Joseph W. Bartlett
Herewith a Case Study of a transaction involving a Series A round of investment in Newco, Inc., a hip, emerging growth “gazelle” as David Birch liked to call U.S. companies running hard on the trip, as I put it, “from the embryo to the IPO.”
In our hypothetical, based on several real life transactions, a term sheet is presented to Newco by a top tier venture fund. The manager of the fund negotiating the investment (the “VC”), is an old hand with long experience in how deals are … or, better, were in the past … papered. VC’s fund is represented by an old line law firm, the partner in charge (“Old School”), like VC, having a wealth of experience in how business has been done customarily. The term sheet contains terms the venture fund has used umpteen times and, accordingly, the VC and Old School assume the terms are appropriate on the basis of that familiar pronouncement: “This is the way we have always done it.”
Newco is represented, on the other hand, by a younger lawyer (“Web 2.0”) who believes she sees the future of the law business … she ‘gets it.’ Newco’s CEO (“Geek”) is much like her, a techie who communicates electronically and surfs the net religiously for useful business information.
Given that Newco is, for example, only approaching cash flow break even and the projections assume the typical hockey stick curve, the VC deems it a waste of time to go through the valuation methodologies taught in business school; discounted cash flow, for example, does not work in the absence of reasonably predictable cash flow. Thus, the VC term sheet contains a pre-money valuation arrived at through intuition and a sense, drawn on VC anecdotal experience, of what other venture capitalists have been doing in the space.
The Geek argues that Newco’s prospects are so rosy the pre-money valuation should be elevated. The VC asserts that he is in the business and he just knows “market” valuation for companies like Newco, a statement which, were it translated, is: “We are professionals and you, on the other hand, have no principled basis for your value assertion. You must take our word for it.”
Then, it’s Web 2.0’s turn at bat. She starts by putting on the screen the data on valuations (pre- and post-) based on comparable transactions from VC Experts, specific to the most recent three calendar quarters, industry sector and region. She argues that information of this sort has to be the starting point for any discussion of pre- and post-money valuation. In 99 cases out of 100, she argues this is the best and most reliable hard information the parties can access. It is based on official government filings; it is up to date and comprehensive; it includes more data points than any other source. To be sure, once this material has been absorbed, the discussion is not closed. Markets can get it wrong; look at what happened recently in the public markets. But, there is no conceivable excuse for not accessing this data as a starting point on pre- and post-money calculations. The best minds in the accounting profession believe that value is best established by “marking to market.” The feature is the most trustworthy “market” data available; there is no justification, Web 2.0 contends, for ignoring it.
The parties go “jaw to jaw” for a bit but Web 2.0 wins the game by pointing out that venture pricing, from before she was born, is largely based on the herd mentality. What, the venture capitalist typically asks, is Greylock doing in this space? Sutter Hill? Bessemer? As the saying goes, 50 million Frenchmen can’t be wrong. Even VC has conceded that his valuation was based on the “market.” Accordingly, Web 2.0 says, here is the market … in black and white.
With the bit in her teeth, Web 2.0 then points out that the value of any security is driven not only by the ostensible and apparent price, but also by the deal terms. The discussion segues to the term sheet terms and VC and Old School repeat their argument: “These are the terms we always get.”
Web 2.0 responds, now leading off with the data on Series A Round Deal Terms from Fenwick & West surveys, available on the Fenwick web site as well as the VC Experts home page … and, indeed, augmented in the VC Experts data base. The data show the “market” cum “industry standard” incidence of various deal terms, collected quarter-by-quarter by VC Experts. The compelling aspect of this data source, she argues, is that it is a reliable guide if and to the extent the parties agree that the deal terms should be “industry standard.” She says, gleefully, that she routinely uses this tool to defuse the adrenalin of the hyper-competitive lawyers (without naming Old School). As Web 2.0 puts it, the room is typically filled with loud claims that:
“We always get this term.”
“Well, we never give it!”
“If the parties decide to diverge from the ‘industry standard,’” she goes on, “at least both sides should know what they are doing. In fact, VC Experts publishes a graph so that the parties can compute their proposed deal against a matrix which ranges from ‘investor friendly’ to ‘issuer friendly.’
She is challenged by Geek, who whispers to her. “What difference does all this make in the final analysis? Are you wasting time?”
She signals for a break and takes her client, Geek into another room. She shows him a 5 minute video illustrating the third tool … the portfolio company analysis tool Solium Scenarios developed by VC Experts and marketed by Solium Capital as Scenarios. It is a waterfall analysis designed to show Geek how deal terms presented will affect Geek’s stake in the company indexed against a ladder of potential events. She points out to him that there are eight significant deal terms in the term sheet which VC has presented. She advises Geek that,” as a matter of human nature, when we push back, we are only going to be able to persuade the other side to agree to our position on, say, three of those terms.” Then, Geek and Web 2.0 both access the Solium Scenarios chart which indicates which three of the eight will have the greatest impact on Newco’s outcome.
With this information under their belts, they rejoin VC and Old School and, initially, win two of the three points, helped in part by showing, yet again, that the VCs do not “always” get the terms in question; according to the data, the incidence varies between 25% to 55% of the deals depending on which of the three terms they are discussing.
With two but not three wins on his score card, Geek can quickly decide whether VC’s offer is worth it to Newco. He says, “No.” And he and Web 2.0 show, from the Solium Scenarios data, their opposite numbers why they think they need to win the third point. As luck would have it, the third point is conceded, in exchange for allowing VC to “win” the other five … which Geek understands, again from the Solium Scenarios tool, are unlikely to be critical. The deal is closed.
At the closing dinner, after a round of drinks, Geek asks the assembled lawyers, rhetorically: “How can you hold your head up as professionals in this field unless you at least review and evaluate the tools and data to which Web 2.0 has introduced us? Ignorance may be bliss; but ignorance cannot be defended in this context, when real money is changing hands and outcomes are affected by the choices made at the outset of the relationship. Q.E.D.”
Before leaving the issues presented by the Case Study, there is one postscript. VC and Web 2.0 take a limo home from the restaurant and the following dialogue occurs.
VC: “You know, old buddy, the times they are a changing.”
Old School: “That’s how you venture capitalists make money. Innovation! Destructive technology! I just didn’t know the animal spirits were invading the law business as well. Ah, for the good old days.”
VC: “Agreed, my friend. But, as they say, the train is leaving the station. We need to get on board so that when we bargain with the next company we want to invest in, I am prepared. We looked like ignorant dopes in the last negotiation.
Old School: “More than that, VC. These days you have to open the hood on portfolio valuations to your investors …”
VC: “Those jerks … but, yeah, ever since the ILPA, you’re right.”
Old School: “And let me mention a couple of other toxic items … 409A and Topic 820.”
VC: “You win. Call those wunderkinds at VC Experts in the morning. Sign us up.”