Lexicon for Private Equity Investment

The purpose of this lexicon is to provide context for some of the terms used in this document. These are not intended to be precise definitions.

  • board of directors
    The group of people, elected by the shareholders of a company, who make major decisions regarding the conduct of the company's business. Directors have a duty to shareholders to manage the affairs of the business in a prudent manner. Control of the board of directors is often a key issue in private venture investing.
  • burn rate
    The amount of overhead and other costs in excess of revenue that a business will incur, usually considered on a monthly basis. Typical of a start-up business, the burn rate is extremely critical for the investor, as it will dictate how long the business or project can survive on available cash resources. The burn rate should be established in advance and monitored very closely.
  • business plan
    In a nutshell, the business plan should clearly explain the what, why, when, who and how of the project. It should be a comprehensive explanation of the opportunity, the people involved, the money required to implement the plan, where it will come from and what financial results the opportunity is likely to produce.
  • carried interest
    A term often used to describe the interest that the founders will be given in a project. This is to recognize the value of the idea and concept behind an opportunity. It also should identify the non-cash contributions the founders have made to the project. Investors in a project should carefully consider the extent to which their investment, usually paid for with cash, will be diluted by the carried interest (usually issued for non-cash consideration).
  • closing of an investment
    The specific date and process by which cash is invested, share certificates (or other documents evidencing the investment) are issued and agreements are signed. Often conditions are set by both sides in the course of negotiating an investment, and dates by which the conditions must be met or waived are set, allowing for a more orderly negotiation. Any questions or uncertainties about making an investment should be resolved prior to closing.
  • common shares
    The class of shares in a company that typically carry the voting rights to elect the directors and participate in the growth of a company; although other investment vehicles (preferred shares, convertible debt and others) can have the same features. In the event of a liquidation of a company's assets and for other purposes, common shareholders always rank behind other types of shares. They also provide the ability to make claims on residual assets after everyone else has made their claims. The trend in venture investing today is to move away from investment strictly in common shares, towards some sort of "hybrid instrument" (see below).
  • competitive advantage
    Perhaps one of the most important aspects of a business plan. How will the product or service gain market share, recognizing that it is not good enough to be only as good as the competition, it will have to be better. However, in commodity-based investments like agriculture, competitiveness may be viewed more from an internal point-of-view than external. Claims of competitive advantage should be fully reviewed and challenged.
  • confidentiality and non-disclosure agreement
    A formal agreement that potential investors are often asked to sign prior to being provided with information about a business opportunity. This is a standard practice that a potential investor should expect, as long as what is being signed is clearly understood. The potential investor should be particularly cautious in signing this type of agreement if the investment project is in any way related to an existing business that the investor may own.
  • contingent remuneration
    That portion of future remuneration (to be paid to a founder for example) that will be based on profitability of the project or business. It is often used to deal with a situation where the founders want a larger carried interest than the investor is prepared to agree to. Contingent remuneration can be paid in cash, equity, or some combination thereof, with the common thread being the fact that it is based on future achievement, usually the accomplishment of predetermined milestones or level of results.
  • convertible debt
    A term used to describe debt financing that has a feature allowing the debt to be converted to equity, often at the option of the investor, in the event of a default on repayment terms. Other times the conversion feature can be granted as a "sweetener", providing the investor with the option of converting debt to equity if results are good. Sometimes the investee company can have the option to convert the debt. There is often little distinction between certain convertible debt and certain types of preferred shares, both often referred to as "hybrid investment" vehicles.
  • debt
    Typically an investment that is written on terms similar to a bank loan. The debt will usually specify the nature of security for the debt, an interest rate and repayment terms. Straight debt is not often used in venture investing. If debt is used in venture investing, it most often contains terms and provisions that make it a hybrid of debt and equity.
  • due diligence review
    The formal process of validating representations made during an investment investigation. Lawyers often are involved to perform company searches and background checks on the founders. Accountants often review historical financial statements and tax filings, as well as review the accuracy and suitability of financial projections that form part of the business plan.
  • employment contracts
