2021 was the year in which global Venture Capital deals crossed the $200 billion barrier for the first time, shattering the previous record of $158 billion, set in 2020.
The overall venture capital dollar volume is also growing.
This growth would be remarkable in ‘normal’ times but set against the backdrop of an ongoing global pandemic, they show that Venture Capital funding is now truly a mainstream form of financing, with a focus on an area of business - startups - that has earned a place in the public consciousness.
Despite its scale, there’s still not a great deal of understanding about how deals in this part of finance work.
What makes companies that often don’t make much money so valuable?
For example, in 2022, investors value Uber at $85 billion, despite posting losses of $149 million in 2021 (its most successful year to date).
Lots of companies looking for VC investments utilize FirmRoom data room to raise funds and in this article, we attempt to shed some light on what makes Venture Capital deal making tick.
How venture capital firms work
This article uses the terms ‘startup’ and ‘early stage company’ interchangeably, but it’s important to understand that most of the companies that Venture Capital firms work with are ‘early stage companies.’
This refers to companies whose business model has been clearly defined, its MVP (minimal viable product) is in place, it may already have secured some funding from friends and family, and is now looking for Venture Capital funding to commercialize the idea.
These companies approach Venture Capital firms with a pitch deck - usually a PowerPoint document of around 15 slides and precious little text - outlining their growth vision for the company.
Every pitch deck, without exception, has a ‘sources and uses’ slide, where the startup founder shows the Venture Capital firm what their money is required for, how it will be spent, and how it will contribute to their growth vision.
This is the basis of the deal terms.
Characteristics of firms being funded by venture capital
Before launching into typical deal terms offered by Venture Capital firms, a recap on some of the characteristics of startup companies is worthwhile. Understanding these is crucial before seeing how deals are structured.
- Low Revenue and Cash Flow: Almost all startups will have some sales to their name before approaching Venture Capital firms, to show that they have a market. Typically though, the sales (and it follows) cash flow will be very low - usually not enough to pay salaries (startup founders typically eschew salaries for a few years to show their commitment to the project).
- Little Track Record: Although a maturing Venture Capital scene means that there are now serial startup founders - giving Venture Capital firms some sense of a track record of competence - most startups are no more than a year or two old when looking for Venture Capital funding. There’s no way for investors to look through years and years of annual statements.
- Overly optimistic projections: Every startup founder thinks they’re going to change the world with their company. Venture Capital firms know this and factor it in, when looking at the projections, usually dividing the SOM (Serviceable Obtainable Market) calculated by the startup founder by a factor of 3 to 4.
- No established market: Unless the startup company is a ‘me too’ (one that copies others in the field while adding a few tweaks on price, geography or target market), there’s a good chance that the market will be hard to calculate. Take Airbnb as an example - it has 5.6 million listings on its site. But as a concept that had never been tried before, how would anyone have arrived at that number?
How to structure a venture capital deal
Now that we’ve got an overview of the kind of company that Venture Capital firms invest in, we arrive at the crux of the issue: How to structure venture capital deals.
At the heart of this is establishing a value for the startup. As mentioned in the previous section, startup founders have a naturally optimistic bent which sometimes leads them to extravagant valuations divorced from reality for their companies.
The business model of most Venture Capital firms is to invest in several different startups at once in the expectation that the stellar returns of one will more than compensate for the losses of the others.
Thus, the Venture Capital environment is volatile in terms of the returns generated by businesses, and the covenants in contracts should reflect this.
Venture Capital firms need to protect themselves on the downside and buy in as much of the upside as possible.
A typical deal structure goes something like the following:
1. The Venture Capital fund invests $5 million in exchange for 30% of preferred equity. The fact that this is preferred equity is important: It usually includes a number of the provisions that protect the VC firm on the downside in the short- and long-term.
- A liquidation preference that gives the VC firm absolute preference over common shareholders until their $5 million is returned (similar to how creditors receive preference).
- Disproportionate voting rights that enable the VC firm to direct the startup’s strategy. This could include everything from capital investments to decisions around later rounds of capital raising.
- Anti-dilution clauses (‘ratchets’) that ensure the equity share of the VC firm is not diluted, regardless of how later rounds of financing pan out.
2. There are also upside provisions that the Venture Capital firm will seek to benefit from should the startup achieve some of the success that it projects.
- An option to acquire a pre-agreed number of shares in the future at a pre-agreed price, enabling the Venture Capital firm to acquire more stock at a discount if the startup does well (even if other VC firms come along and offer much higher amounts for the equity).
- Assurances about the exit strategy - i.e.The VC firm will usually have a clause that determines when the startup has to liquidate its shares, through an industry sale, a sale to another VC firm, or an IPO.
Other provisions, common to all VC deals include the following:
- The Venture Capital firm will include the right to elect the majority of the directors to the startup’s board, enabling it to maintain control over management of its day-to-day management.
- Rights to access all of the startup’s internal documents, including (clearly) it’s financial statements, and documents relating to all of its transactions.
Those with experience in drafting regular share purchase agreements will see that there are large similarities between SPAs and the deal structures agreed with VCs.
The growth of this industry, both in the US and elsewhere, suggests that deal structures have matured to the extent that they now suit the entrepreneur and investor sides.
If your company is considering a VC investment, talk to FirmRoom about how our virtual data room software can ensure the process is frictionless for you.