venture capital

The Empire Strikes Back

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The second stage of the Cap Table Trilogy, The Empire Strikes Back (really no correlation to the Star Wars Trilogy, but I like Star Wars, so we’re sticking with it).  At this point, HotStartup has built an amazing product, we’ve figured out our business model, and we are starting to really scale.  $5.5mm has been invested by some great VCs and Seed investors.  Time for that Series B.

Series B

This is the time to get some real money.  We need bigger investors who are looking for the next three to five years, with some deep pockets.  The investors skill set at this point isn’t focused on business models and early stage operations, but truly has a grasp on how to scale, and scale fast.

Thinking about HotStartup, we MAY have generated a couple million dollars of revenue in the last twelve months, but we are likely somewhere around that $5mm to $10mm range.  In order to start really being interesting to a potential acquirer or to think about going public, we need to hit a minimum of $50mm.  Growing by 10x in 5 years means we need to grow 59% annually – that’s a LOT.  Big growth needs big dollars.

Valuation will also increase with this raise, and hopefully quite a bit.  Thinking about the multiples, if we were able to generate somewhere around $5mm, a pre-money valuation of $25mm (5x revenue) would be fair.  Including the $10mm ask, we would be at a $35mm post-money valuation (7x revenue), something that is within reason.  This raise represents a 28% sale of the equity, and will dilute all the prior investors (remember, we assume no participation from old investors in new rounds).

Series C and Series D

Here is where things start to reach more normal, reasonable multiples for business.  Things are based on the revenue of the business and the performance.  We get a lower premium based on our potential, and a larger premium based on our business.  Customers should be adopting the product, buying lots, and really NEEDING our product.  Without HotStartup, the Fortune 500 would fall apart.  We’ve spent $15.5mm on the product and are starting to scale at more than 50% annually.  Let’s step on the accelerator, throw gas on the fire and really blow this out of the water (generic business terms always make you sound sophisticated, and are never a bad choice).

We need some serious cash to invest in the sales and marketing department (S&M).  Research and development (R&D) are important, and should keep up with the innovation cycle in our business, but we already have a fully functioning product that is performing in the market.  We won’t spend less on innovation, but we likely aren’t growing the R&D budget at 100% annually anymore (every busines is different, so I wont say that all business slow down their spend on R&D, just making an assumption from my experience).  General and administrative (G&A) costs should start to be leveling out, as we should have a C-suite in place (or will have a C-suite in place post-Series C).  We either retained the founder as CEO, or brought in a serial entrepreneur that knows the space; the CTO is one of the founders and is leading the product and innovation; a CFO is helping manage the equity partners, board members, banks, financial planning, audits (you know, the fun stuff!); and the COO is making sure the place isn’t falling down, keeping the business partners in-line and making sure our amazing product is always delivered the way it should be.

We’re investing to grow the business.  Each dollar we invest will add to the growth of the business, and hopefully we can measure how this works.  In a recurring revenue model there are lots of great financial metrics we can use to measure our performance (ARPU, AMPU, CAC, CLTV, Churn, etc.), making it easy to understand why investing $20mm of cash into a business that is spending $5mm to $10mm a year is totally logical.  I promise venture investors are not dumb; there are always metrics that justify the investment.

So, what does this all mean for HotStartup?  Well, we are going to need to balance our cash needs a little more carefully now.  If we take a LOT of money in the Series C, we will be taking on dilution and cash at a time that we might be able to spend it as quickly as we would like.  If we wait to take cash, we might miss an opportunity to grow the business at the exponential rate we need and wont maximize the value of the business.  Here is where the financial expertise of a good CFO really matters, this is when we can start to really explore bank lines, venture debt, tranched equity raises, convertible equity notes, follow-on invetments, vendor financing, etc.  For the purpose of understand how to build a cap table, I’ve put together some assumptions around valuations and capital raises based on the PitchBook VC fundraising report from Q4 2013 (embedded below as well).  There are a TON of great insights in there regarding the valuations of business, investor rights, and standard terms.  I encourage everyone who ever thinks about raising money to look in there and see what the REAL industry averages are for potentially expensive investment terms (which we will cover in the next section).

After all of the capital raised, and all of the money invested into the business – we as founders would own ~26% of HotStartup.  That is really, really good.  As one of two co-founders with 80% of that amount, we would have 10.6% of the business, worth $16mm at a $152mm post-money valuation.  Not bad, but you know what’s really cool? A billion dollars (in my most sly JT as Sean Parker voice).

