Starting A Company? The Key Terms You Should Know | Startup School

[Music] Hi there, my name is Dalton. I'm a managing partner at Y Combinator, and I'd like to talk to you about some startup terminology today.

All right, so I'm going to go through some terms that are common in startup land and give you some more details and define it.

Okay, let's talk about the term MVP or minimum viable product. So let's be specific. The keyword here is "viable." A product that doesn't work at all and is useless to everyone is not viable. So when you're thinking about what is an MVP or how should I build my MVP, it has to be useful enough to serve some kind of purpose for the customer. Again, that's that viable word. It doesn't just mean a simple product that you built that doesn't do anything; it's got to be useful to someone for it to be viable.

So remember this next time you're thinking about what should go in an MVP. The next term I'd like to talk about is the term venture capital. Sometimes, the people that work in the venture capital industry are referred to as VCs. The way venture capital works is they invest a small amount of money to buy equity in startup companies with the hope that enough of those companies become very large to return the original investment that they made. They're also comfortable taking more risk than you would take in a traditional investment.

It's often the case that the majority of a venture capital portfolio does not succeed, but the investments in the really big successful companies pay for everything. So for instance, imagine you were an early investor in a company like Google, Apple, or Facebook. That small investment ended up being worth so much. It was worth taking the risk when those were tiny unprofitable companies. The way to think about venture capital is it's an industry that's looking for businesses that may be risky but could be very huge if they're successful.

I understand the original venture capital was in the whaling industry. The way it worked is when people would go out to hunt whales, a lot of times the ventures would fail. The people that needed money to start a ship needed to raise money from investors. The way they did a portfolio was they would invest in multiple ships in the hope that if one of them was successful in capturing the whale, it would pay for all the failed expeditions.

I'd like to define what an angel investor is. No, that's not someone that is angelic; it's a type of venture capital investor that is investing usually their own personal money, not out of a VC fund. They tend to be the earliest stage investor in a company. They also tend to write smaller checks—say $20,000 or $50,000 or something like that. They tend to do it not as a full-time job. It'll be a hobby or a side project. They might be running a company; they might be retired. There's no qualification to be an angel investor—it's usually just someone that has money.

So you'll see a wide variety of people that do this, and the thing they have in common is they just write personal checks into small startups, and they're doing it not as a full-time job. So that's the best definition of an angel investor.

Okay, another term in startups that I'd like to define is profitability. There are some pretty obvious definitions of profitability, which is just you make more money every month than you spend, and that's a pretty good definition. But to add a little bit more to it, it's good to think about if a business, as it grows bigger and bigger, either has stable profit margins or if the profit margins increase or decrease.

It's common to have a startup that at a very small scale might not be making money, but as it gets bigger and bigger, the profit margins increase. It's good to think about if you're starting a startup or if you're working at a startup how your margins, i.e., the difference between how much you're making and how much you're spending, change as your company grows. What I'd be looking for is at scale the profit margins are pretty good, and there's a clear way you make more and more money.

To give you an example, something like Google. Google did not make any revenue for its first few years of existence, but the profit margins on online advertising are very high. So once Google turned on their monetization engine, they started to make an enormous amount of money. They are very profitable. You can look them up; they're publicly traded, and so that's a great example of a company that initially was not making money, was not profitable, but was able to have an incredibly attractive business at scale once they turned on the monetization engine.

That's the kind of profitability engine you should be looking for as a startup founder too. Next, I'd like to talk about burn rate. Burn rate is how much money at the end of the month has been burned by your company or how much your bank account has gone down. So hypothetically, if you had a million dollars in the bank, and at the end of the month you had $900,000 in the bank, your burn rate would be $100,000.

As a startup founder, it is critical to watch your burn rate. You may be making money in some ways; you may have a lot of topline revenue, but if you're burning money every month, you might go out of business. It's great as a startup founder to think hard about where the money is going and to pay careful attention to the bank account balance, and make sure that your burn rate does not get out of control. Not paying attention to this is harmful to your startup's health.

Next, I'd like to define a seed round. There's not a technical definition of what exactly is or isn't a seed round, so let me give an example. Say someone raises $300,000 on a SAFE; you could call that a seed round. Say that there's some crazy company that's founded by celebrities, and they raise $100 million on a billion-dollar valuation. Sometimes they refer to that as a seed round. Because of this big variability, it's sometimes hard to tell exactly what is and isn't a seed round.

