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Typical private equity/venture capital deals have their own language and process - that language and process can be mystifying for entrepreneurs trying to understand what drives valuations and other deal terms.

As a general rule, venture capitalists utilize a number of valuation techniques and other factors (including discounts-off of those valuations) to arrive at an enterprise value of an emerging growth company. In many cases, a VC will walk the company through its valuation methodology and discuss the assumptions and the basic underpinnings of the proposed deal. So at a micro level, there are usually some answers to why a term sheet looks the way it does.

However, the consequences of deal terms like "anti-dilution," "participating preferreds," "protective provisions," "cumulatively compounding dividends," "preemptive rights," "pay-to-play provisions," "co-sale rights," "registration rights," "IPO participation rights," are often felt after the deal is inked and the deal funded. Even for the initiated, the implications of these terms can be difficult to fully appreciate at the time the deal is negotiated. Since many deal provisions impact the future operations of the company (as well as the financial return to the entrepreneur), it might be useful to think of the deal terms as the framework for the relationship between the VCs and the company. The funding event is what sets that relationship in motion and establishes the dynamic between the control the investors can assert over the company and the flexibility the company has to adapt to change.

Even when you overcome the jargon and navigate through the process, the mystery remains a bit open-ended. Intangible factors such as management strength, the VC's perception of the market potential for the company's products or services and other risk reducing factors enter into the equation - adding a level of subjectivity that makes valuing a venture-stage company more of an art than a science. So, for the entrepreneur looking for the bottom-line on where valuations and deal terms come from, we offer the following answer: rates of return and perceived risk. We believe the funding decision and the pricing of a deal is driven by two overarching factors: the investors' desired rate of return and the investors' perceived risk.

Rates of Return. If you assume that VCs are looking for annual returns on capital in the plus 30% range (and they are), that means that on average at the end of the fund's life, the VC is going to require (on a future value basis) a total return that is above that benchmark. For early-stage funds, an average of 30% of venture deals will be complete losses, 30-40% will go sideways (break even or a little better), and the remaining will have to carry the fund to achieve its Internal Rate of Return (IRR), factoring in the losses. That means the valuation created in the earliest stages of the fund, will be driven by the future value calculation necessary to produce these types of returns (to obtain a 30% IRR in year six of an investment based on a $2 million investment on day one and a $60 million liquidation value in year six, a VC would need to structure the terms of the investment such that percentage ownership on day one would decrease to no less than 16% of the company at liquidation (this assumes no further investment by the VC as well)).

So if you are the entrepreneur getting funded in the earliest stages, it is important to understand the economic pressures on venture funds. It is also worth noting that "new money speaks the loudest." Given current valuations, "old investors" who are not able to (or unwilling to) participate in future rounds may be faced with new (and possibly lower) valuations and adverse terms in later rounds or, as has been fairly common recently, a forced "conversion" to common stock upon a complete recapitalization of the company by its new investors. These later rounds can greatly impact historical valuations. Therefore, it is critically important that investors value deals on a total returns basis (i.e., looking at valuation at exit) and not based on a current valuation. This is the reason many terms are structured to protect early investors from the impact of future rounds.

Other than co-investments, the upside to the principals in a venture fund, generally speaking, is in creating value over what the limited partners in the fund had originally invested. Typically, the general partners' carried interest (which is the GPs' upside) will be between 20% to 25% of the amount of gain for the limited partners which they only receive after the return of all invested capital, and in some cases after an additional preferred return to the limited partners. As well, the key metric for raising a new fund (which is the way venture fund principals stay in business), will be measured by the performance of the principals' previous fund(s). Therefore, the principals of a fund not only have to account for the law of averages to indirectly benefit the investors in their fund, but they also have a direct vested personal economic interest in the total return of the investments which impacts an entrepreneur's deal terms.

Perceived Risk Reducers or Valuation Enhancers. We think of risk reducers for venture capitalists as the corollary of valuation enhancers for emerging growth companies. Because even in the best of times the pitfalls for emerging companies can be many and varied, venture capital funds weigh perceived risk reducers and factor those intangibles into their valuation. Risk-reducing factors may include an experienced management team with identifiable successes, strength of board of directors, breadth of product or service offerings, strength of intellectual property position, early adoption by customers, existence or lack thereof of competitors, credibility and quality of existing investors or advisors and existence of tangible assets.

Yet, VCs also know that other than valuation what matters most in the long term is the flexibility to deal with unknown future events that would threaten the company's future valuation and increase the risk to the VCs. Many things that an emerging growth company would encounter on its road to a liquidation event can reduce (or enhance) the VCs risk or be perceived as reducing (or enhancing) the risk. Barriers to entry, size of the market or lack of market, long sales cycles, personality issues or in-fighting between founders, to name a few examples.

So, to increase the likelihood that the business will progress according to plan and that valuation will continue to build, most funds require a set of provisions that restrict the company's ability to do certain things. These protective provisions (negative covenants) provide the fund with the flexibility to cause the company to adhere to certain parameters. For example, it is not uncommon for the VC to restrict the company's ability to incur debt. And if the company wishes to borrow outside the prohibitions, then the company is required to get the fund's (or some subset of investors') consent that the lack of adherence is permissible. These types of provisions provide the investors' flexibility to deal with unknown future events and exercise control over the company.

The future is very hard to predict- particularly for early-stage companies. Companies survive and become successful because of their ability to adapt to change and therefore need to maintain a degree of flexibility to respond to change.

In many ways venture funds are not much different from the companies they invest in; at least not from a "big-picture" economic standpoint. The venture fund is beholden to its limited partners. The fund's management is measured and in-large part compensated on the returns on the investments the fund makes. And in large measure, many of the terms of the deals are dictated by the economic realities of the fund and what its investors expect and require. Just as a company is restricted in its activities by protective provisions, a fund's activities are restricted by its limited partnership agreement, which is the product of negotiations with its major limited partners. Thus, given the rules of the game for funds, the objective for entrepreneurs should be to enhance their business models in ways that reduce perceived risk for the fund's return and which can enhance total returns at exit. However, generally speaking, funds have limited ability (absent market pressure) to adjust in a very material way the valuation and other fundamental terms of a venture deal. However, VCs do have some latitude in these matters and many times have significant discretion in terms of the deal which build-in redundant flexibility for VCs.

With an eye on the operational and financial goals of the company, entrepreneurs and their advisors should understand and pay critical attention to how deal terms shift during the negotiations. In crafting a deal it is crucial to focus on the fact that subtle changes to some key terms can have a significant impact on who has the power to make decisions and how the final pay-off will be allocated. The value-added by those advisors who assist companies in negotiating these deals is sorting out what is material and knowing how to apply limited resources to achieve these subtle changes while at the same time maintaining some of that critical flexibility for the company.