Seed through Series D Cap TablePitchBook_4Q2013_VC_Valuations_and_Trends_Report

Back to Basics

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Let’s start with how venture funds are set up, and where the money for venture investing comes from.  Venture investors usually raise money in the form of funds, often referred to as LP/GP funds (LP = Limited Partners, GP = General Partners).  Venture funds can range from $25 million up to more than $1 billion, and really there is no limit.

These venture funds raise their money from institutional investors.  Institutional investors are VERY large investors with lots of money (typically an institutional investor will have $250 million to $100 billion plus), think college endowments, public pensions, corporate funds, insurance companies, and high net worth individuals.  These intuitions are known as the LPs (limited partners) in the funds, because they invest their money, but make no direct decisions related to the actual investments.

The venture funds have a team of professionals, known as the GPs (general partners).  These professionals are the ones that will decide how to invest the millions of dollars raised, but not without some rules.

First, the venture funds don’t actually get all the money upfront, but the institutional investors hold on the money until a couple of days before the venture funds need it.  Each time a venture fund needs money, they issue a “capital call” to the institutional investors.  The venture fund is only allowed to issue capital calls for three to five years from the time they start investing money, which means the full amount of the fund (between $25 million and more than $1 billion, remember?) has to be completely invested in the first couple of years!

After three to five years, the next three to five years are known as the “harvest period”.  During this time the venture funds investments are hopefully growing from small companies to really big companies.  But there is no more money going in or out of the fund (kind of, there are other things happening, but for simplicity we will stick with this story).

At the end of the “harvest period”, the venture funds start the “liquidation” of the portfolio.  This results in the venture fund selling all of their businesses; through taking a company public or having another company buy their company (e.g. Google buying Nest Labs for $3.2 billion).   As they sell their business, they are hopefully making lots of money for the institutional investors and returning all of the money.  This whole process, from closing a fund through full liquidation takes 10 years to 12 years (the funds are structured where they are not ALLOWED to last longer than that often).

So, in about 500 words, there it is.  The entire system of venture funds and institutional investors made simple.  Get it?

I don’t get it…

Let’s try to make things make a little sense of these things through some real examples.  Let’s start with who invests in the venture funds and go from there.

Here’s a perfect example: Andreessen Horowitz (known as A16Z) is raising a new venture fund, on the larger size, of $1.5 billion.  Since this isn’t their first fund that means that they already have a bunch of intuitional investors, which have previously invested in A16Z’s funds.  Those investors (many of which are publicly known through a filing with the SEC called a Reg-D) include the Stanford University Endowment (an endowment, obviously), Bloomberg (a public company), and Accolade Partners (a fund-of-funds investor, think a really big private mutual fund).  Each institutional investor will pledge a portion of the full $1.5 billion A16Z is looking to raise.  Simple example, if Stanford commits $150 million (10% of the full fund), every time A16Z needs money, Stanford’s capital call will equal 10% of the total money being requested.

Once A16Z closes their fund, they will start to make investments in new companies.  Using an example from last month, A16Z invested $20 million in Teespring.  In order for A16Z to actually get the $20 million needed to invest in Teespring, they needed to issue a capital call to the institutional investors (such as Stanford, Bloomberg, etc.).  Those institutional investors sent money to A16Z in order for A16Z to invest in Teespring.  In our past example, Stanford would be responsible for sending $2 million to the Teespring investment (10% of the $20 million capital call).  For the next three to five years, A16Z will support Teespring and help Teespring grow, hopefully selling the business for lots of money.

Speaking of lots of money, A16Z is pretty good at making it.  Like back in October 2012, when they sold a company called Silver Tail Systems for $2.1 billion, after investing an estimated $22 million in June 2011.  When this happened, A16Z has to distribute that cash back to their institutional investors.  Because they invested about $20 million, and sold it for $2.1 billion, those investors are very happy.  Now A16Z didn’t necessarily make 10x their money (I’ll explain that later), but they definitely made a lot.  In our example, Stanford would receive their 10% of the total distributions!  Because those investors are very happy, they will invest in A16Z’s new fund today.

So, with a few examples, this is hopefully a little clearer as to who gives whom money, and why.  These basics apply really to all private equity and venture capital funds, and like anything in life, there are exceptions and special cases; but the vast majority of funds are set up this way.  We’ll get into some more interesting specifics soon, but I felt we needed baseline to start from.