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One VC lesson a week

Recently, we have offered a special subscription of ONE lesson from our Venture Capital Executive Program delivered to your mailbox WEEKLY.

VC Academy community met this offer very warmly, and almost 1,500 people signed up for it within just one day! (4,000+ subscribers last time we checked)

What to expect from our ONE LESSON A WEEK subscription?

Engaging articles showcasing venture investment tools and practices including exclusive comments from the industry professionals.

Unique content to which you will not find equal substitute online. 

Most importantly, we explain complex concepts in a simple language making the knowledge accessible to anyone. 

See an excerpt from one of the lessons below.

Grab our special offer and subscribe to ONE LESSON A WEEK now!

We'll be offering this subscription for just $4.99/lesson ($19.96/month and $199/year).

However, first 100 subscribers receive our special offer of $9/month (4 lessons) on a monthly plan and $99/year if paid once. 

An excerpt from one of the lessons

Innovative equity-based approach to determining a startup valuation

Often referred to as private tech unicorns, most of the Silicon Valley darlings grant their common stock as part of their compensation package for their employees (regardless of the form — whether it’s restricted stock units, option stock or additional options). If you amongst the proud shareholders of a Unicorn, you definitely hope that the company’s valuation will grow over time — along with the value of the stock you hold — due to your team and personal efforts and contributions to its success. However, the bad news is that even if you achieve this success leading the company to an IPO or M&A, there is actually a chance that you will not benefit much from your share in the company, if you benefit at all.

Rather than utilizing common metrics for determining a valuation, such as users or revenue growth, professors at the University of British Columbia and Stanford University actually discovered an equity-based approach to calculate the fair value of private companies. They proved in the course of their research that different types and classes of company’s shares may be critically different in value. Unfortunately, this fact often remains ignored by founders and investors until it’s too late to deal with it appropriatelyNot only does it lead to a company being overvalued, but, even if it is acquired or goes public, it can also drop the value of the employees’ shares dramatically. They calculated, as examples, that the common stock of Solar City, Good Technology and Nutanix was was overvalued more than twicewhat their company valuations showed at their most recent private financing round (before IPO or M&A). Common stock holders of JustFab, which is still held privately, was in a bit better position at the last round in 2014, with their shares being overvalued at 192%. Furthermore, the owners of common stock of Box should have been much more aware of their stock being overvalued by a staggering 269% (This, eventually, did not go well for the employees!)   

Silicon Valley definitely doesn’t like drawing attention to such failures — when founders and employees are left with little to zero return, while the investors receive at least partial return for their investments. How does this happen, and more importantly, how can we stop it from occurring? 

Let’s take a moment to refresh our memories. Shares can be what is known as common (which are usually issued to founders, employees and early stage investors) or preferred (which are generally issued to investors in later rounds), where preferred owners possess special rights and preferences that protect them from losing their investment in its entirety if the company fails. Therefore, the more money an investor decides to invest in the company, the more protection they will typically request. If the investor in question feels as if the company is asking for too much, overvaluing itself, the investor can still agree to pay the requested price, or a price close to the original amount, but in exchange for the security of absolute bulletproof protection.

What can such protection be?

To begin with, regardless of whether the company fails or not, most investors want the exact amount of their original investment back at the exit (liquidation preference). Some investors actually want their funds returned with a premium, which can often be as high as 100%. If, due to the protection right of seniority, such an investor is set to be paid off before all of the other shareholders, then they will receive 200% of their investment back, and the leftovers — if any — will then be distributed among the remaining shareholders.

Can it get any worse? Sadly, yes, there are even more volatile circumstances. After the initial investment amount (with any additional premiums) is returned to the senior investor, this same investor may also request the right to participate in the distribution of the remaining proceeds as a common shareholder, along with others (participation), acquiring even a little more for additional pocket expenses. These protection rights are most relevant for an M&A scenario. Yet, even if a company decides to go public, later stage investors can make the decision to block the IPO, get additional share compensation or save their preferential rights in the instance that the IPO doesn’t provide an acceptable return.    

Now, when you read in the news that new investors decided to back your employer at a price per share that is significantly more than the price in the previous round, you can imagine what they are paying for. You can probably start to recognize this as the point where things begin to go wrong.

These shares will, in effect, guarantee investors certain rights that will not be guaranteed to other types and classes of shares. However, to publicly announce the most recent valuation of the company, all the shares of the company, including the common shares that will have no protection rights like those described in the paragraphs above, will be multiplied by the exact price paid by the most recent investors. This is exactly the situation in which most of the current private Unicorns instantly jumped to an over $1 billion valuation. However, you can clearly see now why this math is, in fact, incorrect.

