Demistifying Venture Deals: A Case study
Updated: Aug 30, 2022
The world of Venture Capital (VC) is an enigma to the outsiders. Unlike other investors, who invest in companies with a solid and recurring cash flow, Venture Capitalists invest in risky ideas and ambitious founders. With high risk, obviously comes a high reward - they stand to get rich massively if their bets pay off. Despite the high stakes involved (pun intended :-P), they are still playing a guessing game, and over time they become really good at it.
If you are a junior VC, or planning to start your own company, or even you are a legal professional entering the field, it's important to understand what a typical venture capital raise looks like. In this article, more like a case study on a fictional company called Scoot, I am making an attempt to uncover some of the numbers behind the deals.
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Origin and Incorporation (2012)
Scoot is a brainchild of Kareem, an investment banker in New York. He has developed a concept on democratizing usage of AI in robotics by creating a universal platform and planned to demo some use cases. Kareem has been thinking about the execution for some time and has decided on South Asia as its key market given its dominant manufacturing industry. He is joined by his friends Jenna, a recent CalTech Robotics PhD graduate and Zhong, an ex-Mckinsey consultant who has had operations experience in Malaysia and Thailand.
With mutual agreement, they incorporate the company in 2012. At the incorporation, companies issue common shares, usually a large number. In Scoot's case, 1M of common shares are issued. 40% of the shares belong to Kareem while Jenna and Zhong get 30% each. Usually founding team comes up with a vesting schedule for the founder's stock. For example, a 36-month vesting schedule with 1-year cliff essentially means that the stocks vest in chunks of 1/36 every month for 36 months, and co-founders stand to lose all equity if they leave the company before the one-year mark.
Seed Funding (2013)
Kareem and his team have worked on the prototype platform for an year now. They are also in the process of patenting their core technology. While the bare-bone structure is there, they need to work on other engineering aspects of it. They want to hire three full-time engineers and a software developer as well as buy some equipment to meet their target launch in 6-9 months. Kareem meets a seed stage VC firm called RedTech regarding investment. RedTech values the company at $3M (called pre-money valuation) and wants to invest in $1.5M. How VC firms come up with such a valuation is a mix of art and science. While there are several valuation methods, most of them involve measuring assets and cash flows (non-existent in case of early stage ventures), comparing to similar companies at similar stages, expertise of the key people etc.
With post-money valuation of $4.5M (pre-money valuation + investment), RedTech will receive a stake of 33.33% in the company. The holdings of Kareem, Jenna and Zhong get diluted to 26.67%, 20% and 20% respectively, as they make no new investment. Notice that, that the common shares issued to co-founders were not redistributed to RedTech, rather, new common shares were issued to the VC firm to match its stake.
After seed financing, Kareem is now a millionaire (at least on paper), while Jenna and Zhong are near-millionaires. While all the co-founder's % holdings got diluted, their net worth increased because Scoot is now a multi-million dollar company
You must have realized by now how number of shares do not tell you anything about their worth. While the number of shares of Kareem, Jenna and Zhong remained the same after same funding, but at least they are now worth something (3$ in this case).
SERIES A (2014)
After several months Scoot's platform is ready and is currently being tested by early adapters. With some initial feedback, Jenna reckons there are several technical challenges that need to be overcome before they start to commercialize it. Scoot needs a new R&D team, and a lot of high-tech equipment. RedTech, their investor, introduces Kareem to Edge Capital, another VC firm. Both RedTech and Edge Capital agree to invest in Scoot in a $6M Series A financing at a pre-money valuation of $18M. RedTech contributes $1.5M in this round, while Edge Capital contributes $4.5M. However, an important term is introduced in the Series A funding. On request of Edge Capital, Scoot will set up an Employee Stock Option Pool (ESOP) immediately after the investment round is closed. The ESOP is planned as an incentive tool for the employees and will be equal to 6% of the out-standing shares, post-money. ESOPs are basically "authorized but un-issued" shares which are sliced up and kept aside but haven't been granted.
As new and key hires join the company, they are kept motivated through shares from the options pool. Employees get the ownership-feeling (quite literally) and thus have more incentives to work harder/smarter.
ESOP shares calculations are interesting. In this case, we summed all the outstanding shares as well as the ones being issued and used it as a plug to compute ESOP shares.
