VC Investment Process

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Ways of valuing a private business
1. Compare against similar companies that are on Stock market, 2. Calculate using required IRR from investment
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What ratio is used for comparing against other companies?
Price-Earnings ratio (P/E)
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How does P/E vary?
Industry size, Firm size, investor sentiment to company, management & prospects of company, timing of end-of-year results
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Why is unquoted P/E smaller than quoted?
Shares cannot be traded at ease, Shorter track record, Less experienced managers, Higher cost of monitoring investment
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Why could unquoted P/E be higher than quoted?
Higher than normal projected growth, Fashionable Sector, Competition for investment
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What is the IRR?
Annualised rate of return over the life of the investment based upon cashflows and valuations
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What does IRR take into account?
Capital redemptions, Capital gains upon exit, Income through fees and dividends
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What does the level of IRR depend on?
The level of risk, the stage of the company, the length of the investment, likely ease of realisation, competition for investment
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What are the basics of constructing a VC deal?
Management want as high as possible equity, Investors want the highest return possible, Banks want excellent security on loans
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Describe the Process of the deal
1. Identify the amount of finance required, 2. Define the amount of leverage to be used, 3. Find out the maxmimum the mgt team will commit, 4. VC will balance, 5. Find the Envy Ratio
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What is the Envy Ratio
The amount that the VC pays for its equity stake relative to the effective price mgt paid for their stake.
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Characteristics of Envy Ratio
Higher the ratio, more beneficial for mgt
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Describe process of VC arriving at their stake
1. Define investment required, 2. Forecast earnings of year ending of exit, 3. Discount P/E ratio, 4. Apply Discounted P/E ratio to earnings to get terminal value, 5. Discount terminal value to present day value, 6. Divide investment by PV.
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Type of Equity
Ordinary, Preference ordinary (A), Preference
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Characteristics of Ordinary Shares
Voting power, owned by mgt and family shareholders, last to receive income from profits
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Characteristics of Preference Shares
Can attach rights to shares (antidilution), First to receive income from profits after debtholders, Dividends not paid will be accumulated, Convertible to Ordinary shares, Popular with VC, Redeemable on agreed dates
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What tweaks can be made to VC deal?
Allowing dividends to be paid out to pref. shareholders, Introduce ratchets where equity held by mgt depends on performance, Introduce Stage finance - Finance depending on stage of business
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Why would tweaks need to be made?
Use if VC reluctantly accept a lower valuation than they wanted, tweaks would be made to many terms.
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What is a term sheet?
Letter of intent which outlines the framework of the final deal. It represents VC's preferred terms
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What is term sheet incorporated into when agreed?
Shareholders agreement, Memos & articles, Investor rights agreement
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Is the term sheet legally binding?
No, except for exclusivity, confidentiality and fees.
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Name 7 things on a Term Sheet
Valuation, Liquidation preferences, Vesting, Anti-dilution rights, Redemption rights, Lock-ups, Board composition
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Card 2

Front

What ratio is used for comparing against other companies?

Back

Price-Earnings ratio (P/E)

Card 3

Front

How does P/E vary?

Back

Preview of the front of card 3

Card 4

Front

Why is unquoted P/E smaller than quoted?

Back

Preview of the front of card 4

Card 5

Front

Why could unquoted P/E be higher than quoted?

Back

Preview of the front of card 5
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