🦄Venture Capital and Private Equity Unit 2 – Venture Capital Fundamentals

What's Venture Capital Anyway?

• Venture capital (VC) provides funding to startups and early-stage companies with high growth potential in exchange for equity ownership
• VC firms raise money from limited partners (LPs) such as pension funds, endowments, and high-net-worth individuals to create a fund
• Typically invest in innovative technologies, disruptive business models, and emerging industries (biotech, software, fintech)
• VCs take on high risk by investing in unproven companies with the goal of generating outsized returns
• Investment horizon is usually 5-10 years, during which VCs actively work with portfolio companies to help them grow and succeed
• VCs aim to invest in companies that can achieve a significant exit event, such as an IPO or acquisition, to generate returns for their LPs
• VC investments are illiquid and long-term, requiring patience and strategic planning
• VCs often specialize in specific industries, stages, or geographies to leverage their expertise and networks

Key Players in the VC Game

• General partners (GPs) are the investment professionals who manage the VC fund and make investment decisions
  • GPs are responsible for sourcing deals, conducting due diligence, negotiating terms, and managing portfolio companies
  • GPs typically have extensive experience in the industries they invest in and bring valuable expertise and networks to their portfolio companies
• Limited partners (LPs) are the investors who provide capital to the VC fund
  • LPs include institutional investors (pension funds, endowments, foundations) and high-net-worth individuals
  • LPs commit capital to the fund for a set period (usually 10 years) and have limited involvement in the fund's day-to-day operations
• Portfolio companies are the startups and early-stage companies that receive investment from the VC fund
• Entrepreneurs are the founders and management team of the portfolio companies who are responsible for executing the business plan and driving growth
• Angel investors are high-net-worth individuals who invest their own money in startups, often at an earlier stage than VCs
• Investment bankers play a role in helping VC-backed companies raise additional funding or pursue exit opportunities (IPOs, mergers, and acquisitions)
• Lawyers and accountants provide legal and financial advice to VCs and portfolio companies throughout the investment lifecycle

How VCs Make Their Money

• VCs generate returns for their LPs by investing in high-growth companies and realizing gains through exit events (IPOs, acquisitions)
• VC funds typically charge a management fee (2-3% of committed capital) to cover operating expenses and salaries
• VCs also earn carried interest, a percentage of the fund's profits (usually 20-30%) after returning the initial capital to LPs
  • Carried interest aligns the interests of GPs and LPs, as GPs only earn significant profits if the fund generates strong returns
• VC funds often have a preferred return or hurdle rate (e.g., 8%) that must be met before GPs can earn carried interest
• VCs may also charge portfolio companies for services, such as board participation or strategic advice
• Successful VC firms can raise larger funds over time, enabling them to invest in more and larger deals and earn higher management fees and carried interest
• VC returns are highly skewed, with a small number of successful investments generating the majority of a fund's returns
• VCs aim to generate a 3-5x return on their investments over the life of the fund to compensate for the high risk and long investment horizon

Stages of VC Funding

• Pre-seed: Earliest stage, often funded by founders, friends, and family, focusing on ideation and product development
• Seed: Early-stage funding to develop and launch a minimum viable product (MVP) and test market fit
  • Seed rounds typically range from $500K to$2M and involve angel investors and early-stage VCs
• Series A: Funding to scale the business, refine the product, and expand the team
  • Series A rounds typically range from $2M to$15M and involve larger VC firms
  • Companies at this stage have demonstrated product-market fit and are generating revenue
• Series B: Funding to accelerate growth, expand into new markets, and make key hires
  • Series B rounds typically range from $10M to$30M and involve larger VC firms and strategic investors
  • Companies at this stage have a proven business model and are focused on scaling
• Series C and beyond: Later-stage funding to support continued growth, international expansion, and pre-IPO positioning
  • These rounds can exceed $50M and involve late-stage VCs, private equity firms, and strategic investors
• Bridge rounds: Interim funding between major rounds to extend runway or bridge to an exit event
• Down rounds: Funding rounds at a lower valuation than the previous round, often due to underperformance or market conditions

