Angel investing is an increasingly common practice among high-net-worth individuals. But many would-be angels lack a true insider's vocabulary - and the savvy that goes with it. Do you know the difference between a "burn rate" and a "burn out"? The pros do, and so should you if you're looking to invest in a start-up.
What then, in plain English, are all these venture capitalists talking about?
To begin, remember that pricing private investments on a per-share basis does not make much sense since the start-up company's shares do not trade. As a result, the convention is to value an emerging company as a whole - the so-called "pre-money" valuation. If, say, a company is given a pre-money valuation of $5 million and investors put up an additional $5 million, then the "post-money" valuation is $10 million (pre-money valuation plus the $5 million invested).
Typically, in return for their cash, the new investors obtain securities equivalent to 50 percent of the outstanding stock of the company ($5 million investment divided by the $10 million post-money valuation).
Round and Round
Early-stage companies pass through three initial rounds of financing: the so-called "Rolodex round;" the "seed round" or "angel round;" and the "first venture round." In the Rolodex round, as the name implies, the company founder taps friends, family, and colleagues for capital, generally in the vicinity of $500,000. Based on an unwritten rule of venture capital, the company is usually assigned a pre-money valuation of $1 million at this stage, although, under some market conditions, it can run higher.
If the company's concept holds promise, the founder will seek to tap high-net-worth angel investors for the capital required to prove the concept works. This "seed" or "angel round" is used to raise capital prior to the production of a working model or prototype. If the high-net-worth individuals attracted to the seed round make several investments, they are labeled "serial angels."
Ordinarily, angels will contribute no more than $1 to $1.5 million to the company, and the pre-money valuation at this point is usually no greater than $3 million. Aspirations in excess of this amount at the angel round used to be unrealistic. But new media and e-commerce companies have defied the traditional methods of valuation, and angel rounds have raised in excess of $5 million.
Most professional venture capitalists enter the picture for the next round, known as the "first venture round," the "first professional round," or the "Series A," when the valuation hits between $5 and $15 million. One last "mezzanine round" of professional financing may follow, often at a relatively high price, when public markets are robust and investors sense an easy IPO or sale could be just around the corner. This financing is meant to directly precede the occasion on which the founder and investors become "liquid" through an IPO or a company sale (also known as a "liquidity event").
Pitfalls on the way to the Holy Grail
Measures taken to gain liquidity are referred to as "exit strategies" - the holy grail of venture capitalism.
Of course, there are many pitfalls for potential investors along the way. One of the most critical elements for a start-up is the so-called "burn rate," the rate at which the company incurs expenses, usually expressed on a monthly basis (also known as the "cash out the door" rate). If the burn rate is too high, the start-up could run out of cash and be forced to fold - a phenomenon that has hit a number of high-profile start-ups in recent months.
This term should be distinguished from "burn out" (or "cram down"), which occurs when the percentage interests of the founders and their angel co-investors are diluted by rounds of financing at a low share price in which they do not have sufficiently deep pockets to participate (also known as "down rounds").
These are just a few of the shorthand terms used by venture capitalists. Learn them and you'll be talking like a pro in no time.