Introduction to Venture Capital Part 2
By: Chelsea Braithwaite, Brian Li, Jon Samuel, Wallis Toscarelli, and Cole Felsher
We already know the essence of a VC, but what are the deeper logistics of how they function? Here, we look at how VCs evaluate companies, partner with start-ups, and guide them through funding cycles before making an exit.
What are Capitalization Tables?
Capitalization tables are a spreadsheet or table that shows the equity capitalization of a company. They list out each type of equity ownership capital, the individual investors, and the share prices. Essentially, they are single documents that layout the valuation of the company and the breakdown into who owns how much. Cap tables are used mostly among start-ups and early-stage companies and are considered in the process of every financial decision that has an impact on the company’s market value. Cap tables need to be extremely organized, laid out in a simple manner, and constantly updated as the company evolves and grows through funding rounds, stock options, and terminating options.
One of the best ways to learn what makes up a cap table and how they work is to make one yourself! In creating a cap table, list the names of the security owners on the y-axis and the types of securities on the x-axis. Owners can be listed by founders first, followed by executives, key employees, etc., or by descending ownership. Each row will contain the single holdings of one investor. Look at other cap table examples to see how you compare and to learn about what you missed! Below is a basic idea of how it should look.
What are Term Sheets?
Term sheets are essentially a paper handshake. They are non-binding agreements that lay out the basic terms and conditions of the partnership between a start-up and a VC firm. Term sheets are how VCs express that they have done their due diligence and are committed to invest in and aid the start-up. More detailed, binding documents follow later on. Some key sections include valuation, the amount being offered, shares and prices, voting rights and board seats, founder obligations, and NDAs. An example of a term sheet is shown below.
What are Funding Cycles?
Start-ups cannot function or continue growth without funding, thus they raise capital through funding cycles. As one of our e-board members and partners, Jonathon Samuel, puts it, “the bigger the plane, the more runway needed. The same goes for VC firms.” In order to raise capital, start-ups need to have a good concept with traction, among other factors and be able to present it well to investors. Companies could figure out the cure for cancer, but if they cannot relay it well and prove its viability to potential investors it’s useless and the company will likely fail. Below is a schematic showing the failure rate of start-ups.
VC firms take on a lot of risk when investing in start-ups, but they gain profit from both the product and the people. In return, the start-ups gain aid in strategy, valuation, and other areas. The VC wants to ensure that the start-up is thriving until the next funding round.
The funding round process starts from a humble beginning. This can be from the founder’s personal savings, crowd-funding, or other areas. This is referred to as “pre-seeding”. After the pre-seed round, the VC enters the picture. This is called the “seed” level and is when a company has a good concept and a stable base for future growth. This can range anywhere from $10k-$2M. After the seed level, companies raise capital through more formal rounds called Series A, B, C, etc. These stages are the most commonly pursued and is where the company really starts to take off, turning low valuations into multi-million and multi-billion dollar franchises.
What are Exit Strategies?
VCs need to have a backup plan to keep their best interest in mind in case the start-up fails, as most do. VCs want to maximize their investment so they create exit strategies to generate some return. However, exits do not cease the VC's involvement in the company. Management may still sit on the board or be required to work with the company for the near future. Exit plans are discussed and laid out in advance when the company and the VC first enter the agreement to partner. Below is a graph showing the value of exits over the last few years.
Exit plans can be implemented for a number of reasons whether it be personal health, economic recessions, unexpected buyout offers, or when predetermined goals have been met. The potential exit plans that are laid out at the beginning of the agreement can also evolve and change if better options emerge. VCs need to plan for both positive and negative exit plans. Rarely do start-ups succeed, so it is better to be prepared for the worst. The VC cycle is laid out below.
There are various types of exit strategies including mergers and acquisitions, IPOs, and management buyouts. Mergers and acquisitions are the most common types of exits and are when bigger companies buy smaller companies and start-ups. This is a good exit plan when the start-up has original and advanced technology that is useful to bigger companies. If the VC has financial backups they can endure the risk. IPO, or initial public offering, is a rarer type of exit where the company goes public in an attempt to raise money. This gives the VC and other investors a return. Management buyouts occur when the company’s management purchase all of the company’s assets back from the VC. This exit strategy is about liquidating the shares because there is a large barrier of entry. There are other exit strategies, however, these three are the main modes of action.
