Anatomy of a Deal: How this VC got a 2x return the minute they signed the term sheet

November 13, 2014 Shareworks Marketing

You’d think that investing in a company right before an exit event would yield minimal returns, but this deal proves that you can engineer returns in any situation.

We get to see a lot of VC deals here at Shareworks Startup Edition. As you would expect, and based on our privacy policy, we guard our data very carefully. However, we can use illustrative data to make a point. Startup edition's tools can yield fascinating insights into the veiled world of some of the coolest venture capital deals on the planet. With this post, we would like to kick off a series of posts that we will label with the header “Anatomy of a Deal.” That way, you can look up these posts in the future if you are as fascinated by this stuff as we are.

One of the perpetual arguments in VC is where the best risk-adjusted returns are. Everybody knows that the best risk-adjusted returns probably shift around over time. VC itself was out of favor with large LPs prior to 3 years ago. We are now entering what could easily be a bit of an overheated early-stage VC market. We've always had a bias against VC investors who specialize in investing into a company right before the company exits (either via going public or via M&A). It seemed that, at that point, the opportunity for significant upside doesn’t really exist. If the company and its original investors know that it is likely to go public it would seem that most of the upside would get priced out of a deal like that. Then we came across a deal that looks like this, which is actually quite representative of deals at this stage (see graph below).

Before jumping into this graph, let's explain what is going on. This is a graph of the value that will flow to different security classes at various liquidity values (prices at the which the company might sell) from $0 to infinite value. The ratios that prevail in the last value of the graph will persist across whatever value occurs after that value all the way to infinite value. So basically this chart allows us to see exactly who would get paid how much in any conceivable exit for this company. The different layers represent security classes. So the top blue layer represents all common option holders, the next darker blue layer from the top represents all common shareholders, the third represents all Series B-1 shareholders, etc. After raising some early Series A and Series B capital, the company was performing quite well and thought that it was quite likely it would exit for about $1B. It had raised its last Series B round of capital about 2.5 years earlier at a post-money valuation of approximately $350M. Based on strong financial performance, the company raised a Series C round of approximately $60M, yielding a post-money valuation around $850M. Here is the graph again showing those two valuations:

The interesting thing is the returns profile of the most recent late-stage Series C investors, a well-known firm. In the graph below, I have shown the Series C return in more detail:

The amazing thing here is that this later-stage firm invested $60M and essentially getting a guaranteed 2x even if the company never increases value beyond its current valuation. It gets better, this investor gets a preferred return so it will receive the first money out of the company in any kind of an exit. This means that if the company sells for anywhere from $0-$60M (what the firm invested), it will basically keep all of that money. At values ranging from $60M to $350M, the firm will get only a slight return, but remember the company was valued at approximately $350M two years ago and has grown significantly since then. At values ranging from $350M to $850M (the current value of the company), the late-stage investor will receive between a 1x return and 2x return on its money.

So basically as soon as the later-stage VC signed the term sheet they locked in a 2x return on their money if the company just sells for what it was most recently valued. That is pretty amazing. Now, everybody knows that venture investing is risky and that companies valued at $850M now may go down in value over time. The financial performance of this company makes that highly unlikely. One gotcha in this analysis is that while the company certainly believes in a very bright future for this company, the most recent investors will get a great return even if the company doesn’t increase its value by $1.

We are rolling out a new service that we are calling internally “white-glove” equity management. Basically, we take over all of the equity management functions for your company (more on that later). One of the services we include is “sell-side” advisory services. Basically, contact us before you raise your next round so we can help model out the financial implications of your deal and help you find the right term sheet.


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