On Saturday, November 18, the Passano lobby at Johns Hopkins Carey Business School was filled with the hustle and bustle of participants ready to test their mettle at the Venture Capital Investment Competition hosted by the PEVC club. Each team was given a list of six startups to evaluate a day before the competition. I was part of an incredibly diverse team comprising of Christian Ryan, Jiacheng Li, Yash Santani, and Christian Terrell. While everybody was gearing up for the competition, our team—Stallions Capital LP—was busy brainstorming which company to invest in.
The day started with breakfast and continued with the introduction of the highly skilled judges, Ken Malone, Tricia Ratliff, Jonathan Bradley, Edwin Warfield, Ali Afshar, and Prof. Jim Liew, followed by a formal pitch from all the participating startups: Cubix Health Technologies, Nearby Medic, Ridevert, RoomShare, SmartBridge, and Asulon Therapeutics.
Participants were given a $100 million fund to structure a deal for any one of the above six startups. To create a term sheet, participants were advised to incorporate certain parameters in the deal, and that’s when real learning of private equity/venture capital lingo kicked in:
Pre-money Valuation: The valuation of a company before the VC firms decide to invest in it. This is typically the most analytical and quantitatively challenging part, especially for technology companies, which are different from regular brick-and-mortar companies. We used Comparable Transactions Methods techniques to come up with valuation of Ridevert, the startup our team decided to categorically invest in.
Team’s Investment: The actual dollar amount VC firms would invest in the company for a certain % of equity in the firm. It could either be a convertible debt or direct equity stock deal. A convertible note represents a security that is a hybrid between debt and equity. “Notes are issued in the place of priced equity, typically when a company is raising less than a million dollars and does not want to generate the legal expenses associated with a priced round.” Investors can also set a “cap” and discount rate (15-25%) on convertible notes, so in later rounds, when the notes actually convert to equity, the maximum valuation for the conversion can’t be more than the “cap” agreed upon. This also helps founders protect their stake in the company and when a company does increase in value, they can convert the notes to much lesser equity than they would have in earlier rounds of funding.
Syndicate Funding: Funding that allows investors (backers) to co-invest with relevant and reputable investors (leaders) with expertise in selecting the best startups in the market and structuring a deal. Essentially, it is a win-win for both backers and leaders. Leaders access more funds, and backers avoid the hassle and know-how of structuring a deal. Additionally, since backers and leaders are investing in the same startup, the move aligns interests of both parties and increases returns for both, if the startup performs well.
Post-money Valuation: Simply put, the sum of the 3 points above. Arithmetically: Post-money valuation = Pre-money valuation + Team’s investment + Syndicate Funding. The key point to remember here is that the % of equity owned by a VC firm is always calculated by post-money valuation as opposed to pre-money valuation.
Options Pool: Stock shares reserved for employees. A desirable feature because in early stage startups, a big part of employee compensation comes from shares in the firm. In addition, since earnings of many C-suite employees are tied to a company’s fortune, it motivates them to put in those extra hours required to bootstrap a startup.
Board Structure: Critical for decision making. At times, for strategic purposes, it is important for VCs to have more seats on the board than equity. So, typically, VCs decide to give away some equity in lieu of an extra seat on the board. A seat on the board helps in determining a company’s direction in the long run.
Closing Conditions: These cater to typical due diligence about the startup, which includes a venture capital investor evaluating the company’s financial and legal affairs. They also indicate who will draft the stock purchase agreement and other transaction documents, counsel to the venture capital investor or counsel to the company. The term sheet also states who will pay for the expenses of the deal.
Liquidation Preference: Determines which parties get what payout, if a board decides to liquidate the company. It is also used by VCs to secure their rights on the liquidation money before anyone gets a say in it. Typical liquidation preference is “1x;” however, in certain cases it could be as high as “5x.” For example, let’s assume a VC firm decides to invest $1 million in a startup with pre-money valuation of $3 million, and the liquidation clause at time of signing the term sheet is “1.5x”. If for some reason the company decides to liquidate its assets today, the VC firm would get $1.5 M back and other stakeholders, including founders, will be left with only $2.5 M.
Dividends: A fixed source of income for private equity firms, similar to dividends investors get in a public company. However, startups are sometimes not able to maintain the level of free cash flow required to give dividends to stakeholders. Since debt is cheap, some companies resort to debt in order to pay fixed dividends to their investors. This is also known as dividend recapitalization.
Anti-dilution: Helps protect investors in the case of a “down-round,” a capital raise that happens at a valuation lower than the one in which the share was purchased. For instance, suppose you invested $1 million in a firm with a pre-money valuation of $9 million, giving you 10% stake in the company. Now, assume for some reason the company failed to perform as expected and had to raise capital at a down-round of pre-money valuation of $4 million. Clearly, this means dilution of your investment from $1 million to $400 thousand. In general, there are three types of anti-dilution clause:
- Full-Ratchet: This type of anti-dilution is highly skewed towards investors’ interests. In the example above, if the term sheet included full-ratchet anti-dilution clause, instead of $400 thousand, the investor’s value would remain $1 million, giving him much more equity, and in-turn, significantly diluting the founder and other investors’ share.
- Half-Ratchet: As the name suggests, a half-ratchet clause ensures VC investment doesn’t go below its 50% value. In the above example, the company would maintain $500 thousand worth share instead of $400 thousand, shielding it against a significant drop in the value.
- Weighted Average: This essentially means the value of equity would be repriced at the weighted-average price of the 2 rounds, meaning you would go back in time and pretend as though you had actually made the $1 million investment at a six and a half million dollar pre-money value (average of 9+4=$13 M), in other words, your investment is worth $650 thousand instead of $400 thousand without an anti-dilution clause.
Other Key Clauses: Other clauses include a no-shop agreement, conditions for the usage of capital, and so forth. A no-shop clause precludes the seller from directly or indirectly seeking other buyers for alternative offers for an agreed upon period of time. The time frame for exclusive dealings in a no-shop provision typically ranges from 45 to 90 days.
All teams were given a chance to present their investment strategies followed by an intense round of real-time negotiations between Adam and Ken, which offered immense learning in and of itself. We enjoyed the luxury of owning a fund of $100 million as well as the misery of deciding which firm to put the money in. The whole competition was no less than a thrilling Shark Tank episode, and of course who doesn’t want to play Kevin O’Leary, even if just for a day!