    A very important aspect of a venture. Investors in particular want some commitment that key employees are tied to the business or project by contract. Although it is often difficult for the employer to enforce the terms of employment contracts, to make an investment without key employees being committed to contracts would be ill-advised. Employment contracts should clearly define: term, remuneration, duties, confidentiality issues, conflict of interest guidelines, termination provisions and other relevant details.
  • entrepreneurs
    A widely applied term, often used to describe passionate business types that are prepared to go to the ends of the earth to make a business or project succeed. The term also has come to mean almost any business person in any size or stage of company, dedicated to acting dynamically with an open mind in pursuit of a corporate mission.
  • equity
    Funds are typically advanced by investors to a venture by equity, debt or a combination thereof. An investment vehicle that combines elements of debt and equity is often referred to as a "hybrid investment". Equity is the broad term usually used to describe share capital of various types that a company could issue. When used in the context of shareholders equity, the term would include the money paid in for shares plus the retained earnings of a company.
  • formal offering document
    Usually developed in accordance with detailed securities rules, the formal offering document is often complex with serious legal overtones. Most investment opportunities in the public equity markets are accompanied by this type of document. Many venture investments are promoted by an offering document of some sort as well. The offering document is a very important item in any investment, detailing many key structural aspects of the invest opportunity.
  • founders
    A term used to describe the people who have played a key role in bringing an opportunity to the stage of seeking investment capital. Founders are often looking for a carried interest in the venture to recognize the tangible and intangible contribution they have made to the project.
  • historical financial information
    Financial statements, income tax filings and other documents that detail financial history. Financial statements reported on by independent accountants can have varying degrees of assurance added by those external accountants. The assurance depends on whether the accountants have "audited", "reviewed" or simply "compiled" the financial statements.
  • intermediaries
    A term used to describe people or companies that raise funds for ventures, almost always being paid a commission or other form of success fee when the money is raised.
  • Internal Rate of Return (IRR)
    A method to analyze investments which reflects and accounts for the time value of money. IRR is the discount rate which makes the net present value of revenue flows equal to zero or the investment equal to the present value of revenue flows. To calculate IRR often requires the use of Present Value (PV) tables which are available in most business management textbooks. A simple example calculation of IRR is:
  • A producer is considering making an investment (I) of $500,000 with anticipated annual revenue (R) of $100,000.
    PV = present value
    i = internal rate of return (IRR)
  • 1. Calculate the percentage rate (i) or IRR where I=PV.
    I=PV Factor (Annuity) (L,i) x R
    $500,000 = PV Factor (Annuity) (10 yrs., i?) X $100,000
  • 2. Rearrange formula
    • PV Factor (Annuity) (10 yrs., i?) =
    • $500,000
    • = 5.000
  • 3. Look up PV table for 5.000 at 10 years to find i (IRR).
    i = ~ 15%
  • 4. Therefore, on this investment, the IRR is approximately 15%. Often in making a decision, investors will compare IRR to the cost of capital (interest or opportunity cost) to determine if it is a viable investment or not. Of course, risk must also be factored in when making a decision on any investment.
  • As stated above, this is a simple example. When inconsistent or irregular cash flows over time are considered, this process becomes more complex. For this document, the above example illustrates IRR.
  • investor cash calls
    A practice followed with some venture investments whereby investors can be called upon to advance more money into a project, most often upon certain conditions being met or project milestones being accomplished. This is a potential deal structuring concept to be dealt with c cautiously. Structured correctly a staged investment plan can be an effective tool to ensure that the founders are meeting their targets.
  • investor liquidity strategy
    Quite simply, the liquidity strategy details how the investors will get their money out of the venture in the future.
  • joint venture
    A structure often used to pursue a one-time project with a specific target wind up date. A joint venture is generally not recognized as a separate legal entity, as opposed to a partnership which is. Revenues, expenses and asset ownership usually flow through a joint venture to the participants since the joint venture itself has no legal status. Partnerships and joint ventures can appear to be very similar but in fact can have significantly different implications for those involved.
  • limited company
    The most common form of business structure, the limited company is characterized by limited liability for shareholders (i.e. a shareholder's liability is usually limited to the amount of their investment in the company). It is a separate entity for income tax and legal purposes. The company usually elects a board of directors to run the business.
  • limited partnership
    A partnership (see below) in which certain partners are afforded limited liability, with such limited liability usually being the amount of their investment. The partnership is usually run by a general partner who does not have limited liability. Like a regular partnership, this is a separate legal entity but revenues, expenses and certain other financial transactions and income tax related amounts "flow through" to the partners. This type of structure is often used for tax shelter investments.