Rather than explaining the deal algebra, let me provide you with two other real-life examples to help illustrate how these rights can adversely affect the true value of your employee stock.

Example #1

In the last financing round (in 2014) before its IPO (in 2015), Square was proclaimed a $6 billion Unicorn, but not without the following strings attached: the investors were guaranteed seniority to other shareholders, with a payout of $15.46 per share at the time of exit, and a 20% return at the IPO. When this news appeared on its employees’ smartphone screens, they rushed to multiply their shares by $15.46. However, as these investors received such guaranteed preferential rights, the above-mentioned professors calculated that the fair value of the common shares at that exact moment was, in reality, closer to merely $5.62 — overvalued by $175%!

Triggering the protection rights of the latest investors, Square went public at $9 per share with a pre-IPO value of only $2.66 billion and had to grant those investors $93 million worth of extra shares, which diluted all of the other shareholders. Surely you can easily see how common stock could drop in value after these two events. Just as recently as February of this year, the shares of the company finally hit the last financing round price of $15.46 per share. Those Square employees, who had purchased employee stock options at $9 strike price, couldn’t have earned much until just recently, and most likely lost the money being not patient enough to wait for more than a year.


Collective wisdom for raising your venture fund


What key challenges do venture capitalists face today?

Preqin released its survey of over 350 private equity firms globally to find out their views on the key challenges facing the industry.

Startup valuations remain the No. 1 concern facing venture capitalists, even in Europe and Asia, where valuations are noticeably lower than in the U.S. More than half of the surveyed investors believe that pricing for portfolio companies is higher than last year. As a result, many fund managers are raising much larger funds to get meaningful stakes when backing new startups and avoid dilution in the next rounds. We've talked about why this may be not a good idea in our previous newsletter.

What are the other important takeaways?

  • More than one-third of investors are planning for lower returns because of higher valuations in the market. Don't forget that venture capital indexes still underperform against or barely match the large-cap S&P 500 and the tech-heavy Nasdaq indexes over the 10-year period. Only 11% of fund managers are planning for increased returns. 
  • Thirty-nine percent of surveyed fund managers predict increased exit activity in 2018, compared to only 11% that expect activity to decline. Half of the surveyed investors expect more M&A deals to happen this year, and are split on the prospects for the IPO market. 
  • Alternative investment structures offered to LPs are growing in popularity. For example, 64% of surveyed fund managers offered co-investment option as of November 2017 (12% from 2015). They admit, however, that this structure slows down the deal-making process, requires additional expenses or resources, as well as creates some confusion due to possible different deal terms for co-investors.    

Advice from collective wisdom

  • Start raising your next fund early. Data shows that fund managers start pitching LPs for the next fund in 2.5 years from closing the current one.   
  • Be creative and offer alternative structures to sophisticated investors who are looking to maximize their returns and reduce costs of backing traditional venture funds.
  • Although LPs' appetites have increased, the competition for their money is still very high. When raising a venture fund, spend more time working with Asian investors - they are willing to invest in venture capital like never before. 
  • Work harder on creating additional value to your portfolio companies as competition for attractive investments has grown significantly. "Smart money" has to become "extraordinarily intelligent" nowadays. Third of surveyed fund managers reported they are finding it more difficult to find attractive investment opportunities.

Good news: Seed-investors for venture funds

Unlike the U.S. limited partners, international investors are willing to support emerging alternative fund managers and put their money where their mouth is.

RPMI Railpen (one of the UK's largest and longest established pension funds), along with the Alaska Permanent Fund Corporation (APFC) and The Public Institution for Social Security of Kuwait (PIFSS) have committed a combined total of USD700 million (with potential to grow) to Capital Constellation, a new vehicle that is designed to provide the group with an "unmatched access to the next generation of successful alternatives managers, enabling us to deliver long-term returns that will help us achieve our mission". 

The most promising managers will receive reliable and sustainable capital funding and strategic support, which will enable them to attract follow-on investment from other institutional investors.

This is how Julian Cripps, Managing Director of RPMI Railpen, explains their goal: “As a major global institutional investor, we are committed to using the size of our assets to invest wisely and influentially. We are not afraid to think innovatively and act boldly, as this initiative demonstrates.”

Good luck!