For the sake of argument, here's my suggestion: a seed round is usually the first amount of money that a new startup raises of any consequence. So usually when you begin a company and you raise the first amount of money and you say, "Okay, we're done raising money," whatever amount of money it is that you raised, you would refer to as a seed round. In addition to other fundraising terms you may have heard of, such as a Series A, Series B, or Series C, the difference between one of those rounds and a seed round is, for one, it is often the case—though not always—that in a Series A, B, or C, a lead investor is involved. You also may be giving a board seat to that person.

It's also the case that it traditionally—the lead investor gets a significant ownership percentage. So for instance, traditionally in a Series A, the lead investor might get something like a 20% ownership. In a seed round, anything goes. It could be that it's entirely composed of $50K checks and there is no lead investor, right? It's a very wide definition. But with a A, there's usually one primary lead investor that leads the Series A, to use the terminology, and the same thing goes with Series B and C for startups that have been around a while.

When you keep raising a new round, you tend to give it a new name, and again traditionally you just keep incrementing the letters in the alphabet. So you'll sometimes see companies that are like a Series E or Series G or Series H. I think I've definitely seen that before. What are the normal valuations for these? I don't know; it's a wide range, and so you can't just look at what the round letter is. You also want to look at what the valuation is.

Next, I'd like to define product-market fit or PMF. Product-market fit is something we talk about a lot at Y Combinator, and it's one of those terms where people talk about it so much you might think you know what it means, but the actual definition is a little bit tricky and there's not actually a scientific explanation of it.

A good way to think about product-market fit is when you've built something and people are using it, and they like it a lot, and your biggest issue is no longer trying to define what people want or trying to make something people want; it's to start to be in growth mode and serve as many people as you can. One way to think about product-market fit when you're a founder is that needing to get more customers is not your biggest problem. You probably have other problems like scaling or like performance, like sales. You have all these other problems, versus most startups when they first start do not have product-market fit.

Essentially, all of them do not have product-market fit, and what this means is they may build something; they may have some assumptions about what customers want, but they don't have any customers or they haven't worked with enough customers to really figure out if it's serving their needs properly. Startups in the pre-product-market fit stage are just spending all their time trying to test their assumptions, trying to build, trying to design, trying to talk to customers to really zero in on what these customers want.

From our perspective, there's just a very different set of priorities when you're pre-product-market fit versus post-product-market fit. When you're pre-product-market fit, all you should be worried about is finding product-market fit. When you're post-product-market fit, your job is to stay in that state, to keep product-market fit, and to grow and scale to the best of your ability. So it's good for you as a founder to realize that the tactics and priorities you should have are very different depending on which of these two modes you're in.

I'd like to define the term bootstrapping. Bootstrapping is when you start a company and you do not raise any venture capital. You just use your own personal funds or the revenue from the business to get off the ground. So for instance, if you were to start a new company that built an iPhone app and you didn't raise any venture capital, and you just launched it on the App Store and started making lots of revenue and built a successful company, you would call that a bootstrapping situation. You would say you are a bootstrapper because you didn't raise any money to do it.

One of the reasons is a great option is it's entirely within your control. You don't need the approval of investors to go bootstrap a company. It's also a good option if you're doing something that is not traditionally a venture business, a venture-scale business, which is something that could grow really, really big, really, really fast. Bootstrapping is a much, much better option for businesses that you expect to get to 5 to 10 million a year in revenue, something like that, and to probably not grow beyond that.

Bootstrapping is a great option. A convertible note, in the context of startups, is a financial instrument whereby an investor gives a startup money, and they sign a piece of paper. You should read carefully what this piece of paper says. In the case of a convertible note, it is a debt-like instrument. There are usually terms in a convertible note by which you would pay some amount of interest or you might need to pay the investor back. So it's your job as a founder to read the fine print very carefully.

An alternative to a convertible note is something called a SAFE note. A SAFE, also known as a Simple Agreement for Future Equity, is a financial instrument that was actually initially created by Y Combinator, specifically Carolyn Levy, and it is an alternative to a convertible note. If you're raising as a startup founder and you are not doing a priced round and selling preferred equity, a SAFE is a great option to quickly close money in a seed round ahead of when you would raise a Series A at a future date. If you're thinking about whether or not to raise on a convertible note or a SAFE, I would encourage you to read carefully the fine print and understand the pros and cons of each.

