They are not expensive exams - the Series 82 costs only $60. 

2. SAFE (Simple Agreement for Future Equity)

A SAFE is a financial instrument commonly used in early-stage startup funding and an alternative instrument to a priced equity round. It stands for Simple Agreement for Future Equity. Key points about SAFEs include:

• It's an agreement between an investor and a company that provides the right for the investor to receive future equity in the company.

• Unlike convertible notes, SAFEs are not debt instruments and do not accrue interest.

• They typically convert to equity when a specific triggering event occurs, such as a priced funding round.

The most common trigger for a SAFE conversion is when the company raises a priced round of financing (e.g., Series A). The SAFE converts at either the valuation cap (the max conversion valuation) or at a discount (typically 10-30%) to the new round price, whichever is more favorable to the investor.

Founders typically like SAFEs for their Simplicity: SAFEs are typically simpler and shorter documents compared to convertible notes or priced equity rounds, and Speed: The simplicity of SAFEs often leads to faster negotiations and closings, allowing founders to receive funding more quickly and much cheaper with minimal legal fees relative to a priced financing. 

Investors like SAFEs because the valuation cap provides downside protection and potential for greater equity if the company's value increases significantly, and their Simplicity: Like founders, investors often appreciate the straightforward nature of SAFEs. They’re quick and cheap to get done. 

Primary risk for founders is dilution when multiple SAFEs convert. For example: A startup issues $2M in SAFEs at a $20M cap. If the next round is priced at $10M, the SAFE holders would convert at $10M (not $20M), receiving a proportionally larger ownership stake than if the company had hit or exceeded the cap valuation.

3. Valuation Cap and Conversion Price

In reference to the above, a valuation cap sets the maximum company valuation at which an investment (in a SAFE or convertible note) will convert to equity. For example:

• If a SAFE has a $5 million valuation cap and the company raises a round at a $10 million valuation, the SAFE holder's investment will convert as if the company valuation was $5 million, giving them more shares.

The conversion price is the price per share at which the investment converts into equity. It's calculated by dividing the valuation cap by the company's fully diluted capitalization. 

4. Convertible Note

A convertible note is a short-term debt that converts into equity, typically in conjunction with a future financing round. Unlike a SAFE or preferred equity, a convertible note:

• Is a debt instrument that accrues interest

• Has a maturity date

• May include a discount on the price of shares in addition to a valuation cap

Convertible notes are often used in funding as they postpone the need to determine a specific valuation for the company.

Convertible notes offer several key advantages over SAFEs despite being more complex. Since notes accrue interest that converts to equity, investors get additional shares for their early risk-taking. The defined maturity date provides investors with a clear timeline and protection, forcing either conversion or repayment. 

As a founder, a convertible note can be strategically advantageous because it gives your startup more flexibility around raising funds from traditional or institutional investors who might be hesitant with SAFEs. By offering interest and a maturity date, you're creating a more attractive investment package that can help secure funding from conservative or experienced investors.

5. Expected Dilution per Round of Financing

Dilution occurs when a company issues new shares, reducing the ownership percentage of existing shareholders. The expected dilution can vary by funding stage:

• Seed Round: Typically 15-25% dilution

• Series A: Often 25-35% dilution

• Series B: Usually 15-25% dilution

• Later Stages: Can range from 10-20% dilution per round

These are general guidelines and can vary significantly based on the company's performance, market conditions, and investor demand, but this is worth noting because new investors don’t realize just how much dilution they will face. Dilution tends to be worse in biotech, where there’s significant funding required for clinical trials, and for capital inefficient businesses or R&D heavy businesses. 

6. Option Pool

An option pool, also known as an employee stock option pool or equity incentive pool, is a portion of a company's shares reserved for future issuance to employees, advisors, directors, or other service providers. 

Key aspects of option pools:

1. Purpose: The primary purpose of an option pool is to attract and retain talent by offering equity incentives. It allows startups to compensate employees with potential upside in the company's success, often offsetting lower salaries compared to established companies.