Add to your risk management check-list:

  • Those U.S. startups (and their investors) that hope to be acquired by foreign companies one day, need to keep in mind that the government may become a barrier likely disregarded or underestimated when planning exit strategies. Last week, the U.S. national security panel has blocked the $580-million sale of the U.S. semiconductor testing company Xcerra Corp (XCRA.O) to a Chinese state-backed investment fund. That comes after two other deals with the Chinese companies not approved by the U.S. government lately: money transfer company MoneyGram International Inc. (MGI.O) and chip maker Lattice Semiconductor Corp (LSCC.O). (Reuters)  
  • Since we are at it, Millennials impose another threat to companies, especially public. A couple of days ago, a celebrity Kylie Jenner wiped out ~$1.5 billion of Snap’s market value in just one tweet. We wouldn't be surprised if one or two traders had timely shorted the stock. (Bloomberg)

Bigger is not necessarily better: Larger venture funds don't really advance the industry


Where does the money go?

More and more venture firms raise new funds with total capital commitments of one billion US dollars and above. Only this week, two U.S. venture firms flexed their muscles by announcing newly raised funds. Battery Ventures raised $1.25 billion, and Norwest Venture Partners announced $1.5 billion just days later. Rumors about Sequoia Capital aiming to raise more than $5 billion for a single fund — an amount which would be the largest ever raised by a U.S. firm — have been circulating since December of last year. So where does all of this money go?

Indeed, the round size at every stage has increased over the last decade. We've also seen a historic high number of mega-rounds in 2017. Under these circumstances, some VCs explain that more capital helps them to avoid dilution and keep their pro rata share in companies.

Will larger funds be more successful?

One of the best performing venture funds, Benchmark, has preferred to keep their fund’s size around a humble half a billion dollars for the last decade. Bill Gurley, the general partner at Benchmark, believes that a “systematic swelling of money” will do nothing for the greater good, and that larger funds won’t necessarily achieve proportionately large returns. Mr. Gurley rebuffs the argument that more capital helps venture funds avoid dilution, calling it a “rationalization”, and maintains that a slow and steady approach has not hurt Benchmark’s performance (WSJ). Keep in mind, however, that Benchmark is primarily focused on early-stage startups, with a $1M - $15M preferred investment amount.

According to the MoneyTree report for 2017, early-stage investment activity has remained constant for the last five years. While average round size grows, the number of deals is stagnating, therefore, all these billions must be directed at something else.   

Some of the billion-size venture funds have a stage-agnostic investment focus, while others are raising this money for growth investments specifically. We have yet to see how all these billions will work out for later-stage funds.

How does this affect the industry?

First-time funds suffer from the trend of established venture firms raising larger funds. They raise less money — from $36 billion in 2016 to $26 billion in 2017 — and the number of funds dropped as well, from 283 in 2016 to 226 in 2017, according to a report in RealDeals.

This, however, doesn't upset the LPs. They are happy to invest in established managers who come back to market at a faster pace — just 2.5 years from closing a previous fund, and sometimes with new products — rather than taking the risk of investing in a first-time fund. Moreover, the number of investors reporting a veto on first-time funds also increased in 2017. All that is happening even though first-time funds continue to outperform established managers, showing on average consistently higher net IRRs, as Preqin reports.

As one LP told Chris Witkowsky, from PE Hub Wire: “You’ve got no incremental upside. If [first-time funds] do well, they’re going to do well like a Fund III, IV or V, but if they do bad[sic], there’s a lot more downside. The risk-reward doesn’t seem to be there.”

In other news

  • Peter Thiel is distancing himself from Silicon Valley, reportedly being "frustrated with what he sees as intolerance of conservatism in tech industry", according to sources familiar with his thinking. He's moving his family from San Francisco to Los Angeles, and contemplating his resignation from Facebook’s board of directors — a company he was the first investor to back in 2004 and whose board he has served on since that time (WSJ).
  • "Rather than having their capital cannon facing me, I'd rather have their capital cannon behind me, all right?" said Uber CEO Dara Khosrowshahi, confirming an open secret that during negotiations, SoftBank was willing to invest in Lyft if the Uber deal did not work out.

Recent Industry Reports And Studies:

2017-Q4 Silicon Valley Venture Capital Survey by Fenwick&West
2018 Coinbase Strategy Teardown by CB-Insights

2018 Fintech Trends 2018 by CBInsights
2017 Annual VC Liquidity Report by PitchBook & Deloitte

Webinar: How to get that job in Venture Capital?

At our 30-minutes webinar, you will learn how to stand-out among all other applicants for the job you want! 

What are venture capitalists looking for in new hires?
How to get noticed?
What should you bring to the table?

Our advice comes from the personal experience, so you won't find it on the Internet. There is no straight path to venture capital industry - we'll show you how you can climb in from the window and land your dream job! 

We know that thousands of people with different backgrounds and from different countries are willing to apply for a job in venture capital. That's why we designed the webinar in a way so that every group could benefit from the advice. Get your questions ready - we'll answer them too!