Before reading this article, you can download the Excel version of the model from the link below:
All Entrepreneurs know that Venture Capitalists (VCs) want is two main things: (i) Return and (ii) Control. They want return because they have invested in a company that operates in one of the riskiest industries of the world and they want control to participate in the decision-making that may affect the future returns on their investments. What are the elements affecting their return on investment? How do these reflect to the valuation of the company after a series of investments?
Before contacting a VC (and you need to have a strategy even for that) you must make sure that you know what you need from them and if it is just capital, how much (a reasonable range) would you need and how would you allocate it (R&D and Marketing, or only R&D and then secure a marketing and distribution agreement with a large pharmaceutical company?). In brief, VCs want:
- Initial Ownership: Percentage of stock owned by VCs based on their initial investment.
- Dividend Provision: Future dividends model (no dividends, flat or cumulative?)
- Exit Strategy: M&A or IPO
- Liquidation Preferences: Return multiple (i.e. x times their initial investment)
- Type of Stock received: Usually investors required a convertible preferred stock. That is because, initially, they receive all their stock as preferred stock which means that in the case of bankruptcy the investors get paid first and then the rest of shareholders. This is a “shield” to make sure that in case their investment fails they will get back some money back. Therefore, convertible preferred stock reduces the overall risk of the investment. In case where their investment is successful, they have the right to convert all the preferred stock into common stock which can be sold to collect their investment returns.
- Participation: If the company is sold (or if the equity raised through an IPO) more than its post-money valuation (i.e. premium) then the VCs can “participate” in that premium too.
- Protective Covenants: usually a non-competition covenant is applied – an employee is not allowed to work for a competitor for a specified period of time.
- Board of Directors (BoD) Control: In order for VCs to have actual control on importance decisions made in the company they will certainly ask for board sits.
- Rights of First Refusal: Rights of first refusal allows the VCs to prevent dilution of ownership in case of additional series of investments from other VCs. Full rights of first refusal means that VCs will maintain exactly the same ownership until exit.
- Stock Repurchase Agreement: Restriction on stock repurchases from existing shareholders (mainly founders) to avoid concentration of shares in a single or very few shareholders.
Biostrategy Analytics Corp. is a biotechnology company that with its own funds and Angel investors has succeeded in bringing a drug from research to phase I and seeks VC funding for testing the drug in clinical trials. On average an early-stage biotech company needs needs € 60 mn. in total (nominal value) throughout the clinical development period (6 – 9 years). Due to the huge amount of investment required, the company plans to receive three series of investments: Series A, Series B and Series C.
Table 1 presents the Series A model of investment:
Highlighted in blue are the assumptions of the model, while in green are calculated values. Assuming the initial investment is € 10 mn. and the required ownership is 20%, this gives a post-money valuation of € 50 mn. and a pre-money valuation of € 40 mn. If there are 10 mn. outstanding shares then 2.5 mn. of convertible preferred stock resulting in 12.5 mn. of total shares. The price per share, assuming that all preferred stocks are converted to common stocks is:
Price (€) per Share: pre-money valuation / outstanding shares = € 40 mn. / 10 mn. = € 4
Since this is an investment in an early stage company the risk is very high and the VCs will ask for increased liquidation preferences (4x initial investment) and a participation of 40%. Therefore the required investment return (nominal, i.e. at exit) is:
Required Investment Return at Exit = (Liquidation Preferences)*(Initial Investment) + 40%*(Value at Exit – Post-money Valuation)
In Table 1, the required Investment Return is 4 x € 10 mn. = € 40 mn. (participation not taken into account since there is no exit yet at series A).
An additional assumption is that the conversion ratio (if the preferred stock is converted into common stock) will be 1 in all series of investments.
Table 2 below presents the valuation of the company assuming there are three series of investments: A, B and C. As it can be seen the valuation of the company changes depending on the ownership the investors require and the amount of investment dedicated by each VC. Outstanding shares are cumulative (initial shares + shares issued in each Series of investments).
Cells highlighted in red point to the factors that mostly affect the investment return to the VCs and what is left for the founders of the company. The post-money valuation of the company after series C has been estimated to be € 87.5 mn. It should be noted that full rights of first refusal have not been applied in this model.
In table 3, the ownership structure of the company (post-series C) is shown:
The majority of the company’s equity (69%) has passed into the hands of the VCs while only 31% has remained to the founders. In case where full rights of first refusal were applied the company would dilute further. In addition, summing up the investors’ required return gives € 170 mn. (€ 70 mn. + € 60 mn. + € 40 mn.) which is approximately 2 times the post-money valuation of the company. Therefore, only in case where the company raises equity (through an IPO or sold to another company) at least double of its post-money valuation the VCs will get the required return. Entrepreneurs will receive return only if the company raises equity or sold more than double its post-money valuation, and they will only have a 10% participation of that (see Table 4, click on the figure to see numbers more clearly). That is the only pure profit for the Entrepreneur.
In the IPO scenario it is assumed that the company raises € 200 mn. Together with participation, investors receive € 197 mn. and € 3 mn. are left for the entrepreneur. If the company raises € 3 mn. less, then the entrepreneur gets nothing.
In the M&A Scenario, it is assumed that the company is sold twice its post-money valuation. In that case the return for the entrepreneur is much lower, i.e. € 0.5 mn.
Assumptions and Limiting Factors of the Model
1) Time value of money has not been taken into account. This is mainly a static model rather than a dynamic one as it does not take into account the risk profile of the Company, how it changes and how it develops through times. It is rather a model examining the relationship between the value of the company and the investments to it at discrete time points (pre-money and post-money).
2) Full rights of first refusal were assumed non-existent.
3) All VC investments are assumed to be allocated for R&D, Personnel Costs and Other company operating or capital expenditures. Any potential net income is to be reinvested in the company.
In conclusion, every entrepreneur should know that when seeking investments, going the VC way it is like a long journey with many obstacles and when the destination is reached you might not be rewarded.