2. Size: The size of an option pool typically ranges from 10% to 20% of a company's fully diluted equity, depending on the company's stage and hiring plans. Early-stage startups might have larger pools to accommodate future hires.

3. Creation and Expansion: An initial option pool is usually created before or during the first round of funding. It may be expanded in subsequent funding rounds if necessary.

4. Pre-money vs. Post-money: The timing of when the option pool is created (or expanded) can significantly impact founder dilution:

   • Pre-money option pool: Created before a new funding round, effectively diluting only the existing shareholders (typically founders).

   • Post-money option pool: Created after a new funding round, diluting both existing shareholders and new investors.

5. Vesting: Options from the pool are typically subject to vesting schedules, often over four years with a one-year cliff. This incentivizes employees to stay with the company long-term.

Option pools are relevant for new investors because they are often a hidden source of dilution that new investors don’t factor in. 

7. QSBS (Qualified Small Business Stock)

QSBS refers to stock in certain qualified small businesses that, if held for at least five years, may be eligible for significant tax benefits under U.S. tax law. Key points include:

• Up to $10 million in capital gains or 10 times the adjusted basis of the stock may be excluded from federal taxation

• The company must be a C-Corporation with gross assets of $50 million or less at the time the stock was issued

• The company must meet certain active business requirements

For example, an investor with a $3M gain from qualified QSBS could potentially pay zero federal capital gains tax, while that same $3M earned as salary would face ordinary income tax rates up to 37% plus additional employment taxes. Most early-stage U.S.-based C-corp startups qualify for QSBS treatment, making it a valuable consideration for startup investors.

8. Carried Interest

Carried interest, often called "carry," is a share of the profits of an investment paid to the investment manager as a form of compensation. In VC:

• It's typically 20% of the fund's profit

• It aligns the interests of the VC firm with its limited partners (LPs)

• It's often structured to only pay out after the LPs have received their initial investment back plus a preferred return

Carried interest is controversial because it's often taxed at capital gains rates (taxed at 0%, 15% or 20%) rather than as ordinary income (taxed up to 37% for highest earners). 

9. Pre-money vs. Post-money Valuation

These terms refer to a company's valuation before and after receiving investment:

• Pre-money valuation: The company's value before receiving new investment.

• Post-money valuation: The company's value after receiving new investment.

For example, if a company has a pre-money valuation of $4 million and receives $1 million in investment, its post-money valuation would be $5 million.

10. Term Sheet

A term sheet is a non-binding document outlining the basic terms and conditions under which an investment will be made. It typically includes:

• Valuation

• Investment amount

• Investor rights

• Voting rights

• Board composition

• Liquidation preferences

While not legally binding, term sheets set the stage for more detailed legal documents.

11. Pro Rata Rights

Pro rata rights give investors the option to maintain their ownership percentage in subsequent funding rounds. This allows them to avoid dilution by participating in future rounds proportionally to their current stake. We put out a whole topic covering pro-rata rights and how they are often “earned” despite being given - more on that here if you’re interested. 

12. Common vs. Preferred Shares

Understanding the difference between common and preferred shares is crucial in startup financing.

Common Shares

• Basic ownership in the company

• Typically held by founders, employees, and sometimes early investors

• Come with voting rights

• Last in line for payout in a liquidation event

Preferred Shares

• Usually held by venture capital and institutional investors

• Come with special rights and privileges:

  1. Liquidation Preference: Paid out before common shareholders in a sale or liquidation (usually 1.0x, but can be 2.0x or more in distressed companies) 

  2. Conversion Rights: Can be converted to common shares

  3. Anti-dilution Protection: Safeguards against dilution in down rounds

  4. Potential Dividend Rights: May receive dividends before common shareholders

Key Differences

1. Liquidation Preference: Preferred shareholders get paid first in an exit.

2. Downside Protection: Preferred shares offer some protection if the company doesn't perform well.

3. Voting Rights: Common shares usually have voting rights, while preferred may or may not.

13. Secondary vs. Primary Transactions

Understanding the difference between secondary and primary transactions is crucial in the startup investment landscape.

