As an entrepreneur, you need to have a basic understanding of key business terms, even if you have a head of finance and a real estate service professional, along with bankers, lawyers, and accountants in your company. I think it would be very difficult to run a company without a basic knowledge of finance and accounting, but even that isn’t enough. There are specific business terms that have a special meaning in the startup world, and these are the 16 terms that you should get to know quickly when running a startup business.
(1) Return on Investment (ROI)
To calculate the ROI take the total profit and divide it by the total amount of capital that was invested into the company. That equals the return on investment or ROI. “Profit” from an investor perspective is not the income statement profit, it is the sale price of the company, in the event of an M&A (Mergers & Acquisitions) transaction, or the market capitalization of the company in the event of an IPO (Initial Public Offering). The greater your profit is compared to the total amount of funding invested into the company, the higher your ROI will be. Venture capital investors desire a 10X ROI or more for their investments. Ideally, early stage VCs look for 10X to 20X ROI, while late stage VCs are comfortable with a 3X to 5X ROI, since the investment horizon is shorter to liquidity, and the startup has significantly mitigated risk. Take a look at An Inside Look at Venture Capital from the VC Perspective.
(2) Internal Rate of Return (IRR)
IRR is a metric used in capital budgeting measuring the profitability of potential investments. The IRR is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. In the case of venture capitalists, they are targeting an IRR of greater than 30 percent. Where the VC’s ROI expectation changes for early stage investors versus late stage investors, the IRR as a measure of performance is pretty consistent across investment stages. Once of the best articles I have read on this topic is 30% IRR — a primer for first-time entrepreneurs.
(3) Burn Rate
Burn Rate is the rate at which a company spends money, especially money raised from Angel investment or venture capital, in excess of income. If the monthly burn rate is constant, you can tell how many months of “runway” the company has by dividing the amount of cash on hand by the monthly burn rate. Cash management versus accrual accounting is extremely important for startups. Knowing your burn rate is critically important in knowing how much money you should raise in any given financing round. Ideally, a company should raise 18 to 24 months of cash in any financing round. This will allow the company to reach a number of key milestones that result in step function increases in valuation prior to the subsequent investment round.
(4) Fully Loaded Cost per Employee
Understanding your cost per employee is critically important in setting your hiring plan because it is typically the most significant cost in a startup company. The Fully Loaded Cost per Employee includes the persons salary, payroll taxes, insurance, benefits, meals, supplies training costs, tools, and usually an allocation of the office space. Some people do not include the office space because they consider it a fixed cost, but I think it is important to consider that. In the short term, all costs are fixed. In the long term, all costs are variable. Before making any hiring decisions, you should consider the total cost of an employee. Other key considerations are:
- Do you need this position filled long term
- Is the function critical to the company and part of your core competencies
- Is it cheaper to use a contract or outsource the task in a make versus buy calculation
(5) Real Estate Lease Terms: Triple-Net, Full Service Gross, and TIs
I mention these terms because rent is typically the second largest cost for most startups. Knowing the difference between the cost per square-foot of rent can be very important to your burn rate. In a Triple-Net Lease, the structure of lease requires the lessee to pay the net amount for three types of costs, including net real estate taxes on the leased asset, net building insurance and net common area maintenance. This type of lease can also be referred to as a net-net-net (NNN) lease. Keep in mind, in a NNN lease, you have to pay janitorial and utilities separately. Depending on your space, these can be a big component of your overall cost.
In a Full Service Gross Lease, the rent is all-inclusive. The landlord pays all or most expenses associated with the property, including taxes, insurance, and maintenance out of the rents received from tenants. Utilities and janitorial services are included within one easy, tenant-friendly rent payment.
Tenant Improvements, or TIs, are changes made to the interior of a commercial or industrial property by its owner to accommodate the needs of a tenant such as floor and wall coverings, ceilings, partitions, air conditioning, fire protection, and security. Who bears what portion of TI costs is negotiated between the lessor and the lessee, and is usually documented in the lease agreement.
Having a good tenant-only real estate professional in lease negotiations can make a big difference on the costs you will bear on your company facility.
(6) Customer Acquisition Cost (CAC), also knows as the Cost to Acquire a Customer
CAC is the sum of all the marketing and sales expenses divided by the number of new customers added. By itself, this is not an important number. Where it becomes important is when you look at how much revenue you can generate from each customer. When you consider marketing and sales expense you should include any product “customization” costs. If you have a product that is highly scalable, then these customization costs will be negligible or non-existent.
(7) Life Time Value of a Customer (LTV)
The LTV of a customer is the average revenue per customer times the gross margin, divided by the churn rate of the customer base. This concept is used extensively in startups with a SaaS (Software as a Service) business model, but VCs are also applying it very liberally to most companies that they assess. It is a difficult metric to calculate until you have a run rate business, but VCs and some Angel investors may still ask you questions about it.
(8) Market Size and Market Share: Total Addressable Market (TAM), Served Available Market (SAM), and Share of Market (SoM)
As I called out in my article, Market Research for Startups: Is it Important?, the answer is yes. If the target market for your product is not large enough or growing rapidly enough, Angels and VC investors will not be interested in your company. The TAM is the total market for your product including substitutes and alternatives. The SAM is the market that can directly serviced by your product and competitive products. TAM and SAM can be looked at in terms of units and dollars. Dollars simply being units times the Average Selling Price (ASP) of the product. SoM can be measured as your revenue as a percentage of the dollar TAM and dollar SAM. Most people look at SAM when they look at Market Share. Assessing the market size and market growth of your target market is critically important to your business plan. The underlying assumptions about TAM, SAM, and SoM, will allow prospective investors a much better understanding of your revenue forecast and give it credibility if your assumptions are reasonable.