SERIES B (2016)
Scoot is now being used at major industrial manufacturing factories in Thailand and Malaysia. However, they haven't had good fortunes in China. They need to establish a local team and expand sales Asia wide. On the other hand, while the revenue has been increasing consistently, the costs are still not low enough. In short, Scoot is burning cash and may run out of it in few months. Zhong, who is now Scoot's Chief Operating Officer, estimates that the company needs another $25M in investment to meet its goals. While RedTech and Edge Capital are willing to inject more capital, but with such steep financing needed, Kareem has to attract new investors. Nevada Partners and M Capital have heard great things about Scoot and express their interest in financing. The pre-money valuation for Series B financing, as per them is $60M. They both decide to invest $9M each, while RedTech and Edge Capital provide $2M and $5M respectively, completing the $25M funding round.
Most VC firms have a check size limit: the maximum amount they can invest in a company in a funding round. This is why more and more investors are needed with bigger check sizes as the company grow.
The firms providing the biggest checks every round are called Lead Investors for that round (in this case Nevada Partners and Edge Capital), and the act of joining hands with other investors to fund a company is called Syndicating. Also, note that ESOP shares are adjusted to maintain the 6% employee options pool as decided in Series A financing.
SERIES C (2018)
Scoot is now a major automation platform across Asia and has ventured into manufacturing co-bots too. They have developed strategic partnerships with Convex Motors, a major automaker in China. As Scoot is reaching the revenue break-even point, the cumulative cash-flow is still largely negative. Nevada Partners and M Capital believe that the company needs to embark on further expansion to bring the net cash-flow above zero. Launching in Europe seems to be the best path forward. But European market is huge, and significant amount of funding ($45M) is needed to move further. Kareem's contacts at Convex Motors introduce him to General Partners at Harlem Ventures, a late stage investment firm. Harlem Ventures believes Series C funding will see Scoot through IPO and agrees to invest $27.5M at a pre-money valuation of $150M. Nevada Partners and M Capital join the funding by supplying $7.5M and $10M respectively. One of the terms of the Series C deal is to increase the Employee Stock Option Pool to 15% to encourage employees in this massive expansion plan.
As the company grows quickly, the investors would want to ensure that the company expands the equity reserved in ESOP. One obvious reason is to compensate and motivate the company's workforce. But this act also minimizes the risk of future dilution in investor shares in subsequent financing rounds - something which investors care a lot about!
Notice, how RedTech and Edge Capital decided to sit out this round. It is likely that this round funding could be well beyond their check size. They can find consolation in the fact that in Series C, it is costing a lot more to acquire a smaller % stake.
Initial Public Offering (IPO) (2020)
Scoot is making more money than their costs and they hope to reach cashflow break-even point soon too. They have a lot of enterprise customers and solid sales and support organization. However, there are a couple of new competitors in the market with complementary technologies. To better stabilize their position in the industry, Scoot wishes to acquire the competitors as well as expand to South America and Africa. Kareem and his team estimate that they need another $175 million to achieve this milestone. The company reached out to GMbank, a Wall Street based investment bank, seeking advice on going public. The bankers expressed confidence on Scoot's ability to file for listing successfully. After some deliberation among the bankers and the company officials, it has been decided that to introduce the company at a valuation of $325 million.
Since the price per share before IPO (obtained by dividing $325M valuation by 4.48M outstanding shares) is 72.55 (very high) and traditionally shares of lower prices get traded more, GMbank advises Scoot to split the share and keep the IPO price at $20. Splitting the shares here mean readjusting the number of outstanding shares by multiplying them by the split ratio (3.6275 in this case). For example, Kareem's 400K shares became 1.45M shares after splitting.
Flotation is just another name for IPO - the process of offering a company's shares for sale on the stock market for the first time. At the IPO, new shares are issued and sold to the public. The existing shareholders will not be allowed to sell or transfer their shares for next ~12 months (called lock-up period).
Throughout the life-cycle of Scoot, the size of pie keeps going bigger with the support from investors. At every subsequent round of capital raise, new investors take minority shares, reducing the the % holdings from the shareholders from the previous funding. But, since valuation increases, the returns on investment keeps increasing.
Return on Investment (ROI) for the Investors
As you can see RedTech, though invested only 5M$ in total, managed to pull off 10.1X ROI. Harlem Ventures, the late stage investor, got an ROI of 1.49X only. While RedTech may appear to be the biggest winner here, it did take the biggest risk. 9 out of 10 companies fail to reach IPO. With no real sales, early stage VCs such as RedTech are betting solely on the founders. As the company progresses through several rounds of funding, the chances of its success improve. Investors have to pay big to get a slice of the pie and that is what Harlem Ventures has done.
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This concludes the case study on Scoot. Obviously, the case is a highly simplified one, and a lot of small details are ignored. But I still hope, this article is useful in giving you some clarity on how venture deals are made. For more such pieces, please follow me on Twitter / LinkedIn.
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