Before a company initiates a fundraising process or contemplates a sale, it can be difficult to identify appropriate firms to target, structure diligence items internally, and adequately prepare for the inevitable investor Q&A.
In the first part of this series we will provide a general overview on venture capital (VC) and private equity (PE). Our ABCs of VC/PE series will continue on a quarterly basis throughout 2020.
The Lifecycle Basics
Private equity and venture capital are generally distinguished by the amount of capital and equity involved, as well as the lifecycle of a given company.
Private equity firms generally invest in more mature companies – some of them have criteria such as >15% EBIT margins and/or >$25M in revenue. Within private equity, some firms specialize in investing in assets of companies in distress and on the verge of bankruptcy. Others specialize in management buyouts, which typically involve a much higher mix of debt and leverage than in venture markets.
In the context of a sale process, a private equity firm is considered a “financial sponsor” whereas a “strategic buyer” generally refers to an acquirer in the same industry or business. In exchange for its capital and expertise, a financial sponsor expects to generate returns within a specific time frame and to exit the investment via another sale or an IPO. Occasionally, private equity firms pursue acquisitions for the purposes of a roll-up strategy or a tuck-in on behalf of an existing portfolio company.
A strategic buyer is typically motivated to horizontally or vertically expand, fulfill a capability gap, or defend its market positioning. Publicly traded companies would prefer to announce an accretive acquisition to shareholders, Private companies also have their own payback period and return requirements.
Venture capital firms tend to fund younger, rapidly growing companies in return for a minority stake. Venture capital generally refers to seed funding through Series C+ financings, where debt is limited and funds invest alongside management teams. Lead investors typically focus on owning 20% of the company in each round. VC portfolios are often constructed in such a way that no more than 10% of the fund is allocated to a given company, and ~1/3 of total investment is typically allocated at the point of entry with the remainder reserved for future rounds.
Within Venture Capital, an “early stage VC” is generally focused on seed through Series B financings and a later stage VC is generally focused on Series C and D rounds. As global dry powder has increased substantially over the past decade, venture capital, growth equity, and crossover firms have been moving up and downstream for opportunities. Thus, not every firm can be categorized as “early stage” or “late stage.” In fact, “growth equity” occasionally shares some of the same characteristics as lower middle market (LMM) private equity. Some growth equity firms also pursue majority equity positions.
VC portfolio construction can vary depending on the focus of the firm. For example, life sciences firms require larger amounts of capital to mature than SaaS-based technology (or even healthcare IT) companies. A technology venture fund may have 30 companies in its portfolio whereas a life sciences fund may only have 12.
Finally, a “crossover” round can be used to bridge the private and public equity markets. This pre-IPO strategy has become particularly popular in the life sciences space. Crossover financings typically involve institutional investors who are also active in public equities, such as Baillie Gifford and OrbiMed. Crossover investors include traditional mutual funds, hedge funds, family offices, and other asset management firms. These financings expand the company shareholder base and lend credibility in the public markets, while allowing institutional investors to participate at a lower valuation than the IPO valuation.
The constituents of any PE or VC firms are the Limited Partners (LPs) who have contributed capital to the fund in the fundraising process. LPs include endowments and foundations, pension funds, family offices, corporations, individuals, and other asset management firms.
LPs expect both PE and VC firms to deliver returns above public equity markets. For example, the require threshold might be 4% above the S&P 500 index; however, a VC or PE firm is only entitled to management fees and carried interest. The carry is typically 20% of the profits generated on an exit and the management fee of ~2% of committed capital covers salaries, leases, and all of the other firms’ expenses. Therefore, General Partners (GPs), or the investment professionals spearheading the funds’ investments, are generally targeting over a 2-3x return on invested capital or a 20% annualized rate of return as they may need to meet a 7-8% hurdle rate before the fund receives a profit.
VC Financing Progression
Venture Capital stages almost always begin with a seed stage and each subsequent financing is lettered alphabetically. The size of the financing progressively increases as the company’s growth progresses.
For example, a seed round typically ranges from $1M-$2.5M, with valuations typically falling in the $4M-$8M range, whereas the median Series C financing is ~$30M with a median pre-money valuation of ~$120M. Less than 1/3 of companies that raise a seed round ultimately reach a Series B, and less than 10% reach Series D stage.
As NEA has discussed in greater detail in “What size Series A round can you expect to raise?”, the most variation tends to occur at the Series A stage, with the median size increasing over time to ~$8M. For a Series B and beyond, companies are typically generating revenue, and according to NEA, “an entrepreneur can quickly grasp an expected round size by triangulating on (1) a new VC’s requirement to own 20% (2) his/her company’s next-twelve-month revenue projections and (3) valuation multiples for the company’s space.”
In order to efficiently deploy internal resources as a company prepares to reach out to VC firms, the stage of the venture capital firm and its investment strategy should be considered. Later in our series, we will discuss targeting tactics.
If you are looking for a team to support you as you prepare for a late-stage financing or an IPO, contact us today.
Caroline Paul, Principal