Saturday Nov 18, 8:00 AM Passano lobby at Johns Hopkins Carey Business School was filled with hustle-bustle of participants ready to test their mettle at Venture Capital Investment Competition (VCIC) hosted by PEVC club. Each team was given the 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.
Day started with breakfast followed by introduction of panel of judges followed by formal pitch of all the participating startups. We were grateful to have highly skilled judges namely: Ken Malone, Tricia Ratliff, Jonathan Bradley, Edwin Warfield, Ali Afshar, and Prof. Jim Liew, and startups which decided to be a part of the competition.
Below is the list of participating start-ups:
- Cubix Health Technologies: A 3D-Xray generator firm based on machine learning and artificial intelligence to better predict lung cancer in humans. Yash Prajapati was representing the firm.
- Nearby Medic: A mobile app seeks to remedy healthcare access and delivery across the globe. Represented by a young energetic founder Azraf Ullah.
- Ridevert: A bike advertisement company, wanting to change how consumers think about passive income. Represented by Carey Business School alumni Obinna Ohakawa
- RoomShare: A hotel room sharing marketplace that targets millennial travelers and allows them to share a hotel room with like-minded people. Represented by serial entrepreneur Kash Rehman.
- SmartBridge: An app committed to give users access to world’s top oncologist to improve health outcomes for cancer patients. Represented by Hua Wang – former lawyer and healthcare strategy consultant.
- Asulon Therapeutics: A pharma company that focuses on the development of novel molecules for the rapid treatment of mood disorders. Represented by Adam Van Dyke – a PhD student in Neuroscience at University of Maryland, Baltimore.
Participants were given a $100 million fund to structure a deal for any one of the above six startups they deemed a good investment. 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. I’ll try to explain them one-by-one:
- Pre-money Valuation: It is the valuation of company before the VC firms decides to invest in it. This is typically the most analytical and quantitative challenging part, especially for lot of technology companies, which are different than regular brick-and-mortar companies. I’ll do another post (part-2) explaining in detail how we come up with the pre-valuation of Ridevert – the company our team categorically selected to invest in.
- Team’s Investment: This is the actual dollar amount VC firm would invest in the company for a certain % of equity in the firm. This can either be made as a convertible debt or direct equity stock deal. A convertible note is a security that is a hybrid of both 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, meaning 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 prevent their stake in the company and when company does increase in value they can convert the notes to much lesser equity than they would have in the earlier round of funding.
- Syndicate Funding: This type of funding allows investors (backers) to co-invest with relevant and reputable investors (leaders) with expertise in selecting best startups in the market and structuring a deal. So, essentially syndicate funding is a win-win for both backers and leaders. Leaders get access to more funds, and backers get to avoid the hassle and know-how of structuring a deal. Additionally, since backers and leaders are investing in same startup it aligns the interest of both parties and increase the returns for both, if startup performs well.
- Post-money Valuation: Simply put, post money valuation is sum of above 3 points. Arithmetically, Post-money valuation = Pre-money valuation + Team’s investment + Syndicate Funding. The key point to remember here is: the % of equity owned by a VC firm is always calculated by post-money valuation as opposed to pre-money valuation.
- Options Pool: Share of stock reserved for employees is referred as Options Pool. It is a desirable feature of deal because in early stage startups big part of employee compensation drives from the shares in firm. In addition, since for lot of C-suite employees it is tied with company’s fortune, it motivates them to put in those extra hours required to bootstrap a startup.
- Board Structure: As most of readers may know board structure of any firm is critical in its decision making. At times, for strategic purposes, it is important for VCs to have more seats on the board than equity. So, typically VCs decides to give away some part of equity in lieu of an extra seat on the board. Seat on the board helps in guiding company’s direction in the long run.
- Closing Conditions: It caters to typical due diligence about the startup, which includes venture capital investor to perform an investigation of the company’s financial and legal affairs. It also sets forth 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: This clause determines which parties get what payout, if 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” i.e. in case of liquidation investors will get five times their money back before any other shareholder do. For example, let’s assume VC decided to invest $1 million in a startup with pre-money valuation of $3 million and liquidation clause at the time of signing the term sheet was “1.5x”. Now, if for some reason company decides to liquidate its assets today VC firm would get $1.5 M back and other stakeholders including founders will be left with only $2.5 M.
- Dividends: Dividends are considered a fixed source of income for private equity firms. It is very similar to dividends investors get in a public company. However, for startups sometimes it’s not possible to maintain the level of free cash flow required to give dividends to stakeholders. Since nowadays debt is cheap, some companies resorts to debt in order to pay fix dividends to their investors. It is also known as dividend recapitalization.
- Anti-dilution: This clause helps protect investors in the case of a “down-round” – a capital raise that happens at a valuation lower than the one in which you purchased your share. For instance, suppose you invested $1 M in a firm with a pre-money valuation of $9 M, 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 M. Clearly, this means dilution of your investment from $1 M to $400 K. In general, anti-dilution clause could be of following three types:
- Full-ratchet: This type of anti-dilution is highly skewed towards investor’s interest. If the term sheet included full-ratchet anti-dilution clause in the previous example, it would mean that instead of $400K investor’s value would remain $1 M, giving him much more equity than earlier, and in-turn, significantly diluting the founder and other investors share.
- Half-ratchet: As the name suggests half-ratchet clause ensures VC investment doesn’t goes below its 50% value. So, in above example, company would maintain $500K worth share instead of $400K, giving it shield against significant drop in the value.
- Weighted average: This essentially means the value of your 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 M investment at a six and a half million dollar pre-money value (average of 9+4=$13 M) i.e. your investment is worth $650 K instead of $400 K without anti-dilution clause.
11. Other Key Clauses: Other clause include things such as “No Shop” agreement, conditions for the usage of capital, etc. 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 was an immense learning in itself. In the end, everybody gathered for a happy hour at Mussels Bar !
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