(9) COGS (Cost of Goods Sold)
COGS is directly related to your gross margins. In fact, ASP minus COGS is your unit gross margin. In your financial model in your business plan, an understanding of your COGS and how it changes over time with economies of scale and learning economies is very important to running your business, and it’s important to prospective investors as well.
(10) Gross Margins (GM), also known as Gross Profit Margin
In addition to COGS, you need to understand how your product ASP changes over time, and this results in changes in Gross Margin over time. Gross Margin is one of the three key elements of how a company makes money. The first is revenue. The second is gross margin. The third key factor in a financial model is operating expenses.
Investors want rapidly growing revenue, expanding gross margins, and operating leverage (as you grow revenue, operating expenses grow at a reduced rate).
(11) Operating Expenses (OpEx)
OpEx are all the costs associated with running your business that are not included in COGS, except for taxes. As mentioned above, OpEx is important in calculating burn rate and a business model that makes sense for VCs to invest. At some point in any good business model, there is operating leverage. You need to clearly state your assumptions on how OpEx changes over time.
(12) Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA is a term that is used to calculate company valuation for more established companies. It is also a proxy for cash flow, but since it doesn’t include taxes, it is not a completely accurate representation. It is important for startup founders and CEOs to know what this means, because an investor may ask. It is not the most important metric for a pre-revenue, or even modest revenue, growth company.
(13) Working Capital
Working capital is the capital of a business that is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities. Current assets include inventory and accounts receivable. Current assets include accounts payable. Management of working capital is critically important for startup companies because it directly relates to cash management. Cash tied-up in working capital looks like burn rate, but it really isn’t. As a company ramps revenue, it needs to have sufficient cash to fund the burn rate AND working capital.
(14) Minimum Viable Product (MVP)
The Lean Startup by Eric Reis talks about the minimum valuable product. This is beyond a prototype. This is a product that you can sell but it has the highest return on investment versus risk. This is something where you can really test at least a portion of the market. This deals with so-called “lean” startup ideas.
Many of these ideas in The Lean Startup have been around for decades, but I think Ries has a way of packaging these ideas that are easily digestible by today’s entrepreneurs. Many Angel investors and VCs have read the book, or at least a summary of the book. The idea of refining things, having a minimum viable product prototype that you can get out in front of customers and potentially commercialize does have incredible value.
Here is a quote from the book; “A minimum viable product is a version of the new product which allows a team to collect the maximum amount of validated learning about customers with the least effort.” Anytime that you can get real-time, high-quality feedback from customers, you potentially increase the value of the product and improve your unique value proposition.
(15) Sales Funnel
A Sales Funnel refers to the process a company uses to measure progress of a customer from being a new prospect to being a revenue-generating customer. A sales funnel is divided into several steps. “Above the Funnel” indicates that your company has not made initial contact with that potential customer. I have seen sales funnels be anywhere from four to 10 steps. There are various templates available such as clickfunnels templates to help combat this and in my experience, any sales funnel with over six steps is silly since sales people typically have no way of measuring the progress of a customer with that level of granularity. I like to use a six-step process that has the following steps:
However, if I hire a sales executive that wants to use a four or five step process, that is totally fine with me. The purpose of a sales funnel is to help quantify near term and medium term revenue, with the idea being that the further a potential customer is down the funnel, the more likely they will be a purchasing customer.
In putting together a revenue projection for a business model it is important to have a set of “tops-down” assumptions based on Market Size, and “bottoms-up” assumptions based on a sales funnel. The other most critical aspect of a sales funnel for forecasting purposes is the revenue by customer. Some customers have the potential to be really big, while others are smaller. Having this information also helps to prioritize customer support and engagement. Businesses also have to know there are different types of funnels for different types of business, for instance a non-profit organization won’t benefit from sales funnels, but instead a Non-profit marketing funnel.
(16) Term Sheet
A Term Sheet as it relates to a startup company typically refers to the terms and conditions in a financing of the company. A term sheet exits whether you are doing a debt or equity offering. Debt offerings typically have much simpler terms, even if it is a traditional convertible debt offering. In an equity offering, which is typically a preferred stock offering in the case of venture capital financing, the terms become more complex and far more important. Having an understanding of the key terms in a term sheet is critically important for an entrepreneur that is raising outside money for his or her company. Many entrepreneurs are fixated on valuation in an equity offering, which is only one term. There are many other terms that can be just as important, and in some cases even more important, than valuation. It is worthwhile to look at, Startup Funding Basics: Alternatives & Deal Terms for further edification.
I hope you’ve found this list of key business terms helpful. I’ve peppered-in several additional as well, not to overwhelm you, just to educate. In addition to having a working knowledge of key business terms, there is no substitute for having a good team of advisors including a corporate attorney, a finance person, a human resources person, an accountant, and a solid real estate professional. These people don’t need to work for your company, but you need to have trusted advisors in these areas. It is also very important to have at least one mentor or coach with startup experience and ideally domain expertise in your vertical markets, to help you navigate through the process of building and running your startup. That is what I do full time now with QuestFusion.
This is Patrick Henry, the CEO of QuestFusion, with The Real Deal…What Matters.