Primary Transaction

• New shares are issued by the company

• Capital goes directly to the company's balance sheet

• Increases the company's total number of outstanding shares

• Typically used for funding growth, operations, or expansion

• Dilutes existing shareholders' ownership percentages

Secondary Transaction

• Existing shares are sold from one shareholder to another

• Money goes to the selling shareholder, not the company

• Does not change the company's cap table or total shares outstanding

• Often used by early investors or employees to gain liquidity

• Does not dilute other shareholders

Key Differences

1. Cash Flow: Primary brings money into the company; secondary provides liquidity to existing shareholders

2. Dilution: Primary dilutes existing shareholders; secondary does not

3. Purpose: Primary typically funds company growth; secondary offers investor/employee liquidity

4. Valuation Impact: Primary directly impacts company valuation; secondary may indirectly affect perceived value

14. Venture Performance 

Understanding how venture capital performance is measured is crucial for both investors and entrepreneurs. Here are four key metrics used in the VC industry:

IRR (Internal Rate of Return)

IRR is a metric used to estimate the profitability of potential investments. It's the discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

Key points about IRR:

• It takes into account the time value of money

• Higher IRR indicates a more desirable investment

• It's useful for comparing investments with different cash flows and timelines

• However, it doesn't consider the absolute size of the investment

Example: An IRR of 25% means that the investment is expected to grow at a compound annual growth rate of 25%.

TVPI (Total Value to Paid-In Capital)

TVPI, also known as the investment multiple, measures the total value created by an investment relative to the amount of capital invested.

TVPI = (Current Value of Investment + Distributions) / Paid-In Capital

Key points about TVPI:

• It provides a snapshot of the investment's performance at a specific point in time

• A TVPI of 3.0x means that for every dollar invested, the total value (including any distributions and current value) is now worth $3

• It doesn't take into account the time value of money

MOIC (Multiple on Invested Capital)

MOIC is similar to TVPI but typically refers to realized returns on exited investments.

MOIC = Total Value Realized / Total Capital Invested

Key points about MOIC:

• It's straightforward and easy to understand

• Like TVPI, it doesn't account for the time value of money

• It's often used to quickly communicate the success of an individual investment

Example: An MOIC of 5x means that the investment returned five times the initial capital invested.

DPI (Distributions to Paid-In Capital)

DPI measures the ratio of money distributed back to investors relative to the amount of capital paid into the fund.

DPI = Cumulative Distributions / Paid-In Capital

Key points about DPI:

• It focuses on actual cash returned to investors

• A DPI of 0.5x means that half of the invested capital has been returned to investors

• It's particularly useful for understanding the actual liquidity generated by investments

• However, it doesn't account for the unrealized value still held in active investments

TVPI and IRR were metrics that got completely distorted during the 2021 bubble as it turned out most of the most markups ended up being worthless - those private companies valued at $1B+ in 2021, may be worth a small fraction of that or nothing today. As a result of this market distortion, there’s been an emphasis on “real markups” and DPI (i.e. real distributions). 

This article could have been the length of an entire book, but to start, we wanted to focus on terms you will likely see all of the time as new investors. Part 2, 3, 4, 5, etc. certainly to come on this topic. Let us know what other definitions to cover in detail and we’ll include it in a follow-up. 

If you enjoyed this article, feel free to view our prior issues on adjacent topics

• Breaking Down the Secondary Transaction in Venture Capital

• Understanding GP Authority and LP Rights in SPVs

• The Pro-Rata Trap: How VCs Lose Millions on Their Biggest Winners

Last Money in is Powered by Sydecar

Sydecar empowers syndicate leads to manage their investments more effectively. Organize, manage, and engage your investor network effortlessly with Sydecar’s management and communication tools. Their platform also automates banking, compliance, contracts, tax, and reporting, freeing up syndicate leads to focus on securing deals and strengthening investor relations. Elevate your syndicate operations with Sydecar.

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✍️ Written by Zachary and Alex