Valuation Methods in VC

• Pre-money valuation: The value of a company before receiving new investment
• Post-money valuation: The value of a company after receiving new investment, equal to the pre-money valuation plus the new investment amount
• Comparable company analysis: Valuing a company based on the valuations of similar companies in the same industry or stage
  • Metrics used include revenue multiples, EBITDA multiples, and price-to-earnings ratios
• Discounted cash flow (DCF) analysis: Valuing a company based on its projected future cash flows, discounted to present value
  • Requires assumptions about growth rates, margins, and discount rates
  • Challenging to apply to early-stage companies with limited financial history
• Berkus method: A simple approach that assigns a range of values to five key risk factors (sound idea, prototype, quality management team, strategic relationships, and product rollout or sales)
• Risk factor summation method: Similar to the Berkus method, assigning a dollar value to each risk factor and summing them to determine the pre-money valuation
• Venture capital method: Calculating the post-money valuation based on the investors' required rate of return and expected exit scenario
  • Involves estimating the exit value, determining the required ownership percentage, and calculating the post-money valuation
• First Chicago method: A hybrid approach that combines the best-case, base-case, and worst-case scenarios, assigning probabilities to each

Term Sheets and Deal Structures

• Term sheets are non-binding agreements that outline the key terms of a proposed investment, including valuation, investment amount, and investor rights
• Preferred stock: VCs typically invest in preferred stock, which has priority over common stock in terms of dividends, liquidation preferences, and other rights
  • Liquidation preference: The right of preferred stockholders to receive their investment back before common stockholders in the event of a liquidation or sale
  • Participation: The right of preferred stockholders to "double-dip" by receiving their liquidation preference and then participating in the remaining proceeds with common stockholders
• Anti-dilution provisions: Protect investors from future rounds at lower valuations by adjusting the conversion rate of preferred stock to common stock
  • Full ratchet: The most investor-friendly provision, adjusting the conversion rate based on the lowest price of any future round
  • Weighted average: A more common provision that adjusts the conversion rate based on a weighted average of the prices and amounts of future rounds
• Voting rights: VCs often require board representation and veto rights over key decisions (e.g., issuing new securities, selling the company)
• Drag-along and tag-along rights: Provisions that require or allow minority shareholders to sell their shares in the event of a majority sale
• Vesting and options: Founders and employees typically receive stock options that vest over time to align incentives and retain talent
• Right of first refusal and co-sale: Provisions that give investors the right to purchase shares before they are sold to third parties or participate in such sales

Exit Strategies for VC Investments

• Initial public offering (IPO): A company sells shares to the public on a stock exchange, providing liquidity for investors and allowing them to realize gains
  • IPOs are typically reserved for larger, more mature companies with a proven track record of growth and profitability
  • The IPO process involves significant regulatory requirements, disclosure, and marketing efforts
• Merger and acquisition (M&A): A company is sold to a strategic buyer or another company in the same or a related industry
  • M&A can provide a faster and more certain exit for investors compared to an IPO
  • Strategic buyers may be willing to pay a premium for synergies, market share, or intellectual property
• Secondary sale: Investors sell their shares to other investors or third parties, often through a private transaction
  • Secondary sales can provide partial liquidity for investors without requiring a full exit
  • May be used to restructure the cap table, provide liquidity to early investors, or bring in new investors
• Buyback: The company repurchases shares from investors, using cash or debt financing
  • Buybacks are less common and typically reserved for smaller, founder-led companies
  • May be used to regain control, simplify the cap table, or provide liquidity to investors
• Recapitalization: The company issues new debt or equity to change its capital structure, often to provide liquidity to investors or finance growth
• Write-off: In the event of a company failure, investors may need to write off their investment, recognizing a loss

Risks and Challenges in VC

• High failure rate: The majority of VC investments fail to generate significant returns, with a small percentage of successful investments driving overall fund performance
• Long investment horizon: VC investments typically require a 5-10 year holding period, during which capital is illiquid and exposed to various risks
• Market and technology risk: Startups are vulnerable to changes in market conditions, customer preferences, and technological disruption
• Execution risk: Early-stage companies face challenges in executing their business plans, managing growth, and adapting to changing circumstances
• Financing risk: Startups require significant capital to grow and may face difficulties raising additional funding if they fail to meet milestones or market conditions deteriorate
• Valuation risk: Determining the appropriate valuation for early-stage companies is challenging and relies on assumptions about future growth and exit potential
• Founder and team risk: The success of a startup often depends on the skills, vision, and execution of its founders and key team members
• Competition risk: Startups may face intense competition from established players or other well-funded startups in their industry
• Regulatory risk: Changes in regulations, tax policies, or legal environments can significantly impact a startup's operations and growth prospects
• Macroeconomic risk: Economic downturns, financial crises, and geopolitical events can affect the overall funding and exit environment for VC-backed companies
• Concentration risk: VC funds may have significant exposure to a single company, industry, or geography, amplifying the impact of any negative events
• Reputation risk: VC firms rely on their reputation to attract top entrepreneurs, investors, and talent, and any damage to their reputation can have long-lasting effects