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
- 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
- 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"
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
- 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.
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.
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.
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.
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 Factor (Annuity) (L,i) x R
$500,000 = PV Factor (Annuity) (10 yrs., i?)
- 2. Rearrange formula
- PV Factor (Annuity) (10
yrs., i?) =
- 3. Look up PV table for 5.000 at 10 years to find
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
- 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.
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.
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
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.
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.
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"
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
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
- 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
million - $3 million) X 100%
10% annual ROI
The annual calculation is a "simple average"
ROI percentage. A "compounded" rate of
return would be a slightly lessor amount.
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.
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
A legal document by which investments are purchased,
containing important details about the nature of
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.
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.