    money market
    Generally means the vast array of financial products that earn interest (as opposed to capital gains or dividends) for the investor, although many variations of this type of investment exist. T-bills, most bonds, GIC's and the like would be characterized as money market investments. A money market rate of return is a term often used to describe a low risk rate of return available to an investor. partnership

    Like a limited company, but unlike a joint venture, a partnership is a separate legal entity. Partnership law is complex and in many cases partners can find themselves liable for debts of the entire partnership (see comments above on limited partnerships). For this reason alone, regular partnerships typically are often not used in venture investing. Reporting on financial returns for income tax purposes is also very different between a partnership and a corporation.

    Usually expressed in number of years, payback is calculated as the investors cumulative share of earnings over a period of time divided by the amount of the original investment. The length of an acceptable payback period varies from investor to investor and from project to project.

    preferred shares
    A special class of shares in a company that could have a variety of features. Preferred shares often have a fixed dividend rate, always rank in preference to common shares and are convertible into common shares upon the occurrence (or non-occurrence) of future events. Preferred shares can be voting or non-voting, and usually do not participate in growth in equity in the same manner that common shares do. It is often difficult to distinguish differences between certain preferred shares and hybrid debt instruments.

    professional advisors
    Seldom does a venture get to the point of being ready to accept outside investment capital without the assistance of qualified professional advisors. Accountants, lawyers, consultants, engineers and others are often a crucial part of the team. You can often tell a lot about a venture by the "company" it keeps.

    projected financial information
    A future oriented portrayal of some or all of the anticipated earnings, cash flow and financial position of a venture. Created using a set of assumptions, the projected financial information is usually prepared to demonstrate potential. While the credibility of projected financial information can be established to some degree by evaluating the validity of the underlying assumptions, it is important to recognize that projected financial information is built on "what if scenarios".

    The certainty that can be brought into historical financial statements through verification (by an audit for example) cannot be obtained with projected financial information. Thus, assessing the appropriateness of the underlying assumptions of the projected financial information is of paramount importance.

    The person or company that is promoting the investment. This term has certain legal meanings under securities law, but is generally used to describe anyone who has a vested interest in raising investment capital for a venture, either because they are a founder or because they are being paid a commission on the funds raised.

    A complex and comprehensive document that accompanies many large investment offerings, prepared primarily to enable the investment to be bought and sold without restriction. Costly to produce, a prospectus is seldom prepared in private company investments. Business plans, project summaries and other such documents are often called a "prospectus", however these documents would not generally meet the standards for a prospectus as defined in securities law. The prospectus provides full disclosure of information related to the investment particularly the standards used. It makes no comment on how good the investment is.

    public equity markets
    A general term to describe the "place for investing funds in publicly traded companies". This could mean individual companies listed on a stock exchange, mutual funds that invest in public companies, or other similar types of investments. The common denominator for investments on this type would be the linkage to a public stock exchange, generally an indication that the investment has met the prescribed, and often rigorous, standards of a stock exchange listing. Many of these standards are designed to protect the investing public by ensuring full disclosure of all significant matters.

    return on investment (ROI)
    A term used for calculating the return, usually expressed as an equivalent annual percentage, on the amount invested in a venture. A simple example will illustrate one approach to calculating ROI:

    • Investors put up $4 million
    • Over the first three years of operation the company loses $3 million
    • In the next two years the company makes a profit of $5 million
      The ROI for this investment at the end of five years is:
($5 million - $3 million) X 100%
5 years

$4 million
= 10% annual ROI

The annual calculation is a "simple average" ROI percentage. A "compounded" rate of return would be a slightly lessor amount.

share option
A right to acquire shares in the future, usually at a fixed price. Often issued to founders and other key players in the early stages of a company's development. This practice can be good for the company, because issuing relations does not require a cash outlay. Those receiving the options also stand to gain if they can increase the value of the underlying shares. Customarily, share options are used for employee remuneration arrangements. Share options are very similar to warrants, with certain subtle legal differences.

subordinated debt
Debt that has been ranked behind other debt for purposes of security, preference on repayment, or some other term. For example, investors will sometimes invest in debt that has been subordinated to the bank, meaning that the bank gets repaid before the investors.

subscription form
A legal document by which investments are purchased, containing important details about the nature of the investment.

sweat equity
A term used to describe the contribution (other than cash) that founders have made to a project, and for which the founders usually want to get compensated.

unanimous shareholders agreement
A very critical agreement in many cases with private venture investing. This agreement includes bylaws by which a company will be run, as well as dealing with the procedures for buying and selling of company shares; for example, in the event of a shareholder dispute, a death or other such eventuality.

value analysis
Given the risk involved, value analysis is the critical assessment that the venture investor should perform to establish whether the investment is worthwhile. In its simplest form, the value analysis is a calculation of the future estimated value of the venture times, the investor's percentage ownership. This amount is compared to what is being invested.

Similar to options, warrants give the holder the right to buy a share or other security at some future point in time, usually at a fixed price. Often used as a "sweetener" in a deal to entice investors to participate. For example, an investor buys a certain number of shares and gets warrants granting the right to purchase additional shares in the future at a fixed price, if the investor so chooses. Warrants are very similar to share options, with certain subtle legal differences.

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