The advantage of a SAFE is there's just fewer terms to worry about as well as different rights—fewer rights in a convertible note. So that's often very useful to startup founders. Equity is ownership in a startup company. Equity would refer to what percentage of that would add up to 100% of the company that a founder or employee or investor would own.

If you work at a startup, you may not directly get equity; you may get stock options, which are basically a right to, in the future, execute on the stock options to receive equity at that point in the future. It's important for you, in the fine print, as both a founder, a startup employee, or an investor, to read the fine print and understand if you are getting stock options, or if you're getting equity directly, or if you're investing in a SAFE, or you're investing in a convertible note, or some other instrument. Always read the fine print and understand exactly what you are buying or selling.

TAM or total addressable market is a term that you would hear a lot in the land of startups. What it usually refers to is hypothetically if 100% of the potential customers of your product all purchase your product, how much money would you be making? No one actually would get to 100% of their TAM; it's more of just a thought experiment for how big the market could possibly be.

So for instance, if you were trying to establish the TAM of something like a Tesla or a car manufacturer, you would look at how many total cars people buy across the world, and that would be the total addressable market. You would make an estimate of how many of the cars could be sold by Tesla. One interesting point about TAM calculations is they can be wrong; they can underestimate how big the market could be.

Again, to give you an example, when Tesla first started, the total addressable market for electric cars was tiny. You had to believe that the market for electric cars would grow and be so big it would take over and be effectively the market for all cars for the TAM to seem sufficiently big. In addition, for a company like Uber, when they first started, the total addressable market for taxis or for car services was quite small, but Uber dramatically increased the size of the market because they created a better user experience, and they encouraged people to start taking ride sharing that didn't before.

This led to the initial TAM seeming much, much smaller than it ended up being. So think of TAM as sort of just a potentially helpful thought experiment versus something that is set in stone. Great products tend to grow the TAM.

Next, I'd like to define valuation. Valuation is a term that people in startup land talk about a lot. What it usually refers to is what valuation the last investor invested at. So say there was a company that raised $2 million on a $20 million post-money SAFE; the valuation would be $20 million. The thing about valuation is it doesn't actually mean there are always buyers and sellers.

This doesn't work like the stock market. In the stock market, the stock price is the valuation, and anyone could go and publicly trade the stock at whatever their current market price is. With startup companies, they are privately held; there's not really a liquid market. So it's best to think of valuation as just some measure of how it might be valued by some folks versus a true measure of how much that startup would be worth if it were to sell that day or if it were to go public that day.

Often, you might have noticed that startups with high valuations don't always succeed, so just think of it as a helpful term but not necessarily always accurate. Next, I'd like to define an IPO or initial public offering. An IPO is when a company that is privately held, i.e., it is owned by its investors or its founders or its employees, issues shares or sells shares to the public markets. The public markets are things like NASDAQ or the New York Stock Exchange or other public exchanges like that, and anyone in the public that has some kind of stock brokerage account can buy some of those shares.

The reason IPOs are important to startups is it's often a way for their employees, or their founders, or their investors to be able to realize money from the companies they have built. It's also a great sign that the company is doing well. This isn't always the case, but an IPO is the big goal that a company is financially mature, that it is growing well, and has built something of enduring value.

Next, I'd like to define ARR or annual recurring revenue. You will hear this term thrown around all the time in startup land, and let's break it down. Annual means every year; here, recurring means the customers are either in some sort of subscription that auto-renews or they've signed contracts that renew in some way. The third R is revenue, which should be obvious—that's just revenue.

So the way to think about this is say you have a company and you have 10 customers that have each signed yearly contracts for $100,000 a piece that renew yearly. If you have 10 $100,000 contracts that renew yearly, that would be a million dollars of ARR. The important thing here, if you're going to use this term, is to understand that recurring is important. So make sure if you're reporting—if you're telling an investor you have ARR—make sure it actually recurs.

Also, it's best if it recurs on an annual basis. If you're quoting ARR, traditionally if you're billing people on a monthly basis, you would quote MRR or monthly recurring revenue. So say it's a subscription to ChatGPT or something like that that renews monthly. You would more commonly see that revenue reported as MRR—monthly recurring revenue—versus ARR, which is more traditionally for companies that bill once a year.

All right, that was startup terminology with Dalton. I went through a number of terms you may have heard before, and I'll be sure to define more in the future. Thanks so much. [Music]